Getting to grips with gold's protection potential

Nuances behind haven metal's behaviour relative to stocks should give investors pause

Getting to grips with gold's protection potential

Given the volatility in the stock market and the newly extended forecast for low interest rates, it’s no wonder why more market participants have taken a shine to gold as a portfolio hedge of late. But even as the most fervent gold bugs sing its praises, investors would do well to remember that the metal’s protection properties is not exactly a given.

“When stocks fall, investors want a diversifier that rises in value to cushion the loss,” wrote Wall Street Journal columnist James Mackintosh in a recent article. “But gold fell alongside stocks during the market panic in March and again last month, and might continue to move with stocks for some time.”

Mackintosh noted that in certain points in history, gold has been a better hedge against losses from stock-market drawdowns. To explain that, he pointed to a handful of factors that drive the price of gold. One of them is real rates, as reflected by Treasury inflation-protected securities, or TIPS: like TIPS, gold tends to rise and fall in opposite directions to real yields.

Given the U.S Federal Reserve’s commitment to keeping interest rates at zero for the foreseeable future, inflation would imply lower real rates and TIPS yields, which would support gold. But as Mackintosh noted, higher inflation also points to a stronger economy, which would benefit stocks.

“Gold shines when inflation fears are rising in a weak economy,” he said. “Inflation then makes Treasurys unattractive, while a weak economy both makes stocks unappealing and encourages the Fed to cut rates or keep them low.”

The fact that so much gold is held by speculators, who typically buy their holdings using debt, also impacts the precious metal’s prices. As markets seize up, speculators are pushed to dump all their holdings, making the precious metal a poor hedge when the finance industry is struggling. From the heady highs it saw in early March, gold has fallen 12% before bottoming; in its worst point during the 2008 financial crisis, it shed over a over a fourth of its value, Mackintosh said.

The takeaway, he said, is that gold is best used when the wrong type of inflation is in play – the sort fuelled by supply issues such as commodity and labour costs, such as what might be seen amid stagflation – just as the central bank is trying to prop up the economy.

“That’s not the case when, as now, inflation is more the virtuous type, driven by underlying demand,” Mackintosh said. “Unless you think that’s about to change, expect gold and stocks to move in tandem.”


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