Gold has taken centre stage again in investment strategy discussions. Since the recent bottom in equity markets in March 2020 gold has had a stellar run, increasing by about 50% in value. This has coincided with unprecedented government spending and central bank stimulus through quantitative easing.

Will gold continue to move up? Or is this an early sign of a bubble? A short, sharp increase in price often increases the risk of recency bias (i.e., simply expecting these recent movements to continue). Therefore, we believe it is time to attempt an unbiased analysis of gold as an investment.

Why investors invest in gold

We believe there are four main reasons why investors seek exposure to gold:

Protection against inflation: With continued quantitative easing around the world, inflation risk is hotly debated. Being a precious metal, gold should theoretically be well placed to protect investors against inflation. Gold was historically often used as a currency itself, or, for most of the 20th century, to back a currency. In a fiat currency system, where money does not have any intrinsic value¹, gold is seen by some investors as a fail-safe way to avoid the risk of losing value to inflation.

Protection against an equity market crash: Some market participants see gold as a safe-haven investment that should go up in value whenever equity markets have significant drawdowns.

Protection against government default: In most developed countries, inflation-linked bonds provide an alternative way for investors to protect themselves against inflation. However, some investors are worried about the risk of a government default, and therefore prefer gold.

Protection against a collapse in the economic system: A small group of, arguably very risk-averse investors not only worry about inflation or default, but believe that gold is the best way to store value during a total collapse of our economic system. These investors often do not only seek exposure to the gold price, but want to buy physical gold, and, in extreme cases, look to store it in a premise that they can easily access themselves.

Gold as an asset class

While gold has performed extremely well over the last 20 years, and outpaced inflation-linked bonds by a significant margin, it has done so with fluctuations and drawdowns that make it more closely resemble equities rather than bonds:

1 January 2002 to 31 July 2020. Source: Refinitiv Datastream.

From a risk and return point of view this suggests that gold might not be well suited to be considered a defensive asset class, as investors typically do not want to have high volatility in that part of their portfolio.

Regardless of the volatility, gold’s performance over the last 20 years has been impressive, and it has outpaced inflation by almost 10% p.a. However, we have to be mindful of recency bias. We have doubts that it is sustainable for gold to outperform inflation by such large margins over the long-term, and therefore caution investors from allocating significant parts of their portfolio solely to the metal. Gold investors had, for example, no returns or even losses between the early 1980s and the mid-2000s. And indeed, if we expand the series back another two decades, gold returns start to look a lot more mundane:

1 January 1981 to 31 July 2020. Source: Refinitiv Datastream.

So what should we make of the recent run in gold? Was gold significantly undervalued 20 years ago – or is it in a bubble now?

How can you value gold?

This is arguably the most difficult question for investors considering gold, and the lack of clear answers is one of the reasons why many in the financial services industry are still somewhat sceptical about the usefulness of investing in the metal. In contrast to most other investments that you will find in an investment portfolio, gold does not have any underlying cash flows or yields. It is therefore not possible to do a discounted cash flow valuation and attempt to estimate the fair value of gold (this valuation dilemma is also often cited by critics of cryptocurrency).

To achieve a positive return, investors therefore have to rely entirely on other investors offering them a higher price for gold in the future. This is no different from other commodities such as oil or wheat, and in theory, we could look to the supply and demand of gold for a more fundamental analysis.

However, unlike oil and wheat, gold is not consumed, and its use is in large parts driven by jewellery. While this demand may drive the gold price at the margin, we believe the only fundamental price driver that investors can rely on consistently is inflation.

The first port of call is therefore to compare the price of gold to real yields on inflation-linked bonds. If people are worried about inflation, the price of gold and inflation-linked bonds should go up at and down in sync, or at least in a similar direction. To test this, we compare the inflation adjusted price of gold with the yield on inflation linked bonds. To account for the default risk inherent in government bonds, we also deduct the government credit default swap (CDS) spread, where available, from the yield on treasury inflation-protected securities (TIPS).

The following chart compares the gold price in US dollars net of inflation, on a logarithmic scale, with the real yield net of the CDS spread.⁵

It is clearly visible that the gold price is highly correlated with real yields, in particular since around 2006. However, if we trust that real yield is a good indicator, we have to assume that gold is implicitly priced for “a negative yield” at the moment, as it was in 2010 and 2011. Depending on one’s view of the current situation and the road ahead, this may not bode well for gold investors.

New Zealand perspective

Our analysis has focused on the gold price in US dollars and on inflation-linked bonds issued in the US (TIPS). However, a New Zealand investor should of course look at New Zealand inflation-linked bonds instead.

Unfortunately, issuance of these bonds in New Zealand is scarce, and we cannot do the same index analysis as we can with the data from the United States. However, based on our analysis we believe it is fair to conclude that New Zealand inflation-linked bonds usually track US TIPS, after adjusting for the interest rate differential. The only main difference in the historical data is that – in contrast to US TIPS, no extreme surge in yields occurred during the Lehman bankruptcy in 2008. As long as our economy moves in sync with the world economy, this correlation with TIPS can arguably be expected to continue in the future.

One thing that is important to remember for New Zealand investors is that buying physical gold exposes them to exchange rate movements. In fact, the impressive 20-year return noted above drops by 2.8% (11.2% to 8.4%), and volatility increases further without currency hedging.

As an alternative to hedging the physical exposure against exchange rate movements, investors could also buy futures on gold, which have tracked physical gold reasonably well over the last decade.⁶ Regardless of whether currency risk is hedged or not, the question of where fair value is for the gold price unfortunately remains unanswered for New Zealand investors as well.

Is now the time?

We believe that gold has good inflation-protection qualities over long time periods, but unfortunately it is impossible to determine the fair value of gold at a particular point in time. As such, investors cannot be sure whether investing in gold now means that they are buying at a time of opportunity, as was the case 20 years ago – or at a peak in gold prices, like we saw 40 years ago. Therefore, we believe investors should also consider other real assets – especially assets that can be valued properly – as an alternative for an inflation-hedge in their portfolio.

While we would love to answer the question on whether gold is a good investment at the moment, we do not believe that there is any analysis that would give us a sound answer. The best we can arguably do is to look at real yields as an indicator, and on that basis, gold seems to look rather expensive, or, as some would argue, simply priced for a severe, sharp shock in inflation.

We do model inflation shocks in our asset allocation model, and therefore acknowledge that investors should not disregard these scenarios completely. However, we note that serious concerns about the use of quantitative easing also drove the gold price up in 2010 and 2011, but it ultimately left gold investors that bought at that time with disappointing performance.

Without any reliable way to value gold, the best we can do is to wait and see whether this time it is different.

¹ This is the case in most countries, including, for example, the United States, the Eurozone and New Zealand.

² London Gold Bullion

³ S&P US Treasury TIPS 5+ Index

⁴ MSCI World Index in USD

⁵ Our data for CDS spreads only starts in 2008. However, on average this is only 0.2%.

⁶ Investing in futures will bring along additional challenges that we do not cover here.

Past performance is not necessarily a good indicator of future returns.