There are no two identical business cycles. Their courses depend on the many independent actions of market participants. Also, each time money flows and spreads out differently in the economy, affecting distinct prices in various ways. However, according to a general pattern, business cycles can be broken down into four stages, during which distinct assets classes, including gold, behave differently. To understand what may happen in the gold market during a possible recession, we have to examine how changes in the business cycle affect the performance of different asset classes.
So, according to the literature, stock prices mimic rises and falls in the business cycle, while bonds are anti-cyclical instruments. How does it look in detail? Let's start from recovery. In that phase (or even at trough) stocks - the leading indicator of economic improvement - begin to grow. In the expansion stage, commodities are the best investment. Commodity prices rise because of the increased demand of entrepreneurs and inflation concerns. It is a good moment to sell bonds, because in the next phase interest rates are increased due to higher demand for credits and a rise in inflation expectations. The hike of interest rates and a credit crunch eventually worry equity market investors, who start selling stocks in anticipation of contraction. During recessions, cash is king, while commodity prices fall due to reduction in demand. In the last stage, i.e., depression, bonds perform the best, as the Fed lowers interest rates. Surely, this is a very simplified picture of the business cycle, not taking into account differences among countries (think about commodity exporting countries like Australia) or within asset classes (e.g., dividends stocks vs. growth stocks), however most of the economists agree that, in short, stocks lead commodities, commodities leads bonds and bonds lead stocks.
But where is gold in that picture? Gold generally doesn't sync with stocks or bonds over the long run. This is why gold is the best asset class during slowdowns. It is a very interesting result, because commodities in general perform best during downturns. This confirms that gold is something more than just a commodity and is considered by investors as a hedge against currency weakness or financial turmoil. This also means that gold is neither pro-cyclical nor anti-cyclical. Therefore, gold investors should neither be afraid of recession nor assume that gold automatically gains if stock market collapses. It is true, as we pointed out in the last Market Overview, that in the last few years gold was negatively correlated with U.S. stocks (see chart 3). However, historically, gold moves independently. In other words, the relationship between gold and stocks has been anything but static. Changes in the correlation between these two asset classes depend mostly on two factors.
Graph 3: Gold price (PM Fixing, green line) and S&P 500 (red line) from 2005 to 2014
First, this relationship depends on how capital flows between asset classes. For example, after the real-estate market went bust in 2007/2008, hot money went into both stock and gold markets, significantly increasing the correlation coefficient between them. So the question is where the outflows from equities or commodities will go. We have to remember that markets are strongly interconnected today. Therefore, a sharp downturn in one asset class can actually pull down another, as investors are forced to raise cash. This is why gold fell immediately after Lehman's bankruptcy and the stock market collapse.
Second, the relationship between stocks and gold can be affected by the changes in the greenback's value. Generally, stocks are negatively correlated with the U.S. dollar. However, during the last few years the greenback often declined in tandem with equities selloffs, e.g., between May 21, 2013 and June 5, 2013. Therefore, gold can gain in the case of stocks falling, but a lot depends, as we thoroughly explained in one of the previous editions of the Market Overview, on the behavior of the U.S. dollar. We are not saying that we are already entering a recession; however this is what just happened to Japan. And stock market investors were clearly nervous in December because of the low oil prices. Gold investors should be simply aware that, according to the business cycle approach to the asset allocation, falling commodity prices often signal the recession. Therefore, they should also know what entering into recession implies for gold market, and understand that equity selloffs do not guarantee gains in gold. A lot of depends on Fed's monetary policy and the behavior of the U.S. dollar.
Sunshine Profits' Market Overview Editor