INVESTING

Three trends supporting gold as a hedge

Russ Koesterich, CFA, JD |Mar 12, 2020

Russ discusses the reasons why gold can be an effective hedge going forward.

The point of owning insurance is that it will pay when needed. For investors suffering through one of the most abrupt corrections on record, their insurance policies have had a mixed record.

In early February I suggested that U.S. Treasuries, despite near record low yields, would still prove an effective hedge. Since the start of the stock market correction long-duration U.S. bonds have gained 8%. But what about another favorite hedge: gold?

While gold didn’t do much during the sell-off, acting more as a store-of-value than a negatively correlated asset, this is starting to change. With both nominal and real, i.e. inflation adjusted interest rates in free fall, gold is well positioned to do what it is intended to do: help insulate a portfolio. Here are three reasons gold should continue to act as a hedge against equity market risk.

1. The dollar is collapsing.

The Dollar Index (DXY) is down nearly 3% since the market’s mid-February peak. This is important as gold’s efficacy as a hedge is partly a function of the dollar. While gold can do well even when the dollar is rallying, historically it’s outperformance is strongest when the dollar is down.

2. Growth expectations are falling.

As I’ve discussed in previous blogs, no hedge works in all circumstances; the catalyst matters. Gold tends to do best when investors are worried about too little growth. For example, in month’s when volatility spiked and the ISM New Orders Index, a survey of manufacturing activity, rose the median return to gold versus stocks was 2.75%. If you instead focus on periods when the ISM was falling, suggesting a decelerating economy, the median return increased to 5%. In those months when the ISM Survey was falling particularly fast, as it is today, the median return versus stocks increased to over 8%. In other words, to the extent the coronavirus represents a threat to growth, gold should be a particularly effective hedge.

3. Real yields are collapsing.

Neither a weak economy nor sinking dollar will help gold if real rates are rising. Today, however, we have the exact opposite. U.S 10-Year Treasury real yields are -0.45%, down more than 0.30% in less than a month (see Chart 1).  Historically, the direction of real rates has had the highest correlation with gold’s performance. Since the onset of the financial crisis, this relationship has only strengthened. During the past decade, changes in real interest rates have explained more than 30% of the change in the price of gold. As a rough rule of thumb, every 0.10% drop in real rates coincides with about a 1.25% increase in gold. Based on this relationship, gold’s poor performance during the week of the 24th should continue to reverse.

Lower growth, rates = holding gold

Beyond the human toll, the biggest threat stemming from the corona virus is to the economy. A combination of disrupted supply chains, less travel and dented confidence represents a threat, potentially a serious threat, to economic growth. Under these circumstances, investors may want to consider holding gold.

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