Investors have embraced gold as a key portfolio hedging strategy this year, particularly as expectations for a faster recovery from Covid-19 are shifting towards expectations of a slower recovery, or even potential setbacks from additional waves of infections, the World Gold Council (WGC) says.
However, regardless of the recovery type, the pandemic will also likely have a lasting effect on asset allocation, which the council says, “will also continue to reinforce the role of gold as a strategic asset”.
In the WGC’s new ‘Gold Market Outlook’, it says gold had a “remarkable performance” in the first half of the year, increasing by 16.8% in dollar terms and outperforming all other major asset classes.
By the end of June, the gold price was trading at close to $1 770/oz, a level not seen since 2012.
Although equity markets around the world rebounded sharply from their first-quarter lows, the WGC says the significant uncertainty surrounding the Covid-19 pandemic and the ultralow interest rate environment supported strong flight-to-quality flows.
“Like money market and high-quality bond funds, gold benefited from investors’ need to reduce risk, with the recognition of gold as a hedge further underscored by the record inflows seen in gold-backed exchange-traded funds (ETFs),” the council comments.
Gold-backed ETFs recorded their seventh consecutive month of positive flows, adding 104 t in June – equivalent to $5.6-billion, or 2.7%, of assets under management. This took global holdings to an all-time high of 3 621 t and brought global net inflows for the first half of this year to 734 t, or $39.5-billion.
However, the Covid-19 pandemic is upending asset allocation, the council says, noting that, in response, central banks around the world have cut rates and/or expanded asset buying programmes to stabilise and stimulate their economies.
These actions are leading to several unintended consequences on asset performance, the WGC says.
These include, besides others, soaring equity market valuations that are not always backed by fundamentals, and increase the chance of pullbacks; increasing corporate bond prices, which push investors further down the credit-quality curve; as well as limited short-term and high-quality bonds, which reduce their effectiveness as hedges.
In addition, the council explains that widespread stimuli and ballooning government debt levels are raising concerns about a long-term run up of inflation, or significant erosion of the value of fiat currencies.
Deflation, however, is seen as the more likely risk in the near term.
As these dynamics heighten risk and lead to the possibility of ever lower returns than expected, the council believes gold can play an increasingly relevant role in investor portfolios.
Meanwhile, the WGC says global equities were on a virtually uninterrupted one-way trend for more than a decade.
The council explains that the Covid-19 pandemic changed that, resulting in a significant pullback, with all major equity indices dropping by more than 30% during the first quarter.
However, equities have recovered sharply since, especially technology stocks, although stock prices do not appear fully supported by company fundamentals or the overall state of the economy, the WGC states.
While many investors may potentially be looking to take advantage of the positive price trend, the WGC says there is a growing concern that such “frothy valuations” may result in a significant pullback, especially if the economy experiences a setback from a second wave of infections.
Owing to this, the council states that gold’s effectiveness as a hedge may help mitigate the risks associated with equity volatility, as bonds may only offer limited protection.
The low rate environment has also pushed investors to increase the level of risk in their portfolios via buying longer-term bonds, lower-quality bonds, or simply replacing bonds with even riskier assets, such as stocks or alternative investments.
Going forward, the council does not believe investors will achieve the same bond returns they have seen over the past few decades, but the WGC’s analysis rather suggests that investors may see an average compounded annual return of less than 2% in US bonds over the next decade.
This could prove particularly challenging for pension funds, as many are still required to deliver yearly returns between 7% and 9%. Lower rates increase pressure on the ability to match their liabilities and limit the effectiveness of bonds in reducing risk.
In this context, investors may consider gold as a viable substitute for part of their bond exposure, says the council.
By Simone Liedtke