Against a backdrop of sustained market turmoil, investors are facing a new reality of persistent economic instability and extreme market shocks that can erode wealth, argues Marcus Grubb of the World Gold Council.

Editor's note: This article is by Marcus Grubb, who is managing director, investment, at theWold Gold Council. As ever, while the views expressed here are not necessarily shared by this publication, we are very happy to share these opinions with readers.

Against a backdrop of sustained market turmoil, investors are facing a new reality of persistent economic instability and extreme market shocks that can erode wealth significantly.

In the US, poor payroll data and rising unemployment are dampening what was forecast to be a rosier recovery. Moreover, with a debt ceiling debate due in the third quarter of the year, and presidential elections in November, solving the problem of a $1.3 trillion deficit is likely to challenge the dollar. In the euro area, the sovereign debt crisis remains a persistent threat to stability: the continued failure of the Greek administration to meet its austerity and budget targets threatening the euro, and a further $100 billion pledged to bail out Spain’s beleaguered banking system and the possibility of a national bailout following provincial defaults are far from encouraging. Meanwhile, in the UK, a stagnating economy has not been stirred by a third round of quantitative easing, with gross domestic product falling by 0.7 per cent in the second quarter of the year.

The resultant market volatility is refocusing investor demand on assets that help protect against downside risk, and position portfolios to benefit from upside returns. When market conditions are fractious, gold has a clear role as a hedge against inflation and currency depreciation. Independent analysis by Oxford Economics published in 2011, The Impact of Inflation and Deflation on the Case for Gold, shows that gold’s share of an optimal portfolio is around 5 per cent in a base long-term economic scenario featuring 2.25 per cent growth and 2 per cent annual inflation. The optimal allocation rises in a more inflationary long-run scenario and for more risk-averse investors in a scenario featuring weaker growth and low inflation.

Allocation

Additional research by the World Gold Council also shows portfolios that contain even a small standalone allocation to gold are generally more robustly defended against macroeconomic shocks making gold a critical hedge against market shocks that can trigger widespread value destruction.

But with gold remaining short of its autumn 2011 high, allegations that gold has entered a bear market have gathered pace. Gold’s correlation to other assets increased in the first quarter of the year and price action has been unusually volatile: declining in most currencies during the second quarter with the exception of the euro, Swiss franc and Indian rupee. This has fundamentally challenged gold’s role as a store of wealth.

In fact, gold’s performance can be explained by a number of factors. In the short term, the metal is being sold to provide liquidity for investors and possibly being lent into the market to provide European banks with liquidity. Recent price action is similar to its behavior prior to the Lehman bankruptcy in 2008 when the price fell by as much as a third as financial institutions in need of ready cash unloaded gold. Within six months, the price had recovered, and from February 2009 onward, gold returned 156 per cent over the following three years.

Moreover, demand for gold is already returning: China is preparing to introduce the country’s first interbank gold trading system, which should enable domestic banks to increase their reserves, and in June Russia’s central bank increased its holdings in gold by 6.2 tonnes. A separate report from the US Mint shows that physical gold buying was up 13 per cent over last month. Moreover, gold’s recent correlation to equities and commodities is falling closer toward long-term averages. As central banks and investors move back toward gold, the question is whether asset managers will follow their lead.

Correlations

In short, the long-term correlation of gold to equities remains statistically insignificant and gold’s performance remains independent of risk asset performance. Gold may have returned to its late December levels but in many countries equity markets have given up all their gains on the year, and some are down by as much as 20 per cent. With index-linked government bonds now returning negative yields in real terms, investors need to look to assets that mitigate the destructive effects of extreme market stress.

This behaviour is a direct consequence of the dynamics of the gold market, where gold is often viewed as an alternative monetary asset. Indeed, gold’s functional characteristics set it apart from the rest of the commodity complex – its value more frequently determined by its attractiveness to other currencies rather than by commodities such as iron, zinc or lead. Therefore, gold is normally less exposed to swings in business cycles, typically exhibits lower volatility and tends to be significantly more robust at times of financial duress. In turn, this causes gold’s correlation to other commodities and other asset classes to be low.

Proprietary research by the World Gold Council shows during the period between October 2007 and March 2009 - the height of the global financial meltdown - an investor with a portfolio of $10 million would have sustained an additional $500,000 financial loss simply by not maintaining a position in gold. The study Gold as a Tail Risk Hedge used a composition similar to a benchmark portfolio, which included an 8.5 per cent allocation to gold, to show that total losses incurred during the period reduced by 5 per cent relative to an equivalent portfolio without gold. In 18 of the 24 tail risk scenarios analysed by the World Gold Council, portfolios which included gold outperformed those which did not.

Additional studies by the World Gold Council confirm that portfolios with even a small standalone allocation to gold benefit over the long run versus those that don’t.

Until the short-term outlook for markets becomes clearer, it is likely that gold will continue to trade within a fairly narrow range. But historical analysis shows that the gold price typically reverts after extreme market events and on that basis, gold should continue to move independently of most assets usually held in portfolios and hedge against inflation and currency fluctuations. With no clear end in sight to the sustained market turmoil, gold should remain a foundation portfolio asset for investors looking to protect wealth and reduce losses.