Last week, the World Gold Council (gold.org) released a special report. Although the WGC has not always been very gold friendly in the past, which is definitely surprising, their point of view in their latest report was spot on, in our view. In their intro, they point out that we have entered an unprecedented phase in monetary policy. Central banks in Europe and Japan have now implemented Negative Interest Rate Policies (NIRP). The long term effects of these policies are unknown, but we see discouraging side effects: unstable asset price inflation, swelling balance sheets and currency wars to name a few. Amid higher market uncertainty, the price of gold is up by 16% year-to-date, which is partly due to NIRP. History shows that, in periods of low rates gold returns are typically more than double their long-term average.
In that environment government bonds are not likely to perform well, due to their low-tonegative yields and, in our view, would be less effective than gold in mitigating risk and ensuring portfolio diversification. Portfolio analysis suggests that gold allocations in a low rate environment should be more than twice their long term average.
This is one section from the WGC report:
Given the low interest rate environment, we believe it is almost certain that investors will not obtain the same level of returns from bonds as they did over the past two decades. Our analysis shows that, even when using broader bond indices, current yields are a very good predictor of actual returns in the future. Put simply, this means that bond holders can expect little return, or even negative return, from their sovereign bonds.
Table 1: Gold returns in periods of negative real rates are more than twice their long term average
In our view, investors should not rely solely on bonds to meet liabilities and reach long-term savings goals. Intuitively, gold returns should be higher in periods of negative rates given the low opportunity cost of holding it and its status as a high quality, liquid asset. And while negative nominal rates are unprecedented, negative real rates have occurred often in history. Using these as a proxy, our analysis shows that (Table 1):
- When real rates are negative, gold returns tend to be twice as high as the long term average
- Even if real rates are positive and as long as they are not significantly high (4% in our study), average gold returns remain positive
- Falling rates are generally linked to higher gold prices; yet rising rates aren’t always linked to lower prices.
Bonds may not be as effective as gold in balancing equity risk under NIRP (or ZIRP)
Under NIRP, investors may need to rebalance their portfolios in the short-to-medium term. But in the long term, the implication may be even more compelling. Bonds generally help balance the risks inherent in portfolios. Low yields, however, not only promote risk taking, but also limit the ability of bonds to cushion pullbacks in stocks and other risk assets in investment portfolios. Investors may also require longer periods to achieve their objectives (manage foreign reserves, fund their retirement, fulfil liabilities, etc.)
Our research shows that gold can help investors balance portfolio risks in this largely unprecedented environment.
Chart 3: For foreign reserve managers, the current low yield environment opens the door to higher gold allocations
Chart 4: Lowering expected bond returns significantly increases the optimal weight that gold should have in portfolios
For central bank reserve managers who usually invest in a more limited set of assets, we have found that the optimal gold holding in the current low yield environment would significantly increase.
In particular, we find that even under conservative assumptions for gold returns:
- Optimal gold holdings in foreign reserve portfolios increase 1.5 times
- The multiple increases to more than 2 times if yields fall 1% from current levels (or if current yields persist but gold returns are close to their historical average).
For example, the optimal gold allocation in a foreign reserve portfolio with 55% of its holdings in US bonds (akin to the average holdings by central banks) would increase from 7.6%to 15.7% assuming gold returns only 2% per year, and it could go as high as 19.3% if yields were to drop 1% from current levels (or if yields were unchanged but expected gold returns were 4% per year).
For investors with portfolios that have a mix of stocks and bonds (Chart 4) we found that strategic gold allocations under the current low yield environment are:
- 1 to 1.5 times higher they would be if average bond yields were closer to their 25-year average, depending on the portfolio mix
- 1.5 to 2.2 times higher than they would be if bond yields were to fall 1% from current levels (or if current yields persist but gold returns are close to their historical average).
For example, in the current global low yield environment and even under conservative assumptions for gold returns, our research shows that an investor with a 60/40 portfolio may hold up to 8.7% in gold (up from 5.5% under historical assumptions for bond return expectations), and up to 10%
if yields were to fall 1% further (or if current yields were unchanged but expected gold returns were 4% per year). While these examples use US-dollar portfolios, similar results apply to euro and pound-sterling investors.