Gold is often characterised as a store of value (primarily against the long-term corrosive effects of inflation) as well as a portfolio hedge against a range of risks, including general financial market instability, geopolitical tensions, and currency weakness.

Physical gold has shown a long-run capacity to outperform both inflation and cash, despite not providing an underlying running yield. Our analysis shows gold’s outperformance holds over 10-, 20-, 30- and 50-year time horizons.

From a portfolio perspective, physical gold tends to have a low and, at times, negative correlation to other asset classes (especially equities), particularly in times of acute stress.

Gold’s low or negative correlation is potentially attractive from a diversification standpoint, helping to dampen overall portfolio volatility. Therefore, gold can potentially complement other portfolio “hedges” such as high-grade fixed interest.

Gold in an absolute sense is a higher volatility but relatively liquid asset class, so we place it within the liquid (defensive) Alts segment of diversified portfolios. Physical gold holdings can, of course, be complemented with an additional allocation to gold equities.

There are a few rules of thumb around how gold should behave in relation to its key drivers. These relationships have shown a tendency to vary over time but are undoubtedly worth recognising when we think about the outlook for the gold price and its role in portfolios. 

We would summarise these influences as follows. 

Gold and (real) interest rates

Gold is typically characterised as being negatively correlated with interest rates (most particularly real interest rates). In short, low or negative (real) rates are typically supportive for gold. This is likely to be a result of the fact that the opportunity cost of holding gold falls with low (real) rates. This relationship has tended to hold over the long-term but is not ironclad. 

For example, gold did very well in the five years from 2003-2007, despite the Fed raising rates from 1% to 5% (we note the US$ was weak through this period). Gold has also shown a degree of resistance to the rise in market-based long-term real rates in 2021/22. This was after an extended period of very tight real rate correlation between 2007 and 2020. Gold did come under pressure in mid- to late-2022 from rising rates, falling from around US$2,000 to a low of US$1,650 in October 2022. 

The initial buoyancy of gold in early 2022, even as US bond yields were beginning to rise, was likely a result of the spike in geopolitical risk associated with Russia’s invasion of Ukraine. This saw the price of gold lift more than 10% in the space of a few weeks and hold that level for a period before the impact of rising (real) rates began to weigh on the gold price.

Some of this recent resilience of gold to higher real rates might also be a function of the difficulty in observing the “underlying” real rate. We have used the well-followed 10-year implied real (TIPS) rate in Figure 3. However, alternative short-term real rate measures suggest that real rates based on “actual” rather than “expected” inflation remained deeply negative in 2022, as inflation outstripped nominal interest rates. Thus, it is possible that different constituencies of investors had different views on the medium- to long-term inflation outlook. Ongoing buying from inflation hawks may have cushioned the impact of a rise in long-term “traded” real rates on the gold price.

We would also highlight very strong central bank buying in 2022, which also likely supported the gold price. Presumably as central banks attempt to diversify away from government bonds.

Gold as an inflation hedge?

While gold’s real value can vary significantly from year-to-year and indeed decade-to-decade, gold has tended to hold its relative value over very long timeframes, e.g., the past 50 years. 

Gold also proved itself to be a highly effective hedge in the structurally high inflation regime witnessed in the 1970s and early 80s, when the gold price appreciated more than ten-fold over the course of less than a decade. It was in this decade that gold reached its all time high in real terms.

It is interesting that gold did not really react positively to the inflation spike in 2021/22. We would rationalise the lack of positive reaction to the inflation spike as grounded in the market’s view that the inflation surge was ultimately a transitory shock, which would work its way out of the system over time. While the “sticky inflation” narrative last year created some market nervousness, analysis of the market’s long-term inflation expectations shows that expectations remained “anchored”. While there was plenty of talk from various pundits around a return to structurally elevated inflation, the market did not really move to price in this scenario. Long-term inflation expectations moved up moderately but did not break out to the upside (figure 4). This likely explains why gold did not behave like it did in the 1970s when the inflation problem was indeed a structural one, which took a long time to bring under control.

Gold as a US$ counterweight

Over the long-term, gold has demonstrated a negative correlation with the US$. Historically, gold has shown a long-run tendency to rise in weak US$ “regimes” such as the 1970s, the second half of the 1980s, and the first decade of the 2000s. Once again, gold’s month-to-month and indeed year-to-year correlation with the US$ is less reliable, but gold has performed well in multi-year periods of US$ weakness. At the same time, in short-term phases, gold has shown a tendency to strengthen in concert with bursts of US$ strength in “risk-off” financial market periods. Both assets tend to be seen as safe havens in times of market stress and uncertainty. 

Extended Fed cutting cycles tend to correlate with a weaker US$. This likely explains the tendency for a strong gold price to correlate with both a falling US$ and lower interest rates. The prospect of a new Fed easing cycle in 2024, leading to a weakening trend in the US$ over the coming year, does suggest a supportive cyclical backdrop for the gold price in our view.

Gold as a portfolio hedge against tougher times

Gold tends to act as a portfolio hedge in times of equity market weakness. As a safe-haven asset, gold’s tendency to protect against equity market downside is reasonably good. While gold has shown some brief vulnerability in the epicentre of market dislocations, its performance has been mostly solid when measured against the peak to trough performance of equities in major corrections. The 2021/22 gold price correction was not surprising when we think about the drivers of the equity correction. A cyclical inflation shock, rising rates, and a strengthening US$ was a less than ideal backdrop for gold in 2022. While shocks are, by definition, difficult to predict, we see the most “probable risk” for equities over the coming year as a disinflationary growth disappointment, rather than an inflationary surprise. If correct, this would likely lead to significant Fed easing. The direction of the US$ in this scenario would depend on how stressed risk assets became, given the safe haven character of the US$. 

The ideal scenario for gold over the coming year would likely be a significant but orderly deceleration in US growth, leading to a significant fall in interest rates. Equities may muddle through, the US$ would likely decline, and gold would likely appreciate. 

From this perspective, we retain a moderate exposure to physical gold via exchange traded funds (ETFs). With the A$ looking undervalued, we see a US$-hedged version as particularly attractive to gain exposure to the US$ move in the gold price.