Our financial wellbeing is closely tied to the performance of the economy, through our businesses, jobs, financial assets and property. But in volatile and uncertain times, as the world experienced recently, the fragility of this prosperity can become apparent. Many are drawn to gold as a way to hedge this vulnerability. But what kinds of disruptions does gold effectively mitigate, and why? Primarily, gold acts as a hedge against three substantial risk factors that cause economic instability. The first is rising inflation and interest rates, the second is an economic downturn such as a recession, and the final factor is fear of geopolitical risks and political instability in our own country

Inflation and interest rates

Gold usually rises in price as the US dollar falls, and declines in the US dollar are often caused by inflation expectations in the US rising more than in the rest of the world. Therefore we often see that upward surprises in US inflation are positive for gold, in anticipation of a dollar sell-off. However, the ‘excess supply’ of dollars that causes inflation also causes US interest rates to rise. Since the USD is gold’s primary competitor, gold prices tend to be negatively affected by higher US interest rates. For this reason, gold has shown a slight negative correlation with US interest rates of -8% to -14%.[1]

Recessions and bear markets

Gold consistently shows zero correlation with US or global stock markets. However, the value of gold comes from the fact that gold sometimes seems to exhibit a negative correlation with stocks when it is needed most - in a recession or bear market. After a short but sharp three-month fall in the third quarter of 2008, gold recovered its losses by the end of the year, and then rose strongly, doubling over the next three years. Gold also rose sharply during the previous 2000-2003 bear market, and was roughly flat during the recent 2022 bear market, when the S&P 500 fell by 25%.

Image 1: Gold prices were volatile along with other assets in 2008, but spent much of the year in the green, even as stock markets declined. After a brief sell-off in the third quarter, gold ended the year up about 5%. 

Credit: investing.com

Sentiment

The final major factor influencing gold prices is investor sentiment. Investor sentiment on gold is affected by many factors such as geopolitical events and economic newsflow. It is this final factor that often gives gold its reputation as a ‘safe haven’ during times of geopolitical risk. Its impact has been seen recently, when gold shrugged off the shock of COVID-19 with a small fall in early March 2020, followed by a large rally over the next six months, which lifted prices by over 20%. Gold also rallied by over $100/oz in the month following the Russian invasion of Ukraine in February 2022.

Conclusion

We have discussed some of the major drivers of gold returns and its unique characteristics as a hedge for many of the largest economic, financial and political risk factors faced by investors. These include inflation, the US dollar, recessions and equity bear markets, and geopolitical event risk. Gold has a deserved reputation as meeting many of the critical requirements of a core asset class, offering a low, robust correlation with existing assets and a long return history. While no asset class can be a perfect hedge for all risks, a long-term, secure gold holding can be very close to an all-weather asset, providing a portfolio with critical ballast in rough seas and solid growth potential in calmer conditions.

References

[1] The Economics of Commodity Markets, Julian Chevallier and Florian Ielpo, p.74