Anthony M. Wile
Global Market Strategy Team
J.P. Morgan Funds
Gold: Currency or Commodity?
- Despite gold traditionally serving as a safe haven asset, investors should be wary of fear-inflated investments given the potential for improving global growth.
- While central bank actions suggest risks of future inflation, other real assets such as consumption-driven commodities may provide a better store of value.
- In the context of a diversified portfolio, gold has provided a hedge during times of U.S. economic weakness and against losses in the value of the U.S. dollar.
Despite a "lost decade" for equities in the 2000s, it is worth noting that investors benefited from being invested in one asset class over that time period: gold. While gold's meteoric rise has led to an almost cultish following, it is important for long-term investors to remain cognizant of the facts. Gold does not have a fundamental intrinsic value, and does not provide any cash flow, a right to future earnings or a promise of repayment at a later date. Furthermore, it has little economic use and is not tied to global consumption. However, given its rarity, gold does have a perceived value and has played an important role in the global monetary system over the last century. Additionally, while short run catalysts are few, the precious metal is still tied to long run drivers of price appreciation, including limited supply and robust demand from the emerging world. Below we discuss some of the truths, and half truths, surrounding the value of this precious metal.
Supply & demand: Why gold is not an inflation hedge
As is the case in any market, gold prices are determined by supply and demand. Regarding supply, while commodities in general are scarce, gold is the epitome of a rare good. This inherent rarity has given gold its reputation as a global medium of exchange and notable hedge against fiat currency inflation. Given that the supply of gold is relatively stable, changes in aggregate demand have a disproportionate effect on the price. As shown in chart A, the majority of gold consumption is jewelry purchases. However, given the illiquid nature of jewelry, financial investments are a core driver of intra-day gold prices. Representing 36% of gold demand on average, investors poured into the asset, as a flight to safety, during the recession. Not surprisingly, as an improving economy has begun to deflate many "safe haven" assets, gold has suffered year-to-date. Nevertheless, with jewelry manufacturing and investors together representing more than 85% of demand, gold prices remain independent of inflation.
Chart A: Sources of Gold Demand
5-year average, 2008-2012
Sources: World Gold Council, Thomson Reuters, J.P. Morgan Asset Management. Data are as of 11/21/13.
The world's oldest currency
The changing link between gold and inflation stems from the pivotal role it has played in currency valuation during the past century. Until the early 1970s, the U.S. dollar was pegged to gold at a rate of $35 per troy ounce and was the basis of the Bretton Woods international monetary system. However, by the late 1960s and 1970s, a burgeoning U.S. trade deficit and rising inflation caused a fundamental disequilibrium in the pegged value of the dollar and gold, leading to capital outflows of the precious metal. In response, President Nixon unpegged the U.S. dollar in 1971, allowing both the price of gold and the U.S. dollar exchange rate to float based on market determined levels (chart C).
Most inflation hedges are related directly to consumption or industrial use. However, this logic does not hold in the case of gold. As shown in chart A, gold's industrial and technological uses remain very limited, as jewelry represents the majority of demand. Additionally, as shown in chart B, absent of a pass-through mechanism for prices, gold has shown a limited ability to act as a traditional inflation hedge, with a negative correlation to consumer prices of approximately -34% over the past 30 years. Charts B and C illustrate an important concept regarding inflation, the U.S. dollar and gold prices.
While commodities in general can help hedge against domestic inflation, the price of gold has generally maintained a very low correlation to consumer prices. However, the link between inflation and gold prices has been observed through another indirect channel: the U.S. dollar. Not surprisingly, the correlation between gold and the U.S. dollar has been consistently negative since the two were delinked, supporting the long-time argument that since gold is primarily traded in dollars, a weakening U.S. dollar should lead to higher gold prices.
Chart B: Gold Prices and Core Inflation
Year-over-year, % change
Sources: BLS, Dow Jones & Company, J.P. Morgan Asset Management. Data are as of 11/21/13.
Chart C: Gold Prices the Trade-weighted Dollar
Sources: Federal Reserve, Dow Jones & Company, J.P. Morgan Asset Management. Data are as of 11/21/13.
An unsafe safe haven
The consistently negative correlation between the U.S. dollar and gold makes fundamental sense given the metal's historic role in the international monetary system. Traditionally the U.S. dollar is viewed as the world's safe haven currency, which is confirmed when individuals purchase U.S. Treasuries during crises. However, with one exception, gold has exhibited similar tail risk properties during some of the worst market sell-offs since it was delinked from the U.S. dollar. As shown in the chart below, although it has normally displayed a highly volatile and unpredictable correlation with equity markets (with average correlations near 0%), gold has done well during periods of market turmoil. Nevertheless, investors should be aware of purchasing this expensive hedge, especially given a still healing global economy and no obvious or recognizable economic crises on the horizon.
Chart D: Gold and Stock Market Correlation
S&P 500, gold prices, rolling 1-year
Sources: Standard & Poor's, Dow Jones & Company, J.P. Morgan Asset Management. Data are as of 11/21/13.
Where to now?
Few assets are more prone to changes in investor sentiment than gold. With no direct tie to global growth, the intrinsic value of gold is based on negative investor sentiment, as it has historically served as a hedge against depreciation of the U.S. dollar. However, with the potential for stronger economic growth and tapering of Federal Reserve asset purchases in 2014, U.S. interest rates, and therefore the U.S. dollar, will most likely become increasingly volatile. Consequently, the still fear-inflated price leaves gold vulnerable over the coming quarters. With limited and unpredictable links to global demand as well as sentiment-driven prices, investors need to remain aware that gold is an expensive and limited hedge.
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Any performance quoted is past performance and is not a guarantee of future results.
Diversification does not guarantee investment returns and does not eliminate risk of loss.
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Reference to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
Commodity investing is subject to greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.
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© JPMorgan Chase & Co., December 2013