Stockholm (HedgeNordic) – The role of gold in an investment portfolio as a diversifier or a hedge has been debated thoroughly over many years and decades. And yet, there is still no consensus on what role the yellow metal truly plays in a portfolio. Gold’s role as a hedge or diversifier may really depend on the risk one is trying to protect against.
Ned Naylor-Leyland, the Head of Strategy, Gold & Silver, at Jupiter Asset Management, argues that gold, above all else, serves as protection against the loss of purchasing power – reflected in real interest rates – rather than against inflation per se. “Gold is the risk-free instrument in the system, not treasuries,” asserts Naylor-Leyland. When real yields – the nominal yield on a security after accounting for inflation – turn lower or even negative, money will flow into the yellow metal to preserve purchasing power. “Bear in mind that gold does not go up or down at all. Gold is just gold.”
“Gold is the risk-free instrument in the system, not treasuries.”
Eric Strand, the founder of precious metals-focused AuAg Funds, corroborates Naylor-Leyland’s “Gold is just gold” statement. “We like to see gold as the constant and then measure the currencies in gold,” says Strand. “The Euro, the world’s second-largest currency, has lost over 83 percent of its value measured in gold since its inception back in 1999.” Anna Svahn, the founder of Antiloop Hedge and a long-time advocate for having gold as a dynamic part of one’s portfolio, brings the US Dollar to the same discussion.
“We like to see gold as the constant and then measure the currencies in gold.”
“This year marks the 50th year anniversary since the U.S. was the last country to abandon the gold standard,” says Svahn. “Since then, the US Dollar has lost almost 84 percent of its purchasing power and for some reason, it is widely accepted that gold has never outperformed the stock market,” she continues. “That is not true. Gold has on average returned 10.51 percent every year since 1971, while S&P 500 annual average return was 9.16 percent.” Strand has similar observations, saying that “over the past 50 years, since the price of gold was set free, the average annual return for gold has been 11 percent in US Dollars.” In years when inflation was higher than three percent, the price of gold increased 15 percent per year on average.
Driven by Real Interest Rate Expectations
According to Naylor-Leyland of Jupiter Asset Management, monetary metals such as gold and silver are driven by changes in real interest rate expectations. “The bond market creates price discovery for the metals through real interest rates,” says Naylor-Leyland. Eric Strand follows the same line of thought. “Real rates are already negative and will just go ever more into negative territory, which of course, is an environment where gold thrives,” explains Strand. “The central banks are growing their balance sheets and will continue to be behind the curve as they are raising rates slower than the inflation rises. The macro cocktail does not really become brighter as so many countries and companies have ballooned their balance sheets with debt, reaching unprecedented levels.”
“Real rates are already negative and will just go ever more into negative territory, which of course, is an environment where gold thrives.”
At the moment, gold and silver are priced off three observations in the real interest rate world, according to Naylor-Leyland. “First, market participants are assuming inflation is transitory,” starts the fund manager. “Second, we are assuming that central bank tapering is coming in November, it will be the size that we expect and it will not be withdrawn,” he continues. “Third, we are getting rate hikes starting next year. That is what is priced in. I would say though that it is much more likely that all three are wrong than all three are right,” says Naylor-Leyland. “Only one of the three observations needs to be wrong for gold and silver to be going way higher,” he adds. “But I do think it is very likely all three of those assumptions are wrong.”
“Gold is a long-term hedge against inflation, against the loss of purchasing power. This, however, does not mean that gold, or any other asset, works as perfect day-to-day, or even a quarter-to-quarter hedge against money printing.”
“Gold is a long-term hedge against inflation, against the loss of purchasing power,” agrees Anna Svahn. “Since the United States left the gold standard, the gold price has gone up on average as much as the Federal Reserve has expanded the monetary base every year,” she continues. “This, however, does not mean that gold, or any other asset, works as perfect day-to-day, or even a quarter-to-quarter hedge against money printing.”
