Should investors worry about the falling gold prices?

On August 06, 2020, spot gold touched a lifetime high of $2067/oz, so the correction from that point is almost 15%. Is the fear really justified?

Dec 03, 2020 08:12 IST India Infoline News Service

In November 2020, there was a sense of panic among gold investors. That is hardly surprising. Gold prices slipped over 6% in November and fell to $1765/oz in the global market. Nov-20 happens to be the worse month for gold in the last 4 years and that is making traders and analysts jittery. On August 06, 2020, spot gold touched a lifetime high of $2067/oz, so the correction from that point is almost 15%. Is the fear really justified?

How gold returns fared across different time frames?

Data Source: (3-year and 5-year returns are CAGR)

As can be seen from the above chart, gold as an asset class in India has given very attractive returns over the longer term. The negative returns are visible only at the very short end of 1-month and 3-month returns, which is anyways a very short time frame to judge an asset class. If you look at longer time frames of 3 years and 5 years, gold has actually done better than equity as an asset class. Hence it may be inappropriate to read too much into this gold price correction and start making extrapolations. Then what explains the sharp correction in gold price since September?

What triggered the fall in gold prices?

There were a number of factors that triggered the sharp fall in gold prices. From a peak of $2067/oz on 06-Aug, gold prices have fallen sharply. Here are five factors that triggered the fall in gold prices.

• An economic recovery has been underway with GDP contracting lesser than anticipated and core sector and IIP getting back to pre-COVID levels. That takes away the uncertainty, which is normally the fuel for gold price performance.

• The election of Biden is expected to bring stability to the global economy and to global geopolitics. Gold appreciated in the last few months as the US China stand-off was keeping markets jittery, driving investors towards gold.

• The world is much closer to the COVID vaccine than ever before. With Pfizer, AstraZeneca and Moderna into the final stages of clinical testing, the vaccine is expected by middle of 2021. That will reduce the impact of COVID and make gold less attractive.

• The global central banks and governments infused $7 trillion of liquidity into the markets to combat the effects of the pandemic. With the infusion almost done, the liquidity impact on gold has come down sharply.

• Lastly, gold has had a phenomenal rally and has been one of the best performing asset classes over the last 18 months in particular when the returns have been more than 60%. That froth is certainly coming off around psychologically significant levels.

But it is actually about gold versus real yields

Let us first look at the trend of gold versus real interest rates and then try and look at why this inverse relationship happens.

Chart Source:

The above chart presents an interesting relationship between real interest rates and gold prices. Real interest rates are the interest rates adjusted for inflation. For example, currently the yield on 10-year bonds in India is 6% and inflation is 7.6%, so the real interest yield in India is (-1.6%). Let us look at the relationship over the last 50 years between real yields in the US and international gold prices. There are 3 phases that we can see.

In the first phase between 1971 and 1979, the real interest rates remained negative in more than half the months. During this period, gold rallied from $35/oz to $800/oz. In the second phase between 1980 and 2000, the real interest rates were negative for less than 6% of the months. Gold prices during this period remainedlacklustre and actually drifted lower from $800/oz to $250/oz. The third phase between 2001 and 2020 has seen negative real rates in a whopping 58% of the months. During this period, the gold price has rallied from $250/oz to $2067/oz.  What explains this strange relationship?

There are two reasons why this happens. Firstly, when the real rates are negative, investors have no incentive to stay invested in bonds. As an investment, gold looks relatively better. Secondly, negative real rates reduce the opportunity cost of holding gold, which is normally regarded as an unproductive asset. It also makes sense to borrow and invest in gold. That explains why real interest yields have such a profound impact on gold prices.

Last word: take a portfolio allocation approach

To cut a long story short, it is tough to time gold as it tends to move in multi-year cycles. However, what this underscores is that gold deserves a default allocation in every portfolio. While there are no hard and fast rules, the thumb rule is to allocate 10-15% of your overall portfolio in gold. Not only does gold enjoy a low correlation with other asset classes, but it also acts as a natural risk reducer.

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