Gold can mitigate downside, but comes at a price

After bouncing around to little real effect for several years, the gold price has risen steadily since August 2018, moving from $1,175 (£909.33) an ounce to over $1,300 an ounce. It has risen in particular at times of peak political tension. For example, the Royal Mint reported a significant increase in demand for gold in January, with sales up 73 per cent on the same period in the previous year. And there was a 74 per cent spike in gold sales on the day after the postponement of the meaningful vote on Brexit.

Investors who have been running out of lower-risk options with which to protect their portfolios in times of market stress may now be considering gold as a possible solution. However, before assuming that it will provide certainty in an uncertain world, it is worth considering whether it has any other investment merits.

It is generally cheaper to buy 'insurance' when the house is not on fire. But gold is now around 13 per cent more expensive than it was six months ago and that should give potential investors pause for thought.

Gold certainly has defensive qualities. It is the only ‘currency’ that is asset-backed, in contrast to fiat currencies of which the supply is determined by governments, as policymakers can’t print more gold to suit the prevailing economic conditions. It is cyclical and its price will vary, but the new supply of gold is increasing by around 2 per cent a year, which protects it from devaluation. This supports gold's status as a safe-haven asset outside conventional financial markets, with which it has little correlation. But it does not necessarily provide shelter from turbulent equity markets.

Adrian Ash, director of research at BullionVault, says: “Investing in gold to protect against short-term drops in the stock market is no better than a coin toss. Since 1968 gold has risen in sterling terms in 54 per cent of the months when the FTSE All-Share index has gone up, and risen in 54 per cent of the months when the FTSE All-Share index has fallen. Over longer time horizons, however, gold has shown greater value in terms of balancing equity losses. Across all 12-month periods over the last half-century, gold rose 60 per cent of the time that share prices went up and rose 67 per cent of the time stock markets fell. Across all five-year periods, again looking at month-end data, gold rose 63 per cent of the time that share prices went up and gained 96 per cent of the time the stock market fell.”

David Jane, manager of Miton's multi-asset funds, agrees: “[When you hold] gold you spend a long time thinking ‘why am I holding this?’ Then something happens and you thank your lucky stars that you’ve got it in your portfolio. You often hold it without the expectation of a long-term return. Rather, you own it for its value in times of distress. Gold is particularly valuable in certain types of distress – political volatility, government failure and currency debasement.”

In other words, gold tends to be a hedge against the world going wrong. This often –but not always – coincides with equity market volatility, so it is not a perfect hedge. Gold has also proved a good hedge against inflation, but again the relationship is not perfect.

“Gold has tended to act as a safe haven in times of great stress, increasing in value both through the great depression [via increases in the share prices of] gold mining stocks, and through the 1970s," explains James Knowles, investment director at Psigma Investment Management. "Both were sustained periods of systemic crisis. However, the first example was deflationary and the second was inflationary, suggesting it is a long-term safe haven rather than just an inflation hedge, as often suggested.”

And you are unlikely to be able to achieve a similar type of return with anything else, although index-linked gilts have shown a similar performance. But Mr Ash argues that there is not really an equivalent to gold. 

“Nothing else is quite so useless for anything other than storing value," he says. "Gold does so little it doesn't even rust, but that and its rarity is why it has been prized as a store of value in all ages and cultures. More steel is poured every hour than all the tonnes of gold ever mined. Less than 10 per cent of end demand today comes from industry, and that boosts gold's non-correlation with other assets, because gold is less exposed to the economic cycle than equities, corporate bonds, real estate and other commodities – including other precious metals.”

Worth the price?

Stock markets have been calmer since the start of the year and investors may be reluctant to hold an asset simply for those rare moments of crisis. And the gold price is trading towards the upper end of its range over the past five years.

It has also risen against the currencies of many G20 nations. Mr Ash points out that in 2019 the gold price has risen within 5 per cent of its all-time high for six members, set new all-time highs against the Australian dollar and Indonesian rupiah, and become expensive for private savers in India.

That said, gold still has another 40 per cent to rise before matching the all-time high of around $1,900 per ounce it hit in the summer of 2011.

