Increased volatility, increased uncertainty and inflationary pressures are all good for gold, and long-term investors should now hold some of the gold in their portfolios.
In the past few months, although the median inflation expectations did not show a clear trend in the impact of the COVID-19 epidemic, the uncertainty and divergence of respondents' inflation expectations increased significantly. While short-term deflation is inevitable, respondents disagree on how long deflation will last:Some believe that inflation expectations could suddenly rise within 12 months, while others think deflation will last for at least three years.
Therefore, there are great differences in the dynamics and prospects of asset prices in the short to medium term, which makes asset allocation difficult. Empirical research found that the degree of differences among agencies will lead to insufficient diversification and an increase in savings.
This may explain why institutional investors are so pessimistic about the market that total assets of money market funds reached an all-time high of $4.3 trillion in the first quarter of 2020 (figure 1). And it is possible to reach a higher level in the coming quarters (due to rising uncertainty). Figure 1 shows that the index of economic policy uncertainty has soared to new highs in recent months and that the market will be priced at higher volatility in the near future.
Figure 1, source: Baker et al. (2016), Eikon Reuters, FRED
In the long run, however, there is one asset that seems to have won over investors: gold. Figure 2 shows how the assets of the top five central banks change with the year-on-year price of gold, which is an example of the long-term potential of gold. therefore,If the currency continues to depreciate to avoid long-term deflation, gold should be boosted by inflation and continue to hit record highs.
Annual asset movements by the world's five largest central banks reversed from-$1.3 trillion in March to more than $6,000bn in June, leading to a sharp rise in gold prices (from $1300 to $1800).Since central banks' balance sheets are expected to peak in the next 12 to 18 months, it makes sense for gold to continue to climb during this period.
Figure 2, data source: Eikon Reuters, RR calculations
Some investors expect gold to replace "bond trading", the biggest winner of the past 35 years. Long-term interest rates in all advanced economies have now hit zero and gold's share of risk parity portfolios is likely to increase as investment managers replace some bond allocations with gold in the coming years. In addition to profiting from long-term inflation hedging, gold sometimes benefits from market shocks.
As shown in figure 3In the past two selloffs, gold rose 7.6 per cent in the fourth quarter of 2018 and 3.6 per cent in the first quarter of 2020, while the stock market fell 14 per cent and 20 per cent.In addition, gold has been the best hedge in highly volatile times over the past 30 years. As shown in figure 3, when the VIX is above 20, gold averages 80 basis points per month.
Figure 3, data source: Eikon Reuters, RR calculations
So if investors are prepared to "digest" rising price fluctuations in the short term, they should hold some gold in their portfolios as long-term investments. As mentioned earlier, gold is slightly overvalued at current levels based on a variety of short-term drivers (negative yield debt, 10 years of break-even inflation). And gold prices are vulnerable to higher real yields in the coming months.
Figure 4 shows the annual performance of gold relative to the G10 and some emerging market currencies since 1971. While most squares are green (suggesting that gold is positive against a particular currency), gold has also experienced "red" bearish periods, usually marked by a rise in real yields.
Figure 4, source: Eikon Reuters
Most investors believe that in the context of the current massive currency devaluation, gold will hit a new high in the long run. Within three to five years, gold prices are much more likely to rise than gold prices to fall (up: 90%, down: 10%), and if inflation expectations start to rise suddenly, gold prices may actually start to soar sooner than expected. However, due to the rise in real interest rates, gold is likely to consolidate slightly over the next 12 months.