Interest in gold has soared among private investors in recent months, as a financial crisis unmatched since the Great Depression has created a demand for traditional safe havens. For the high-net-worth investor, the case for gold is particularly compelling. Moreover, the advent of gold exchange-traded funds means that accessing the gold market has never been easier.
Gold is a unique financial asset in that it has no counterparty risk-a highly desirable trait amid the mistrust and uncertainty prevailing in the financial markets. But a strategic allocation in gold can offer more than safety in times of financial distress.
Gold's lack of correlation with other mainstream financial assets means it can help diversify a portfolio and boost risk-adjusted returns regardless of the health of the financial sector or broader economy. Gold also has a long history as an inflation hedge, outperforming bonds and equities in high inflation years. Although the deepening recession means that inflation may be off the immediate economic radar, many high-net-worth investors are concerned about the long-term inflationary impact of the massive government rescue packages being injected into the market.
Gold Has Surged
The deterioration in global economic and financial conditions triggered a surge in identifiable investment demand in gold in the third quarter, to 382 tonnes-up 179% from the previous quarter and 56% from a year ago. Gold ETFs, securities traded like a stock but backed by physical gold that have proved particularly popular with high-net-worth investors, enjoyed record inflows of 150 tonnes during the quarter. The peak came in mid-September following the collapse of Lehman Brothers, when holdings surged by an unprecedented 111 tonnes-the equivalent of $7 billion-in five consecutive trading days. At the same time, retail investment in bars and coins rose by a staggering 121%, to 232 tonnes.
Gold's lack of counterparty risk was no doubt a factor in the steep rise in demand, but its lack of correlation to the mainstream financial market also made it stand out in the ongoing crisis-and underscored the broad role gold can play as a portfolio diversifier.
The correlation coefficients between gold and a range of U.S. assets are shown in the chart below (Figure 1). It shows that over the past five years, the correlation between gold and each of the equity and bond indices, with the exception of global treasuries, has been close to zero. Research suggests that putting as little as 2% to 4% of a portfolio-closer to 10% for riskier portfolios-into gold can help optimize its risk-return balance.
The lack of correlation between gold and other assets reflects the unique drivers of supply and demand in the gold market. These drivers include exploration spending, mine production, producer costs, producer hedging, seasonal demand in the jewelry sector and changes in official reserve holdings. Although some of the drivers of investment demand for gold, such as inflation and dollar depreciation, may also impact other financial assets, they do not generally do so in the same manner and their effect on the correlations is simply not strong enough to negate other influences.
The unique drivers of supply and demand mean that changes in the gold price do not correlate with changes in U.S. economic growth (see Figure 2). Since the gold price was fully freed in 1971, there have been times when it has fallen as the economy has slowed, as it did between first-quarter 1988 and first-quarter 1991, when U.S. economic growth slowed from 4.3% to -1.0%, and the gold price declined from $456.95 per ounce to $355.65 per ounce. But there have also been times when the reverse has been true. Between second-quarter 2004 and third-quarter 2008, for example, U.S. economic growth slowed from 4.1% to 0.8%, while the gold price increased from $394.25 per ounce to $844.50 per ounce.
Since 1971, there have been five recessions, according to the National Bureau of Economic Research, the organization charged with identifying the U.S. economy's official business cycles. The recessions took place between November 1973 and March 1975; January 1980 and July 1980; July 1981 and November 1982; July 1990 and March 1991; and March 2001 and November 2001.
In the first recession, gold went up 88%. During the second, it fell slightly. In the third and fifth recessions it rose moderately. In the fourth recession, the price fell by 4%. In short, there has been no clear pattern in the behavior of gold during an economic downturn. This suggests that the current recession will not necessarily have negative implications for the gold price.