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Gold as a safe haven investment

March 2020

Winning gold

Gold divides opinion. But while its role is open to question in normal times in extreme market conditions it's a good safe haven.

As the coronavirus sends shockwaves through the global economy, one asset stands out against the broader market rout: gold. 

The logic behind gold's appeal isn't necessarily obvious: it doesn’t generate an income, is too unwieldy to be used as money and incurs storage and insurance costs. Warren Buffett once famously pointed out that it is dug up in Africa, shipped half way across the world only to be sunk back into the ground in a heavily fortified bank vault, while John Maynard Keynes called it a “barbarous relic.”

That may be true, but what gold does offer is diversifying and hedging qualities - highly prized characteristics during bouts of severe market turmoil, such as the one we are experiencing now and the one seen during the global financial crisis. As Dirk Baur and Brian Lucey at Dublin City University and Trinity College Dublin respectively explain, “gold is a hedge against stocks on average and a safe haven in extreme stock market conditions”.That’s to say, gold is a moderate hedge against equities and bonds during normal market conditions, becoming a very good hedge in times of crisis, albeit for short periods.

A safe haven in a topsy turvy world

This is an attribute investors should prize right now. Gold’s ability to mitigate the impact of market upheavals owes much to its distinctive correlation profile with other asset classes. Most of the time, the precious metal tracks bonds slightly more closely than equities but is not particularly correlated with either. But in times of market stress, its relationship with equities turns negative, giving investors useful protection against bouts of risk aversion. We saw this in action in recent weeks, with gold hitting seven year peaks as global equity markets sold off.

Our analysis shows that adding gold to a typical investment portfolio with an initial 60 per cent allocation to equities and 40 per cent to bonds can reduce volatility – thus improving the portfolio’s Sharpe ratio, lessening peak to trough falls and lowering worst losses in slumping markets. Indeed, a 10 per cent holding in gold (and proportional reduction of equities and bonds) since the start of 2007 would have improved a portfolio’s annual returns and lowered its volatility by half a percentage point over a decade, according to our models.

Gold also acts as insurance against potentially damaging effects of policy errors. Ultimately, ever more extreme monetary measures will trigger inflation. And when inflation finally arrives, there’s a substantial risk that central banks will be reluctant to step on the brakes for fear of causing another severe recession. Although gold’s historic performance as an inflation hedge has been mixed – for instance the price of gold declined during the 1980s and early 90s even as consumer prices were rising – it has been a useful store of value during periods of very high inflation such as during the 1970s. Which is why Alan Greenspan argued, when he was chairman of the Federal Reserve, “the price of gold…can be broadly reflective of inflation expectations.”2

More than just a commodity

Gold is a proto-currency. In a zero or negative interest rate world, such as the one we live in, gold looks like an increasingly attractive alternative to the main currencies.It has been used as a unit of exchange throughout history and continues to be made into coins that are held by households around the world. Meanwhile, the traditional disadvantages of holding gold – the cost of carry, insurance etc. – evaporate when the alternative is a negative interest rate. With deposit rates turning negative, it becomes increasingly costly to keep money in a bank. Under these circumstances, gold’s lack of rental yield no longer matters.

Other commodities may appear to generate a return because of the difference between their spot and futures prices. But this is a financing yield, essentially a return made from extending a loan rather than anything to do with the commodities themselves.

That’s not to say the productive assets behind commodities aren’t good investments. A forest can be managed, it can generate a yield. You can rent land out usefully. But you can’t rent out a stack of wood.

What might tarnish gold

Of course, there are potential risks to holding gold. In extreme circumstances, authorities may try to restrict its use. There is a precedent. In 1933, US President Franklin Roosevelt issued an executive order forbidding “the hoarding of gold coin, gold bullion and gold certificates,” and furthermore that almost all gold was to be sold to the Federal Reserve.4 What’s more, in extremis gold has limited use if the financial system completely breaks down. Because of its proportionately high value, it is less useful for most transactions than, say, silver.

But for slowing economic growth, rising rates of inflation that central banks find themselves unable to control, market meltdowns and financial crises, gold represents a valuable hedge and portfolio diversifier. When the world’s at its most worrying, one of the most ancient of assets comes into its own.