It may be time to replace bonds with gold
Recently the Investment Update published by WGC says, It may be time to replace bonds with gold and this update is on the back of March 2019 ink, The impact of monetary policy on gold WGC says, An analysis based on historical returns for major asset classes suggests a 2%-10% optimal gold allocation for portfolios with various asset compositions, increasing as riskier assets are added.
But when we include lower expected returns for bonds based on the results from our model, we find that across most portfolios the optimal gold allocation increases by an additional 1%-1.5% . And for a hypothetical average pension fund portfolio, the optimal allocation with the maximum risk-adjusted return increases from 4.2% to 6.6%.
Central banks have shifted to a new regime of easy monetary policy, thus reducing expected bond returns. As negative yielding debt increases alongside stock-to-yield valuations to all-time highs, gold may become an attractive and more effective diversifier than bonds, justifying a higher portfolio allocation than historical performance suggests.
Re-optimising portfolio structures for lower future expected bond returns suggests investors should consider an additional 1%-1.5% gold exposure in diversified portfolios. WGC considers 5 points to be focussed.
1: High risks and low rates Investors are facing:
An environment with flat to inverted yield curves often a signal of an impending recession & that stock valuations at extreme levels, particularly when compared to the level of interest rates. Historically preceded meaningful stock sell-offs and an increasing set of geopolitical concerns, including trade tensions, Brexit and Middle East turmoil. Within this context we believe that there are clear indicators for higher levels of safe-haven assets like gold.
2: Low opportunity cost makes gold attractive:
One of the key drivers of gold, especially in the short and medium term, is the opportunity cost of holding it. Unlike bonds, gold does not pay interest or dividends because it does not have credit risk. This lack of yield can deter investors.
But in an environment where 26% of developed market sovereign debt is trading with negative nominal rates and, once adjusted for inflation, a whopping 82% trades with negative real rates, the opportunity cost of gold almost goes away, even providing what can be seen as a positive, cost of carry, relative to sovereign bonds.
3: A race to zero:
Countries around the world are arguably trying to competitively devalue their currency, most notably through loose monetary policy. The global currency depreciation is reflected in the performance of the price of gold in those currencies. While the price of gold in US dollars and Swiss francs is still some way from all-time highs, the price of gold in all other major G-10 currencies is at or near all-time highs.
Not only has gold provided purchasing power to gold investors within those countries, but it has put the US at a significant disadvantage from a trade perspective, as the US trade-weighted index is at all-time highs signalling a stronger US dollar. US leaders have responded by calling for sharp reductions in rates, behaviour that could be repeated elsewhere globally. Simply put, there is evidence that suggest there is a race to zero, or negative’ for interest rates, which should help support the price of gold.
4: Portfolio risk is rising yet bonds may underperform:
The low rate environment has also pushed investors to increase the level of risk in their portfolios, either by buying longer term bonds, lower-quality riskier bonds, or simply replacing them with riskier assets, like stocks or alternative investments.
For pension funds, this may be particularly tricky, as underfunded liabilities have increased yet many are still required to deliver annual returns between 7% and 9%.
5: Investors are adding gold to their portfolios
Central banks bought the most gold in history in 2018, with continued robust purchases y-t-d in 2019. And gold-backed ETF holdings have reached all-time highs in September as investors respond to the high-risk, low rate environment.
6: Gold excels when rates fall:
A lower rate environment may make gold more effective than bonds in mitigating stock-market risk, providing portfolio diversification and helping investors achieve their long-term investment objectives.
Bonds usually make up a significant proportion of portfolios, and while it may not be feasible for investors to fully replace all bond exposure with gold, the environment warrants consideration of augmenting gold holdings.
Gold has historically performed well in the year following a shift in Federal Reserve policy from tightening to: on-hold” or easing, the environment in which we currently find ourselves.
