Last week, gold was once again in the headlines as its price exceeded US$2,000 for the first time.

Have such heady valuations propelled the ‘barbarous relic’ to unrealistic heights? Has gold outlived its usefulness in portfolio construction?

Whilst substantial gains have been made already in this rally, over time, further appreciation is possible as gold catches up with the recent, and globally widespread, expansion of the monetary base; meaning gold remains a very useful tool in the portfolio construction toolkit.

Gold is a useful portfolio construction tool because:

• Gold generates no income: it can’t be valued like a stock or a bond using a discounted cash flow technique.
• Gold has few industrial usages: consumption demand is modest and unconnected to economic cycles[1].
• Gold has limited supply and is difficult to mine: more like a Bitcoin than a dollar bill!

You might think that these are undesirable characteristics and therefore prejudicial to gold’s status as a viable investment. However, because of these characteristics gold is unlike all other traditional financial assets that are used in investment portfolios. It has diversification benefits, resulting in smoother return streams.

When does gold perform well?

Gold has a range of trigger factors and tends to perform well when; volatility in financial markets is high; geopolitical risk factors are elevated; real yields are falling; the supply of fiat money is expanding; and/or the US dollar is weakening.

Gold supply has no obvious fundamental linkage to these factors which, incidentally, do not all have to be apparent at the same time. However, the common denominator is that when investors are most uncertain as to what the future holds, they prefer the certainty of gold, even if that is the certainty that comes from owning a non-income earning asset. Those combined investor preferences lead to gold demand increasing, only for it to fall away once investors start to become more confident in the future.

Of course, the key thing is that heightened uncertainty always creates buying pressure on gold, driving price action – a phenomenon that is sometimes called the ‘safe-haven’ effect. For example, at the start of the year before COVID-19 dominated the news agenda, the assassination of Qasem Soleimani exacerbated tensions in the Middle East, driving a rise in gold prices, principally on elevated geo-political fears.

Gold is therefore a very useful diversifier, capable of ‘firing up’ in a portfolio when a wide range of other assets might be underperforming. Adding gold improves resilience and provides downside protection within economically balanced, diversified portfolios that may otherwise be over-exposed to periods of market stress.

This gold rally is not unprecedented in scale, but it is certainly up there amongst the biggest. Other examples include: the late 1970s oil crisis, Q4 2001, the period between the Global Financial Crisis and the solving of the Eurozone Sovereign crisis.

What happens next?

Until we see markets settle and investors start to discount less uncertain economic conditions, Gold can continue to make new highs. Once a calmer market environment is established, in conditions when certainty is less highly valued, prices could easily fall back. And of course, there’ll be peaks and troughs along the way, this week it only took the Russian Government to announce the licensing of a putative vaccine (public health officials in the rest of the World are sceptical) to knock back prices.

This second point is important; the gold market is not underpinned by a quantifiably favourable fundamental valuation metric, so the present pace of gold price gains cannot extend indefinitely. That said, we think that the most important trigger factor that started the present rally at the end of Q1 was the rapid and coordinated expansion of the monetary base by global central banks. The US Federal Reserve’s actions, and the consequential weakening of the US dollar, rank among the most dominant drivers. We do not expect to see a reversal or retrenchment of current accommodative monetary and fiscal policy conditions, and hence see the potential for longer term rises in gold prices.

[1] There are seasonal effects concerned with the jewellery trade’s production calendar but these are relatively modest.