In the past few weeks we’ve seen a fall in both sterling and in US bond yields, with the 10-year Treasury yield hitting its lowest level since late 2016. These two facts are related, and are helpful for UK investors.
It is common for sterling to fall when US bond yields do. The same thing happened in 2000-02, 2008 and in 2016. Since 2000 the correlation between sterling’s trade-weighted index and the 10-year Treasury yield has been a hefty 0.78. There’s a simple reason for this. US bonds are a safe asset and sterling is a risky one. When investors get nervous they therefore buy Treasuries and dump pounds, which means that bond yields and sterling often fall together.
For UK investors this is very handy. It means that major foreign currencies such as US dollars, euros or Swiss francs rise in bad times. And this gives us assets we can use to protect ourselves against risk. International diversification works well for sterling-based investors.
This does not mean that overseas equities are safe in sterling terms. Yes, sterling tends to fall, and the US dollar rise, when overseas share prices fall. But it doesn’t do so enough to prevent the worst losses. In 2008, for example, overseas stocks, as measured by MSCI’s world index excluding the UK, fell by over 40 per cent in US dollar terms. Even factoring in sterling’s rise against the dollar this still gave sterling-based investors a loss of almost 20 per cent.
There is, however, another asset we can use to help spread risk – gold. It gives us double insurance against bad times.
First, because sterling tends to fall when investors get nervous so gold rises in sterling terms even if its dollar price doesn’t change much.
Secondly, gold itself tends to rise in dollar terms when US bond yields fall. This isn’t just because investors regard gold as a safe haven. It’s also because when bond yields fall so too does the opportunity cost of holding gold – the income we forego when we hold gold rather than bonds. As bond yields fall, therefore, so the gold price rises in dollar terms. Seen from this perspective, it’s no surprise that gold recently hit a six-year high in dollar terms as US bond yields fell.
For these two reasons, gold does well in sterling terms when equities do really badly. In 2008, for example, it rose 40 per cent while the All-Share index fell over 40 per cent. And in the tech crash of 2000-03 gold rose almost 18 per cent in sterling terms while the All-Share index lost almost 50 per cent.
Gold, therefore, can be good insurance for a sterling-based investor worried about serious equity bear markets.
It does not, however, insure us against all such bear markets. If share prices were to fall because investors fear a tightening of monetary policy bond yields would rise in expectation of higher future short-term interest rates and gold would fall as the opportunity cost of holding it rises. The metal would then be no protection against falling equities. This is no mere theoretical possibility. It happened when the Fed raised rates in 1994, and again during the 'taper tantrum' of 2013.
For this reason, gold is not sufficient diversification against equity losses. Cash – both sterling and foreign currency – does a better job of protecting us against nasty surprises about monetary policy.
But do we need such diversification now?
My central case forecast is: probably not. Non-inflationary growth in the US economy, an above-average dividend yield on UK equities and weak sentiment among global investors (as measured by them being big net sellers of US equities in the past 12 months) all point to decent returns on shares in the next 12 months.
But we should never base our investment strategy solely upon central-case forecasts. These can always go wrong. Our knowledge of the future is very limited because even strong historic relationships can break down.
One concern is that with futures markets now pricing in three cuts in the Fed funds rate by December there is plenty of room for monetary policy to become less loose than investors currently expect – unless the economy turns out weaker than expected, in which case equities would get a nasty surprise. If investors are disappointed by the path of short-term rates, bonds and gold might well both sell off. Against this risk, cash – and perhaps US dollar cash – offers some protection.