Gold: still marching 400 years later

Gold has fallen out of fashion over the past five years, but SMSF investors might be advised to reconsider its place in their portfolios due to late-cycle concerns and heightened geopolitical risk.

The Dow has been at record highs, spurred in part by United States President Donald Trump’s extraordinary tax cuts and the response of central banks to the 2008 financial crisis. In a low interest rate environment, bonds have been watertight, with US junk bond yields at all-time lows. In such a benign investment environment, stocks almost everywhere provided double-digit returns in 2017. And gold – historically the safe-haven asset during dark times – looked irrelevant.

Sliding into the end of 2018, however, the battlefield looks quite different. Financial repression is ending as the US Federal Reserve raises interest rates. Volatility is on the rise again thanks to heightening geopolitical risk. This all shows up in performance.

This year, global equity markets have hit bear territory. In 2018, Chinese stocks, as measured by the CSI 300, have fallen 20 per cent. Britain’s FTSE 100 is down 8 per cent. Australia, for its part, has fallen too with the ASX 200 down 6 per cent for the year. While the US equity market appeared to be defying gravity, it too is starting to trade sideways, with the S&P 500 up a mere 1 per cent this year.

With the Fed set to raise rates even further and political uncertainty set to come to Australia, SMSFs may start wondering: is it time again to consider gold?

Gold is often said to be the safe-haven asset – and with significant justification. This is because gold has provided a constant and reliable store of value more than any other asset.

Several studies bear this out. In a sweeping review of every major US asset class, Jeremy Siegel, the professor of finance at the University of Pennsylvania, found gold provided investors with a real return (inflation adjusted) of 0.5 per cent from 1802 to 2016. Crucially, he found gold outperformed cash during that period as cash delivered a negative real return of -1.4 per cent. The divergence between gold and cash became pronounced at the end of the gold standard.

Winding back the clock even further, Professor Roy Jastram, in his seminal book, The Golden Constant, found gold had held its purchasing power for 400 years, from 1560 to 1977. Throughout this time, however, many state-backed currencies (that is, cash) had come and gone.

Moving on from performance, gold is a powerful diversification tool. Gold is one of the few asset classes known to perform in a bear market. This gives gold the rare quality of low to non-correlation with stocks and bonds.

Gold, as mentioned earlier, has no fundamentals: it has no dividends, yield or cash flows. For some investors, this counts as a weakness. Yet the lack of fundamentals can also be a strength.

Because gold does not produce cash flows, it does not fit neatly into financial models and cannot be valued in line with income-producing assets.

As Michael Batnick, the director of research at Ritholtz Wealth Management, notes: “The fact that gold moves on god knows what is precisely what makes it a very effective diversifier.”

And diversify gold does. As changes in the gold price rarely move in tandem with stocks and bonds, gold can reduce drawdowns and reduce risk in investors’ portfolios. This is most famously true in the US, where gold negatively or non-correlates with every pocket of the US equity market.

But we see something similar closer to home. If we look at the ASX 200 over the past 10 years, again we see gold has provided something of a hedge. Something similar can be said for Australian real estate, which typically correlates with the ASX 200 – but does not typically correlate with gold.

Gold’s refusal to correlate with other asset classes can work magic on portfolios, where even a small allocation leaves performance and terminal value more or less the same, while crucially lowering risk. While this is certainly true of data based on the US market experience, which can be back-tested more reliably and over a longer time period, several studies have found gold provides very similar benefits in Australia.

The past five years have witnessed one of the biggest ever bull runs on Wall Street, which has left some investors forgetting how important risk management can be. Yet as the bull run begins to wind down, investors may want to consider the benefits gold can provide when the good times no longer roll.

Kris Walesby is head of ETF Securities Australia.

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