There’s no asset that elicits more emotional reactions than gold, so I really shouldn’t have ruled out its role in a modern investment portfolio with a simple throwaway line in a recent column.
I pointed out that gold had been a desperate hedge last month and warned that it would likely continue to move in the same direction as stocks, rendering it ineffective as a way to protect against price losses in actions.
As several readers have said, the full story needs more than just a line. Gold’s role as a hedge depends on the risk you are trying to protect yourself against and it has its uses. Metal has been the last word in state collapse insurance for millennia, being almost universally tradable and easy to hide or transport across borders. A wealthy family can reasonably hold a small portion of their physical gold wallet abroad and know that they will be able to flee and start their lives elsewhere, albeit very small, if the company collapses.
But gold is not a good replacement for Treasuries in a standard 60% equity and 40% bond portfolio. When stocks fall, investors want a diversifier that increases in value to cushion the loss. But gold fell alongside stocks during the market panic in March and again last month, and may continue to move with stocks for some time. This does not make it a bad investment in and of itself, and the magnitude of the loss (and gain) will be different from that of stocks, but it is of little additional use to investors looking for an investment. alternative to bonds in their portfolios.
We are in an environment where stocks love inflation and gold loves inflation. The outlook for inflation is closely tied to the economy, with a stronger economy (possibly due to a stimulus deal) meaning more inflation and vice versa. An improving economy should help stock prices, so stocks rise with gold. A deteriorating economy would mean less inflation, so stocks fall, just like gold.
In the past, gold has sometimes been a better hedge against stocks. To understand why this sometimes works, and others not, we need to consider the main factors in the price of gold.
These include real rates, best illustrated by Inflation-Protected Treasury Securities, or TIPS, whose yields already take inflation into account. Like TIPS, gold tends to rise when real yields fall and fall when real yields rise – and gold peaked this year on August 6, when 10-year TIPS yields hit a new low. .
With the Federal Reserve committed to keeping interest rates at zero for the foreseeable future, higher inflation would translate into lower real rates and TIPS yields, which would help gold. But higher inflation also suggests a stronger economy, helping stocks.
It’s different from the summer of 2011. At the time, stocks were suffering as Congress was fighting for the debt ceiling. But inflation was exploding, and investors believed that rapidly growing China’s commodity demand would keep prices up. Gold soared as 10-year TIPS yields turned negative for the first time, reaching a high that was only broken this summer when TIPS yields plunged again.
The pattern has been repeated several times in the past. Gold shines when inflation fears rise in a weak economy. Inflation then makes Treasuries unattractive, while a weak economy makes stocks unattractive and encourages the Fed to cut rates or keep them low. The stagflation of the 1970s illustrated this perfectly, with gold peaking in January 1980 that still has not been broken once adjusted for inflation.
Speculation also has a great influence on gold. Because so much gold is held by speculators, often bought through debt, the metal also suffers when markets seize up and speculators throw it all away. This makes gold a particularly bad hedge when the financial sector is struggling, which is exactly when many expect it to shine. Since its high in early March this year, gold has fallen 12% before hitting a low, as it lost more than a quarter of its value at its worst time in the chaos of the financial crisis in 2008.
There is no precise formula for converting the return on TIPS and expected inflation into the price of gold. What is clear, however, is that the best time to use gold to hedge stocks (company collapse aside) is when we worry about the wrong kind of inflation, driven by problems. supply such as raw material and labor costs, while the Fed tries to help the economy.
Gold is a good way to protect against such stagflation problems. This is not the case when, like today, inflation is more of the virtuous type, driven by underlying demand. Unless you think this is about to change, expect gold and stocks to move in tandem.
Write to James Mackintosh at [email protected]
Copyright Â© 2021 Dow Jones & Company, Inc. All rights reserved. 87990cbe856818d5eddac44c7b1cdeb8