Market moves: gold and portfolio risk hedges

Gold has served as a store of value for millennia. Across different eras and regions, it has consistently been exchangeable for goods and services, earning its reputation as the ultimate “safe haven” asset.

Over the past two years, gold has staged an impressive rally – rising from around £1,600 per ounce to over £3,000. These price moves have caused some investors to reevaluate the role of gold in their portfolios. In this article, we explore the drivers behind this rally, assess the outlook, and consider the role of gold in multi-asset portfolios.

This article is for authorised intermediaries and professional investors only. 

What’s been driving the price of gold?

Historically many currencies were directly linked to gold. However, this practice largely ended after World War II. Since then, gold has tended to appreciate during periods of currency instability – such as high inflation – but remains relatively stable or underperforms compared to financial assets like government bonds during calmer periods.

The most recent rally in the price of gold initially began when Russia’s central bank reserves were frozen following the invasion of Ukraine. The weaponisation of the dollar in this instance increased the urgency for central banks not aligned with the US to diversify their reserves – leading to increased gold purchases. This event also marked the start of a prolonged period of heightened global geopolitical tension that’s unfortunately yet to abate. Coupled with a period of elevated inflation that has caused heightened bond market volatility, more investors have turned to gold as their safe-haven asset.

Another key factor has been the “currency debasement” trade. Following high inflation, unprecedented fiscal stimulus, and extensive quantitative easing, some investors fear that traditional safe assets – such as US Treasuries- may no longer reliably preserve value. These concerns have been amplified by many governments being reluctant to address rising debt and fiscal deficits.

In addition to these fundamental drivers, speculative interest has gathered pace. Momentum traders and short-term speculators have likely fuelled the latest leg of the rally, which increasingly resembles a crowded-momentum trade. Flows into gold-related exchange traded products have been very strong, while futures exchanges also report record long positions. Such crowded trades can reverse as swiftly as they rise.

Are these market forces set to continue?

Currently, US debt-to-GDP stands at around 125% - with deficits running at 6% - both near historic highs outside of wartime. With little political appetite for austerity, the most likely path forward involves inflating away the debt and engaging in financial repression (i.e. maintaining artificially low interest rates and imposing capital controls). This appears to be the preferred course of action for the current administration.

Geopolitical tensions remain at elevated levels. And while the dollar remains the dominant international currency, the threat of further weaponisation is prompting diversification – even among US allies. In this context, some of the fundamental tailwinds that have been priced into the gold price are likely to remain intact over the medium term.

However, the momentum-driven portion of the rally is unlikely to persist. If current price action were justified by fundamentals alone, it would imply a significant level of weakness within the international financial system. Despite some minor signs of stress, we don’t think that’s the case and it’s not something that’s reflected in the price of other assets.

More plausibly, a rally rooted in solid fundamentals has morphed into a momentum trade vulnerable to sudden reversal. For this to continue, flows would have to remain strong and fundamental tailwinds would have to reaccelerate.

Should gold be held in a multi-asset portfolio?

Some investors include gold or other precious metals in their strategic asset allocation as an “everything hedge” against a wide range of low-probability, high-impact risks. However, we choose not to use gold for these purposes, preferring instead to match hedging instruments to specific risks.

There are several reasons for this approach:

• Our analysis of long-term returns suggests that a strategic allocation to gold through the cycle would reduce portfolio performance.
• As an “everything hedge”, gold doesn’t offer complete protection against any single risk. Even its much-touted inflation protection is imperfect and often delayed. We have also seen during the market sell-off in April this year that gold isn’t necessarily a diversifier, especially as there’s an increasing amount of money in financial derivatives linked to gold rather than physical gold itself.
• Gold can potentially improve a portfolio’s Sharpe ratio, but this benefit alone doesn’t justify a strategic allocation.
• In recent months, we’ve seen gold trading as a risk-asset rather than risk-off asset, in many trading sessions. 

Instead, we prefer targeted hedging strategies. For example:

• Inflation risk is hedged using short-duration inflation-linked bonds.
• Equity risk is hedged with nominal sovereign bonds at the 10-year point on the curve, which we believe still offer the best value as a risk anchor during equity market selloffs.
• Currency risks managed through targeted hedge ratios on the main currency pairs. 

For the reasons outlined above, we don’t hold gold as a strategic position. However, there may be a case for tactical exposure if gold presents a compelling return opportunity. On this point, we acknowledge that we didn’t fully anticipate gold’s ability to drive returns over the past year. Nonetheless, we aren’t inclined to chase the rally. We believe gold has now outpaced its fundamental tailwinds, and recent price momentum leaves limited upside potential while introducing significant downside risk.

We would also note that for the potential benefits of gold to be captured at the portfolio level, you’d generally need to be willing to hold a material allocation such that the contribution to return is significant enough to protect against tail risk scenarios. However, we often see investors holding a “de minimis” amount that’s unlikely to drive enhanced outcomes at the portfolio level. With that in mind, we prefer to build the majority of our portfolios with traditional asset classes entitling clients to modellable cash flows capturing fundamental return drivers associated with our real-return objectives. 

Accessing gold within portfolios

How to access gold within portfolios is a key consideration for global, multi-asset solutions given we cannot hold the physical gold bars directly. Where permitted we can invest in physically-backed gold exchange traded commodities. This should directly mirror the gold price, but this requires the investment mandate to permit exchange traded vehicles. There are also exchange traded products that synthetically replicate the performance of the gold price by using derivatives, but these are more complex in nature and do have some characteristic differences to owning physical gold. 

For solutions limited to unit trusts, the only accessible options are products which invest in miners and commodity companies rather than gold itself. While at times the performance of these products shadow gold prices, they represent a different investment proposition without many of the desired characteristics of the physical metal itself. Not only are these equity investments, but they are also more skewed towards smaller-sized businesses – some of which have speculative business models (e.g. companies that are involved in gold mine exploration). These high beta equity investments don’t provide portfolios with the safe-haven properties of physical gold – quite the opposite.