The relationship between economic downturns and gold

Gold has risen from around $1475 in late March, when the coronavirus pandemic led to shutdowns across the world, to about $1750 in mid-June as the global economy went into a tailspin.

Jun 24, 2020 09:06 IST India Infoline News Service

Gold preserves value

It is said that when the Shah of Iran fled the country, he left with thousands of kilos of gold. Stories like this might float around in your family too if they were forced to flee a place at short notice. Gold has been used to pass on wealth for thousands of years. It is such a reliable preserver of value that when there’s a meltdown in the financial markets or the economy goes into a downward spiral, investors flock to the safe haven of the yellow metal.

Legendary investor Warren Buffett is quoted to have once said, “Gold is a way of going long on fear”. The Berkshire Hathaway CEO explained that if people “become more afraid, you make money, if they become less afraid you lose money, but the gold itself doesn’t produce anything.”

While the yellow metal doesn’t pay you an interest or a dividend, it goes a long way to protect the wealth you have already accumulated. For example, you could buy a brand new suit for the price of an ounce of gold in the early 1970s (it was around $35). While the value of the dollar itself has eroded and you can’t buy the same suit at that price anymore, you could still purchase it with an ounce of gold today.

Knight in shining armour

Looking at how gold fared whenever S&P 500 — the world’s biggest index — went through a meltdown will tell us that the yellow metal moves in an inverse relation to stock markets during times of crisis.

Source: https://www.suissegold.ch/

A closer look tells us that the length of the crash didn’t make a lot of difference to the correlation. The only instance when there was a deviation from this principle was during gold's only important selloff (-46% in the early 1980s) that happened just its largest bull market in history. Gold climbed over 2,300% between 1970 and 1980. As such it is not very surprising that it dropped with the wider stock market.

It responds to geopolitics too. Global financial markets were roiled when the United Kingdom voted to leave the European Union in June 2016. The price of gold rose $100 an ounce in just six hours as investors panicked and flocked to the yellow metal as a hedge against the euro.

After the Lehman brothers crash of 2008, which led to a prolonged global recession, the value of gold increased by leaps and bounds as there was a 101.1-percent rise in the Producer Price Index (PPI) for gold. As former US Federal Reserve Chairman Bernanke had stated, gold prices can act as an indicator of the health of the economy. An increase in the price of the yellow metal could mean that the economy is struggling.

Gold in the times of corona
Source: kitco.com

Gold has risen from around $1475 in late March, when the coronavirus pandemic led to shutdowns across the world, to about $1750 in mid-June as the global economy went into a tailspin. The yearly outlook for the yellow metal in 2020 anyway was that it would increase in value given the US-China trade war, Brexit negotiations, ailing emerging economies and growing tensions in West Asia. The pandemic only catalysed the impending rise.

A double whammy

During most economic crises, the supply of gold doesn’t get impacted much. However, shutdowns because of rising Covid-19 infections have meant that mining of the yellow metal has halted in many places. For example, South Africa closed Mponeng, the world’s deepest gold mine, in March after 164 workers tested positive for the disease. As such, while the demand for gold increases, there might be a shortage in its supply in the immediate future. That could lead to a steeper climb in its value.

Gold to oil ratio
Source: Economic Times

While discussing the relationship of gold and economic downturns it is important to consider oil — the commodity that fuels the global economy. A rise in oil prices more often than not indicates greater economic activity as opposed to gold. Consequently, the ratio of gold prices to oil prices is a good indicator of the magnitude of an economic crisis. A look at the chart above will tell you that this ratio is at a historical high today — hence, the possibility that the corona crisis will cause a lingering economic recession.

How to hold gold as a safe harbour?

1) The first and most obvious option is physical gold. However, this might not be a very good idea given the cost of storage and security. Moreover, buying and selling charges of physical gold are also quite high.

2) Gold ETFs (exchange traded funds) track domestic spot prices and are units representing physical gold in paper or dematerialised form. This is one of the easiest methods to hold gold as a safe haven.

3) Another option is to invest in gold shares — stocks of companies who mine gold. However, you should be careful in your assessment of the miner. These stocks can be volatile and prices depend not only on the quantity and quality of the metal produced but also the cost of production

4) You could also invest in a gold fund run by an asset manager. These funds invest in a diversified portfolio of gold miners, thus spreading the risk. However, these funds also generally invest in other metals too apart from the yellow metal

Conclusion

The everlasting value of gold comes from the fact that the chances of its price going to zero is negligible. Investing in gold is not only a good way of diversifying your portfolio to build a stronger moat, but it’s also a highly liquid investment option that can come handy during an emergency. As the coronavirus crisis has taught us, a global Black Swan event could impact every single human being on the planet.

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