Fiduciary investors have tended to shy away from gold as an investment, for various and solid reasons. But the predictive powers of the price of gold are worth observing, at least, in the institutional market.
The main attribute of gold, at which many professional investors look askance, is that it is deemed to be a “store of wealth”. Individual investors have liked it through the centuries because of its portability and its universality. They have also liked it, even if they didn’t know it, because it is arguably still the best hedge against inflation.
Gold is difficult for fiduciary investors to buy and store, physically. It produces no income – only capital gain or loss. Its industrial use is limited, its position as a governmental reserve is waning and the main use as jewellery is highly correlated with economic good times. And if you want to take an easier position, such as through gold bonds or ETFs, you would have to wonder why you are bothering.
Yet, gold comes into its own in times of real stress. If the people lose faith in the fiat currency of a country, when it is not linked to a physical reserve, it shows up in the price of gold and exchange rates.
The interesting thing for fiduciary investors to observe is the relationship between the gold price and sovereign bond yields.
The price of gold has almost doubled since early 2007, whether measured in US$, euro or sterling. This has probably been driven by a lack of confidence in fiat money, as the world entered a scary phase, rather than fears of inflation. Or has it?
In its latest half-yearly report on private markets, global private markets investment management firm Partners Group says in its macroeconomic outlook, that it is “quite remarkable” to see gold prices at record highs while at the same time US treasuries are below 3 per cent.
“Gold is traditionally seen as inflation protection whereas inflation is bad for government bonds, therefore one would expect an inverse correlation between the performance of gold and treasury bond prices,” the firm says. “The last time the gold price accelerated to all-time highs, in 1980, the 10-year (US) treasury bond yield reached 10.8 per cent and fixed income investors had suffered nearly a decade of negative real returns.”
Partners Group’s analysis, as an institutional investment manager, focuses on what this means for bonds rather than gold. It’s conclusion is: “We are still convinced that government bonds are no longer a ‘safe haven’ and we recommend staying away from the bond trap. Even during the ‘Great Inflation’ of the 1970s bond markets took years to realise the risks.”
Meanwhile, a US researcher recently produced some analysis which showed that institutional investors may be able to use the relationship between the price of gold and the price of bonds to tie their core asset allocations to equities and bonds.
David Ranson, the president and head of research for Boston-based Wainwright Economics believes that gold is the best predictor of inflation and the spread between corporate and sovereign bonds is the best predictor of economic growth. His results were reported in The Economist this month.
He looked at the four possible combinations of the relationship: Gold down, spreads down. This indicates a period of disinflationary growth, so buy equities.
Gold down, spreads up. This indicates a weakening economy with disinflation, so buy government bonds.
Gold up, spreads down. This indicates inflationary growth, so buy commodities.
Gold up, spreads up. Growth is decelerating and inflation is accelerating, so buy gold.
Ranson back-tested the system over 40 years. If you equally-weight the portfolio between bonds and equities only, you get a compound return of 10.7 per cent, higher than equities over the same period with less volatility.
If you pick the favoured asset class, then the return leaps to 18 per cent a year, at the risk of some bigger swings (the loss of nearly a third of your assets in 1981, for example).
Ranson points out that spreads have widened by about 50 bps in the past two months. The price of gold has risen from $300 in August 2000 to $1,226 early this week.
*Greg Bright is the Beijing-based publisher of Top1000Funds.com