Other Diversification Benefits
“Gold is diversification that works,” asserts Eric Strand. “Many assets become increasingly correlated as market uncertainty rises and volatility is more pronounced, driven in part by risk-on/risk-off investment decisions,” he elaborates. “During the great financial crisis, equities and other risk assets tumbled in value, as did hedge funds, real estate and most commodities. Gold, however, increased in price, rising 21 percent in USDollars from December 2007 to February 2009. And in the most recent sharp equity market pullbacks of 2018 and 2020, gold performance remained positive.”
“With few exceptions, gold has been particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses.”
“With few exceptions, gold has been particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses,” points out Strand. The gold market’s average daily trading volume is almost equal to the volume of all the companies on the S&P 500 together. Therefore, the very liquid gold market offers an additional great property, allowing investors to meet liabilities when less liquid assets in their portfolio are difficult to sell or possibly mispriced,” he emphasizes. “Gold’s favorablee low correlation properties do not just work for investors during periods of turmoil. It can also deliver a positive correlation with equities and other risk assets in positive markets, making gold a very efficient hedge.”
Gold’s role as a diversifier does really depend on the risk one is trying to protect against. For Anna Svahn, in addition to acting as a hedge against the loss of purchasing power, gold also acts as a diversifier for a stock portfolio. “To appreciate the case for gold, one must understand the reason for owning a yellow pet rock in the first place,” begins Anna Svahn. “Although many economists call gold a “safe haven,” it’s not the real reason to own gold,” she emphasizes. “Even if the gold price tends to rise short term during times of uncertainty, it almost always falls back to the same levels shortly after. Meaning buying gold on one of those price spikes is usually not a profitable affair in the short run.”
“The main reason, however, to why you should want to hold at least some gold, is to be able to sell when the stock market is plummeting so that you can buy equities at a lower price, as gold tends to be contra cyclical to stocks over time.”
“The main reason, however, to why you should want to hold at least some gold, is to be able to sell when the stock market is plummeting so that you can buy equities at a lower price, as gold tends to be contra cyclical to stocks over time,” argues Svahn. “The long-term focus in a portfolio should always be to find ways to maximize the amount of producing assets. Owning assets with low correlation to stocks can help you achieve that.”
Gold – the Money of the Future
“For thousands of years, gold has played an important role as money – a medium of exchange, store of value, and a unit of account,” says Anna Svahn. “When we introduced “paper money,” backed only by trust in a centralized entity, with the promise of keeping the value stable, gold lost parts of this original role,” she explains. “In 50 years of unbacked paper money, central banks have proved that the one thing they are capable of, is in fact not to maintain the value of the currency, but to devalue it to almost nothing while keeping its users in the dark.”
“For thousands of years, gold has played an important role as money – a medium of exchange, store of value, and a unit of account.”
However, gold will likely have a different and more important role in the future monetary system than today. “The assumption that we will be continually bailed out with fresh credit money is a powerful negative on fiat currencies right here,” argues Ned Naylor-Leyland. “But bear in mind, central banks have large gold reserves, so they know full well there is no problem for them,” he continues. “All central bankers who ever lived have been gold bugs.”
“Central banks have been big buyers of gold since the great financial crisis, and they know how important gold will be in the future.”
“Central banks have been big buyers of gold since the great financial crisis, and they know how important gold will be in the future,” agrees Eric Strand. “Fiat currencies are based on trust and backed by “the right of every state to tax its citizens indefinitely.” History tells us a lot about fiat currencies, just watching the Roman and other great Empires rise and fall,” he elaborates. All this history repeating itself over the centuries led to Voltaire’s famous quote – “Fiat currency always eventually returns to its intrinsic value – zero,” according to Strand. “Gold[Au] is the only currency, along with Silver[Ag], that does not require a counterparty signature. No one refuses gold as payment to discharge an obligation, while credit instruments and fiat currency depend on a counterparty’s creditworthiness.”
This article featured in HedgeNordic’s “Diversification” publication.
