Gold remains an integral asset in a diversified portfolio

Gold was one of the best performing major assets in 2020, breaking through $2,000 an ounce for the first time in history in August and returning 25.1 percent for the year, the highest return in a decade, according to figures from Bloomberg. There are many ways to access gold, from buying physical bullion or purchasing jewelry to investing in mining companies or gold-backed exchange-traded products, including several shariah-compliant ETFs for investors in the Middle East. The demand for gold-backed ETFs was particularly strong in 2020 with net inflows hitting a record 877 tons, according to the World Gold Council. The remarkable performance was driven by investors turning to gold as a safe-haven store of value as the pandemic brought uncertainty to global markets.

The first quarter of 2021 saw gold have a weak start to the year, as investors regained appetite for riskier assets on the back of an improvement in the global economic outlook. The price of gold declined 10 percent in Q1 2021 finishing the quarter at $1,708 per fine troy ounce, Bloomberg reported. The fall in the gold price during the quarter can be attributed primarily to rising nominal and real bond yields, which have also encouraged a stronger US dollar. As the value of the dollar rises against other currencies, gold becomes more expensive in non-US dollar currencies. Further, investors have been increasingly willing to add more risk to their portfolios such as equities and corporate bonds, as Covid-19 vaccination programs roll out and global economic growth outlook improves.

What does this mean as far as gold allocations in an investment portfolio? When considering gold, investors typically look at its relationships with the US dollar, inflation, interest rates and growth expectations. But what ultimately drives the price of gold is the same as for any commodity – supply and demand. The supply side of gold is relatively stable in terms of newly mined production and a varying amount of recycled gold, and relatively constrained by the amount of gold that is in the ground. Whether investors are moving into or out of the asset seems to have the most impact on price. Therefore, understanding what drives investor demand will help to understand what factors drive the gold price.

Most investors hold gold as a real asset protection against rising inflation, as a diversifying asset against a significant decline in markets or a significant drop in growth expectations.  Gold is unique in that unlike equities or fixed income assets it is a non-income-paying asset, so the other key driver of gold price is the opportunity cost of holding it, which would effectively be interest rates. As interest rates rise, investors look elsewhere to find better returns.

As major global economies have begun to show signs of recovery, supported by continuing fiscal and monetary stimulus and vaccination program rollouts, the level of global economic uncertainty has declined. A clearer outlook reduces the attraction of assets such as gold. The reflation trade is pushing expectations for interest rates to go higher. Bond yields are rising from a low level, causing a fall in bond prices. Rising rates, positive earnings reports and improved economic data are expected in an improving economic environment, putting pressure on the price of gold.

There are many ways to access gold, from buying physical bullion or purchasing jewelry to investing in mining companies or gold-backed exchange-traded products, including several shariah-compliant ETFs for investors in the Middle East

Loose central bank monetary policies and stimulus spending fuel inflation expectations. Despite higher expectations for inflation, gold has not moved in response. It may be that the market is waiting for inflation to come through in the data, or that investors no longer see it as the inflation-hedge it was once perceived to be, particularly when the rise is inflation is expected to be relatively contained and there is not yet evidence of excessive inflation. But as economic growth pushes inflation higher, there is potential modest upward bias for the price of gold, and rising bond yields could lead to tighter fiscal conditions which would give support to gold. Given that gold is also considered a hedge against geopolitical risk, the current environment could also provide an upward push on gold.

While the price has fluctuated in the recent short-term, gold can still play an important role a diversified investment portfolio. Over the long term, gold generates returns which are competitive with other major investment assets. The gold market is large and liquid, and gold-backed exchange-traded products have increasingly become another source of liquidity. ETPs also make it easier for investors to gain exposure to gold, with a degree of price transparency. Gold acts as a diversifier to mitigate losses in times of market volatility and shock, serves as a hedge in a higher inflation environment and against currency risk. Gold has also been a hedge against geopolitical risk. A combination of these factors would mean that adding gold could help improve portfolio risk-adjusted returns.

Alessio Cirillo, EMEA Sales Director, Invesco.