Gold gleams through the mists of uncertainty

Financial markets have seen considerable volatility this year with global growth concerns, political events and questions around the next steps of central bank policies all adding to uncertainty.

Investors are scrutinising each pronouncement by the U.S. Federal Reserve members while the Fed carefully monitors data points on the U.S. and international economies. Despite a strong rebound in U.S. non-farm payroll data in June following a weak reading prior to that, interest rates were held steady in July in part because of the UK’s ‘Brexit’ from the E.U., which has reduced global growth expectations.

In this environment, many investors are holding high levels of cash on a historic basis. Against this backdrop, asset classes where we have seen real investor conviction have been few and far between, year-to-date. When we looked at Exchange-Traded Product (ETP) flows, we found that gold was one of the few asset classes that has been gathering assets consistently this year. This was particularly in evidence during the market falls at the start of the year, with gold seeing a correlation with the U.S. equity volatility index [1] (VIX) rising to eight-year highs.

Following the high level of gold ETP purchases recorded in January and February – and the abating of such interest in favour of more risk-on themes in March and April – in May, global ETP investors showed a renewed and marked preference for gold and fixed income investments over equities. After strong inflows into gold in May, flows continued into physical gold funds as well as gold mining ETPs in June too, attracting another $5.4bn. This brought the total flows into gold ETPs to US$22.0 billion in 2016 to date. This is a new annual record – with six months’ flows still remaining to be tallied up for 2016. The previous high for global gold ETP inflows was US$17.0bn during 2009. Elsewhere, at mid-year, fixed income flows remained poised for a record year.

As well as gold’s representing a traditional store of value in uncertain times, a far more ‘dovish’ trajectory of interest rate rises from the Fed than had been expected at the start of the year seems to have boosted interest in gold and its price has risen accordingly – above US$1,310 per troy ounce at the time of writing. Looking ahead, with the potential for US inflation to rise, gold may remain popular as it has often been viewed as an inflation hedge – with varying degrees of effectiveness. This theory could be tested again soon, given that there has been a pick-up in U.S. inflation metrics, such as the consumer price index (CPI).

More broadly, a range of political issues is likely to contribute to uncertainty in the second half of the year, including ongoing concerns about the global growth outlook – particularly if the US economy falters. Compounding that is the possibility that investors may lose faith in the effectiveness of central bank policies such as quantitative easing. Hedging against volatility is likely to remain relevant in a portfolio context. We believe investors could still consider a strategic holding in gold, even though its price has already risen strongly year-to-date, because of its safe haven qualities and, as is the case with many alternative assets, it does add diversification to a portfolio.

We recently carried out some analysis on alternative investments to see what could be a good diversifier and be beneficial from a risk and return perspective within a portfolio. As an example, for a standard 60%/40% equity and fixed income asset allocation over a time frame of the last 8 years, we found that an optimal combination of gold and broader commodities exposures reduced the overall volatility of the portfolio, while a combination of gold and other precious metals produced a more efficient portfolio overall with both lower risk and higher returns. Overall the analysis showed the advantage of alternatives exposure in this portfolio where gold and broad commodities were the greatest diversifiers from a historical perspective. Despite its progress in performance terms in recent months, we believe that gold seems likely to remain a popular trade because of its diversification status and, potentially, its risk and return benefits.

Ursula Marchioni – Chief Strategist EMEA – iShares-BlackRock