With much investor and media focus on the phenomenal rise in Bitcoin and how much it should be worth, it is time to review the drivers of a true alternative currency, gold. Numerous academic thought pieces and Market commentaries have tried to pin down gold’s fundamental drivers and fair value. Different approaches and conclusions have been put forward. Most focus on gold’s links with various macroeconomic variables and attempt to establish a short or long-term relationship. Gold’s role in the context of broader financial markets is also considered – whether it acts as insurance and/or a safe haven, and gold’s behaviour under different scenarios is also studied, but there is no one answer to the question of what drives gold price changes over time, nor to the question of gold’s fair value.
As a macroeconomic asset, one of the most common ways of looking at gold is as a hedge (insurance) against inflation. Under this assumption, a unit of gold should be able to allow the holder to consume the same basket of goods, even when the price of this basket increases over time. It is for this reasoning that academic articles and gold promoters have looked at the ‘real price of gold’ by adjusting current prices by inflation. Ultimately, however, gold is a multi-faceted asset that is driven by more than just one factor such as inflation.
Gold is also typically considered as a safe haven, and insurance against exposure to more traditional asset classes investors hold, such as stocks and bonds. A hedge can be defined as any asset with returns that are either uncorrelated or negatively correlated with that of other assets held in a portfolio. A diversifier is viewed as any asset that is not perfectly correlated with another asset or portfolio. With regards to this view, gold’s relationship with equities, US Dollar, and bond yields have been examined closely. Studies have shown that on average, gold tends to act as a hedge and safe haven for equities, especially during bear markets, and a hedge against the US Dollar. Gold is also considered a safe haven against uncertainty and tail risks (rare events), trending well with safe haven currencies like the Japanese Yen and Swiss Franc.
Nevertheless, relationships are generally not stable over time. Gold’s changing relationship with various factors is probably in large part due to its utility extending beyond financial markets. Given gold is a hard asset that is also consumed as jewellery or as input to industrial applications, it is not like other financial assets and therefore tends to have a wider set of drivers. Physical markets are clearly important and provide the overall foundation in the long-term, but macroeconomic variables and corresponding investment interest tends to drive price trends, not least because, in addition to trading physical gold, a large part of the activity also occurs in derivative markets.
The fact that gold continues to be viewed as a valid asset to hold in a portfolio for diversification, suggests that positions tend to be stable. Although global macroeconomic risks are perceived to be lower than they have been in previous years, investors also acknowledge lingering worries that could change this view. As such, gold’s role as a diversifier and hedge against uncertainty remains relevant.
We wish you a Happy Christmas and prosperous New Year – when Market Commentary will return.