Since the turn of the century, the gold price has performed incredibly well, rising from below AUD $500 to AUD $1,645 per ounce. This performance has led to a huge rise in physical gold demand across the Western world, including in Australia. Demand has also exploded in Asia, where high rates of income growth and high savings rates have fuelled demand for the precious metal. The chart below, produced by the World Gold Council in early June 2017, helps put the impressive performance of gold into context, comparing it to a range of asset classes including stocks, bonds and commodities, over 10 years, 20 years, and since 1971, when the price of gold became free floating. As you can see, the yellow metal has more than held its own over the past 46 years, outperforming cash and bonds, and more or less matching the return delivered by equity markets.
Despite the strong performance, most investors do not own physical gold in their portfolio. This is true of institutional investors as well, with many unsure how they should characterize the precious metal, as it does not neatly fit the profile of a traditional growth investment like shares, nor a traditional defensive investment like bonds. The fact that gold doesn’t behave at all like a traditional commodity (as the 10 year performance in the above chart demonstrates) also causes confusion for some. In this article, we’ll explain why gold should be thought of as global currency, the uses of gold for Australian investors, and the benefits that it brings to a portfolio, including protection against rising inflation and market downturns.
Gold as a global currency Gold has been used as a currency for millennia, as the following chart, which comes a World Bank report highlights.
Despite its history, today, many investors struggle to see gold as a currency. At first glance, we can understand why that it is. After all, we don’t use it to buy goods and services on a daily basis anymore. It’s also actually physically mined and refined, unlike the actual currency we use, which is either printed on paper and or created by a computer entry. Physical gold is also used in industry (including in dentistry and in medical) whilst it is also worn in jewellery, with close to 50% of all the gold that has ever been mined in bracelets, necklaces and the like. Nevertheless, gold remains a monetary asset and a global currency today. The best way of realizing this is by looking at the foreign exchange reserves of major central banks around the world today.As a collective, central banks own more than 32,000 tonnes of physical gold, which is roughly 18% of all the gold that has ever been mined in human history. They clearly see it as an important asset, with developed market central banks (in Europe, the United States etc.) holding on average close to 20% of their foreign exchange reserves in gold. Central banks have been net buyers of gold since the GFC hit, with purchases that have averaged over 450 tonnes per annum in the last several years. This can be seen clearly in the chart below, which looks at annual net purchases from 2005 onward.
The Bank for International Settlements also see gold as a monetary asset, stating in their 2013 report that “gold is to be dealt with as a foreign exchange position”, whilst further evidence of its ongoing monetary status is found when one looks at the formation of the European Central Bank (ECB). When the ECB was formed back in 1998, central banks from the Euro area all transferred foreign reserve assets to the new institution, which totalled approximately 40 billion Euro. Some 15% of the 40 billion Euro that was transferred was physical gold. By 2016, the ECB held over 25% of its reserves in physical gold.
Uses of Gold for an Australian Investor Gold is a highly relevant investment for prudent Australian investors today, which offers a number of benefits for those looking to first preserve, as well as build wealth. The two primary benefits of holding gold are that it has historically provided excellent protection against inflation, and it is a simple and transparent hedge against market downturns. We will look at both of these in turn detail.
Protection against inflation As gold has held its value across the millennia, it has a well-deserved reputation as a protector of wealth whenever inflation threatens to seriously reduce the value of the paper money we are paid and save in. We saw a great example of this in the 1970s when inflation averaged over 10% per annum. Most assets fell in real terms during that decade, but gold was an exception, rising by an average of 37% in AUD terms across that 10-year period. One of the neater ways to visualize the ability of gold to protect purchasing power an even longer time frame is by looking at the number of beers an ounce of gold can purchase, which is seen in the chart below. Paper money on the other hand is designed to lose money over time, with it being part of the RBAs mandate to generate inflation. Investors are typically compensated for that inflation to some degree via the interest they receive on the money they keep in the bank. But today, with rates at record lows, they earn next to nothing, causing them to look for alternatives. Gold is likely to be one of the alternatives they look at, for in Australia, from the end of 1970 to the end of 2016, there have been 22 years where ‘real’ interest rates were 2% or less, like they are now. The gold price rose in 19 of those 22 years, with an annual average gain of over 20%. Given gold has proved itself to be a superior long-term savings currency than Australian dollars, is generally more tax efficient, and that at present;
- The rate of interest one earns leaving money in a bank is near all-time lows today, and likely to stay that way for years
- Inflation may well head higher in coming years
- That gold tends to do very well when rates are so low
It’s no surprise that every day, more and more investors are choosing to switch some of their savings out of their bank, and into gold.
Hedge against market downturns The second main benefit that gold offers Australian investors is that it is uncorrelated to financial markets, which provides diversification benefits when constructing a portfolio. Indeed gold has historically been the most effective hedge against market downturns, when traditional assets like shares fall in value. To help visualize this, it is worth looking at the following table, which highlights the worst 5 calendar years for the stock market from the 1970s until the end of 2016. The table also shows the returns for traditional defensive assets, like bonds and cash, as well as gold.
Asset Class Performance in Worst 5 Years for Stocks
Source: ABC Bullion, Global Financial Data As you can see, in the years where the stock market performs worst, with average declines of close to 25%, gold has been the highest performer, recording an average gain of almost 40%. It’s not just those five years either, with the gold price increasing by an average of 16% in all of the years that equity markets have declined since the 1970s. This highlights clearly how gold can help bring much needed balance to an investors’ portfolio. In this sense, gold acts like an insurance policy for your overall portfolio, and it pays off best when it is needed most, as any good insurance policy should do. Over the next several years, we think Australian investors will be well rewarded by keeping that insurance policy in their portfolio, as there remains a litany of risks that the global economy will have to navigate. Global debt levels have continued to climb uninterrupted, both in dollar terms, and even more importantly, as a percentage of output, or GDP, affecting both developed and emerging markets, with the latter being the primary drivers of growth in the past few years. Monetary policy also remains incredibly loose around the world, despite the focus on the Federal Reserve, and the few rate hikes they’ve pushed through in recent months. As it stands today, there have been some 700 interest rate cuts since the GFC, with some 90% of the industrialized world still anchored by zero or even negative real rates. As per our earlier section on gold and its ability to protect from inflation, those negative real rates will likely be a primary driver of gold demand, and prices, in the coming years.Finally, expensive financial markets are likely to drive further demand for gold in the coming years, as it will be seen as a sensible holding in an environment where risk assets like shares likely fail to maintain the strong returns they’ve delivered in the past. Whilst others may disagree with this perspective on risk assets, it would seem to closely reflect the view of Simon Doyle, who is the Head of Fixed Income & Multi-Assets from Schroders. Doyle recently stated that; “Current valuations across most assets tell us that future returns will be low and the risk of a significant correction is high.” Doyle’s comments in effect echo research from other well respected commentators, including BCA Research, who see a portfolio of financial assets alone delivering returns of just 2% per annum from 2016-2026, whilst Jeremy Grantham of GMO is even more bearish, projecting negative real returns in most markets over the next seven years. The combination of low real rates plus the potential for sub-standard returns and higher risk in traditional assets in the years ahead will continue to drive prudent investors wishing to hedge and protect their portfolio toward a physical gold allocation in their portfolio today.