Baker steel: the return of volatility – good or bad for gold?

Last week's sharp correction in equity markets marks the end of two years of steady price rises and historic lows in volatility. Rising volatility underscores the growing importance of portfolio diversification for investors. Gold is a useful diversifier.

After nine years of a bull market in the U.S., and especially after the last two years of steady stock market gains and record low volatility, the sudden return of volatility and signs of a possible more significant correction have added a dose of realism to the markets. Equity valuations are high and in many cases have stretched out in recent months. The decline in share prices in recent days, mainly due to fears about the impact of rising nominal interest rates, underscores the value of diversification for investors in times of rising financial market risk.

"Investor complacency" is widespread

2017 was the year with the lowest volatility in the equity markets (VIX index), underpinning growing complacency among investors. In the U.S., equity markets have overcome the vagaries of an unpredictable president, questionable growth prospects for the global economy and risks to international trade caused by rising populist sentiment around the world. Despite frequent warnings from market participants and commentators of "bubbles" developing in a range of financial assets, investors' optimistic outlook remained undeterred. Even after this week's stock market losses, recommendations to buy stocks cheaply appear widespread among major asset managers and market commentators.

Investor complacency is at least partly the result of years of intervention by central banks and policymakers in financial markets since the global financial crisis. The perceived willingness of central banks to support their economic and domestic markets in times of stress over fiscal and monetary policy is an obvious bailout for the markets, which has increased optimism and probably risk appetite as well. Given the current financial risks, it seems likely that this will be tested again in the not too distant future.

Developed markets experienced a wave of economic optimism in 2017. The improved outlook for growth and profitability in the U.S. Following trump's election in late 2016, which promised higher spending and tax cuts, contributed to the resurgence of the economic situation in europe with president macron's reforms. In france and with steady economic growth in germany, investors had reason to be confident in the ongoing equity rally.

Gold – a "safe haven" with strong fundamentals

We expect a period of heightened volatility as investors adjust to an uncertain and somewhat contradictory macroeconomic situation in which policymakers seek to raise nominal interest rates amid president trump's "reflationary" growth agenda of increasing inflationary pressures and rapidly expanding public and private debt. Investor confidence in equity markets belies the reality that there are significant risks to financial markets. It is true that trump's policies have had a positive impact on the U.S. Economy, especially on employment, although participation rates are still lagging and wage growth is less than stellar.

Concerns about economic difficulties and policy failures are often reasons why investors invest in gold. However, we also believe that positive effects of tax reform and spending on the US economy could have positive effects on the gold sector. Signs of a return of inflation would be a positive indicator for gold, while the potential impact of the wealth effect on spending could also boost demand. For the gold price, it is noteworthy that the overall outlook for the U.S. Dollar is negative under both optimistic and pessimistic economic scenarios. The U.S. Deficit is expected to rise under trump's economic agenda, given rising debt and signs of a deteriorating U.S. Trade balance.

Rising interest rates pose a number of risks to growth and markets, especially due to the high levels of debt that have developed over the past decade. However, the U.S. Federal reserve's cautious approach to interest rate "normalization" has had a positive effect on the price of gold. Two years into the current rate hike cycle, gold has recovered significantly from its late 2015 lows.

Interestingly, every fed rate hike announcement since december 2015 has been preceded by a consolidation and retracement of gold, followed by a strong rally in the gold price. This bullish technical positioning was supported by persistently low real interest rates, as shown by the u.S. TIPS yield, which barely rose over two years despite rising nominal interest rates. Gold is in the midst of a recovery phase, and we believe that short-term price weakness due to speculation about interest rate decisions presents a good opportunity for investors looking to establish a position in the gold sector.

An effective portfolio diversifier

While recent losses in global equity markets may not herald an imminent market collapse, they do suggest that more turbulence is ahead. We believe that investors have the opportunity to diversify their portfolios using tangible assets, which have lagged behind the growth of financial assets in recent years. Gold is largely uncorrelated to most financial assets and provides effective protection against rising volatility in equities and foreign exchange markets. In addition, a recent study by the world gold council showed that an allocation to gold can significantly improve risk-adjusted returns for a portfolio. Data collected for an average pension fund portfolio showed that an allocation of 1-5% in physical gold generated higher returns with low volatility over a ten-year period¹.

Given the increasingly favorable economic environment for gold, in particular low real interest rates, the return of inflation and governments' difficulties with debt burdens, we expect the recovery of the gold sector to continue in the coming months. There are a number of investment options for investors in gold. Physical gold offers a safe haven and store of value without counterparty risk. Gold etfs offer easy access to gold and high liquidity, while an investment in gold mining stocks can provide operating leverage and an opportunity to benefit disproportionately from the recovery of the gold price in a largely undervalued sector. While gold equities have been caught up in the initial downturn in general equities in recent days, historical performance suggests that the sector will outperform during a broad equity bear market such as was seen in 2008, supported by rising gold prices and inflation expectations.

As gold sector specialists, we believe that an actively managed portfolio of gold equities currently offers the best risk-adjusted return potential.

Baker steel capital managers LLP manages the BAKERSTEEL precious metals fund.

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