August 2018

Weekly Commentary August 17, 2018

What Role Should Gold Play in a Portfolio?
By Tim Courtney, Chief Investment Officer

Advertisements have touted gold as an infallible investment – one that maintains its value and consistently hedges against market risks. Gold certainly may be a fit in portfolios, but it’s no panacea.

To shed some light on some of the claims made about gold, Exencial periodically reviews gold and its role within the market. Based on the results of our research, we believe there are two main forces that influence the behavior of gold prices: fear and inflation.

The first force, fear, tends to play a big role in the short-term pricing of gold. When uncertainty and fear rise among investors, gold generally performs better¹. For example, we had two significant market pullbacks in the 2000s, and gold performed well during both². In fact, our study revealed that gold was positive during all of the last seven recessions spanning from the 1960s through 2009 (albeit sometimes as little as 1 percent, but other times as much as 200 percent)³. Fear and greater market uncertainty drive the price movement of gold in the near term.

The second force, inflation, acts over the very long term – the operative word being very. Gold has tended to track inflation fairly well if you look over periods of 50, 100 or hundreds of years⁴. As such, it can serve as a good store of value and hedge against inflation and currency devaluation over longer periods of time.

But because fear and uncertainty (and to some degree, factors such as production cost) are also moving prices, gold can significantly decouple from inflation in the near-term only to be pulled back into line with inflation over the longer-term. This means that gold prices can far outperform inflation for a while but subsequently go many years underperforming inflation as it falls back closer to its trend. During those years, it is not an effective hedge against inflation at all.

We saw this in the 1970s when gold increased over 1,300 percent² driven by: stagflation⁵, a recession between 1973 and 1975,⁶ and an oil embargo⁷. These factors converged to build a lot of fear among investors and push up the short-term price of gold. But as inflation began to recede in the 1980s and the economy started to recover, the gold fever began to fade. As a result, gold had a negative return,² throughout the 1980s as the U.S. was experiencing lower, but still meaningful, inflation.

Similarly, from 2000 through 2009⁸ we experienced two recessions, two major market pullbacks and a gold price surge. But we’re now in a period where gold’s shine is fading and its return has been negative between 2013 and 2018², while inflation has still been positive at about 2 percent⁹ annually. Additionally, Exencial’s study revealed the price volatility of gold over this time period was higher than that of stocks, and about four times as high as bonds³. This signifies that gold is anything but a stable asset.

For these reasons, we believe there are better options in today’s market for investors hoping to shield their portfolios against uncertainty and inflation risk.

Bonds, for example, have many of the same positive attributes of gold, but with only about a quarter of the volatility, as discussed above. During times of recession, 5-Year Treasurys have been more reliably positive than gold¹⁰, and according to our study, outperformed gold in four of the last seven recessions³. Treasury inflation protected securities (TIPS)¹¹ can also be useful in hedging an unexpected jump in inflation.

In addition, we believe real estate or a diversified basket of commodities – that includes gold, but also assets that can be utilized such as food, base metals and energy – can be a better hedge against inflation. These products and goods drive inflation itself so their prices tend to be more correlated to inflation than gold¹².

Gold can certainly have a place in a portfolio but because of its price behavior and expected return (inflation), we believe it should be used sparingly. It is not a foolproof hedge against macro risks and there are other hedges available to investors that we feel are likely better fits over time.

Sources:
1 Reuters- Why do people turn to gold as a safe haven asset?
2 MacroTrends- Gold prices – 100 year historical chart
3 Exencial study on gold based on data from DFA Returns, St. Louis Fed, National Bureau of Economic Research
4 The Balance – Gold price history from 30 B.C. to today
5 Investopedia – Stagflation, 1970s style
6 National Bureau of Economic Research – The recession and recovery of 1973-1976
7 The Balance – OPEC Oil embargo, its causes, and the effects of the crisis
8 Yahoo! Finance – S&P 500
9 US inflation calculator – Current US inflation rates: 2008-2018
10 MarketWatch – U.S. 5 Year Treasury note
11 Investopedia – Treasury inflation protected securities – TIPS
12 DFA Returns, Gold, Bloomberg Commodity Index

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