Mr Knowles says falling interest rates, or the prospect of falling interest rates, tends to be positive for the gold price. Gold doesn't pay an income, so there is always an opportunity cost for holding it. And if interest rates are higher, that opportunity cost increases. The US central bank, the Federal Reserve, appears to be reining back its interest rate increases at the same time as China is enacting some fiscal stimulus.

Alasdair McKinnon, manager of Scottish Investment Trust (SCIN), points out that the trillion dollar deficit in the US is likely to weaken the dollar, which in turn should push gold prices higher. Politicians' and policymakers' apparent willingness to ease fiscal policy and keep interest rates low should also push gold prices higher.

Mr Knowles says that, over the longer term, supply and the cost of production are major swing factors. “There does seem to be some evidence that the demand cycle from the Far East, particularly the build-up to the Indian wedding season, at least underpins the price in the latter part of the year,” he explains.

Central bank buying has also been important in supporting the gold price. The World Gold Council reported in January that central bank buying was at its highest level in 50 years. Central banks added 651.5 tonnes to their official gold reserves in 2018, the second highest yearly total on record. This offset some weakness in exchange traded commodity (ETC) demand over the year.

Tom Holl, co-manager of BlackRock Commodities Income Investment Trust (BRCI), says the key things to watch are the US dollar, real rates, the outlook for global growth and the performance of broader equity markets.

“This year, we expect investment demand from futures positioning and ETC holdings to be the primary driver of the gold price," he says. "We have seen consistent inflows into physically-backed gold ETCs over the past three months. In the longer term, we expect increasing Asian physical demand and mine production plateauing, as a result of cutbacks in company spending, to support the gold price. The gold price has strengthened since the start of the fourth quarter of 2018. Our base case is that the gold price remains range-bound unless there is an economic shock and/or broader equity market weakness, which we would expect to push the gold price higher.”

Getting exposure to gold

If you believe in the investment case for gold, there are a number of different ways to invest in it and the right option for you will depend on your reason for holding it in your portfolio.

Shaniel Ramjee, multi-asset manager at Pictet, argues that the right option depends on the current market cycle. “When the gold price is rising but the environment is relatively benign, gold mining shares, which have operational leverage, should rise faster than the gold price," he says. "Merger and acquisition activity is often a good indication that the gold in the ground is more valuable than the current market price. When the environment becomes more cautious and there are real concerns about governments or monetary systems, then you want actual bullion. This implies that people are losing faith in the financial system.”

Mr Knowles says exposure to physical gold is the best insurance policy, but it is relatively difficult to handle and hard to secure. A number of internet or smartphone apps have emerged allowing people to buy and own physical bullion in a secure jurisdiction. BullionVault is the longest-established provider of these, having launched its peer-to-peer platform in 2005. Glint also offers this service.

But Mr Knowles says ETCs and gold mining shares are the simplest way of gaining exposure. ETCs that own physical gold, rather than getting exposure to its price via derivatives, include Invesco Physical Gold ETC (SGLD), which has a net expense ratio of 0.24 per cent, and iShares Physical Gold ETC (SGLN), which has a net expense ratio of 0.25 per cent. 

Gold miners used to be considered a little ‘wild west’, but Mr McKinnon says they have come a long way since then. “Miners had a wake-up call and recognised that they needed to become proper businesses, reduce costs and install strong governance," he says. "The sector has become much more disciplined.”

He has invested Scottish Investment Trust in Newcrest Mining (NCM:ASX) and Newmont Mining (NEM:NYQ).

Mr Knowles adds: “A portfolio of gold mining shares to limit specific mine risk has traditionally given a geared return to the price of physical gold. Buyers of gold miners should be equally aware that they tend to multiply the downside if the price of gold falls.”

There are a number of specialist funds that invest in gold mining shares. One of the longest running is BlackRock Gold & General (GB00B99BDY18), which launched in 1988 and has been managed by Evy Hambro since 2009 and Mr Holl since 2015.

Other funds offering exposure to gold mining shares include Investec Global Gold (GB00B1XFGM25) and Smith & Williamson Global Gold & Resources (GB00B3RJHY30).