In September 2022, gold prices in the international market dropped below $1700 an ounce for the first time since the Covid19 pandemic broke out in March 2020. The yellow metal closed at $1672 per ounce in September, its lowest monthly close in two-and-a-half years. In India, gold prices in September were the lowest in eight months, according to data from the World Gold Council.
This has been disappointing for yellow metal investors and lovers. Their disappointment with gold has been amplified by the fact that the Indian equity market has been pretty resilient during the period. While the gold prices in the Indian market is down 5.2 percent since March this year, the equity benchmark BSE Sensex has been almost unchanged during the period and has thus outperformed the yellow metal.
The poor performance of gold in the international and domestic markets is attributed to a rally in the dollar index and a sharp rise in the bond yields in the United States and other advanced economies.
Gold vs Dollar
The dollar index hit a 20-year high last month as the rate hike by the US Federal Reserve (Fed) and rising yields on the US treasury made it more profitable for investors to hold dollars over the precious metal.
The dollar has benefited from the uncertain macroeconomic environment, with concerns about high inflation, the prospect of recession, slowing growth in China and the impact of the Russia-Ukraine war prompting investors to sell other assets in favour of holding dollars.
Gold competes with US treasury bonds for safe haven status during times of economic uncertainty and a higher yield or interest on US bonds makes gold less attractive for investors. Unlike US government bonds, gold doesn’t yield any interest.
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This is especially true for investors in India where gold is one of the best assets to protect your savings and investments from the corrosive power of rupee depreciation against the US dollar.
Historically, gold has been a hedge against inflation and economic uncertainty and typically, the yellow metal performs well when financial assets such as equities and bonds break down such as in the first half of the 2020 calendar year.
The long-term data also suggests that an economic recession in major economies such as the United States is supportive of gold prices, but the sharp increase in interest rates being used to tackle inflation has so far limited the upside for the precious metal.
Limited room for an interest rate hike
The recent action by the Bank of England to restart its bond-buying programme to suppress bond yields and make it cheaper for the British government to borrow shows the limit to the rate hike by the major central banks. The growing consensus in the market is that the central banks including the US Fed and Reserve Bank of India will allow inflation to stay above the comfort level rather than face the prospects of a meltdown in the equity and the bond market.
The public debt to gross domestic product (GDP) in most major economies including India is at a record high and a sharp rise in the government's borrowing cost will ruin public finances. This limits headroom for central banks to hike interest rates to bring down inflation to the target zone. It will translate into a higher level of structural inflation in major economies for many years to come. This coupled with low or stagnant growth in GDP will potentially create stagflation in major economies that would crush financial assets such as bonds and equities.
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In the current years, only investors such as pension funds have lost money in both bonds – as bond prices crashed due to higher yields and equities. The Dow Jones Industrial Average is down 17.2 percent year to date and September 2022 is the worst for the markets in 20 years.
60:40 portfolio is not working
This is killing the traditional long-term portfolio comprising 60 percent equities and 40 percent in bonds and other fixed income instruments. Long-term investors are now scrambling for the right hedge to protect their portfolio from simultaneous volatility in both equities and the bond market. Gold is perfectly suited to iron out extreme volatility in a long-only portfolio given there is no counter-party risk in holding gold and it’s a store of value on its own merit. The yellow metal also has a negative to a very low price correlation with other financial assets.
Gold prices are also relatively low on a historical basis compared to equities and bonds which are still relatively expensive compared to past ratios. For example, the Dow Jones index to gold price ratio was 4X on average in the 1980s, less than a fourth of its current ratio of 17X.
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Similarly, the Sensex to gold price (in rupees) has been 27 percent on average in the 1990s and 31 percent on average in the last 30 years, nearly 25 percent lower than the current ratio of 42 percent. Here we take the rupee price of an ounce (around 28.35 grams of gold) as provided by the World Gold Council.
This suggests that going ahead, gold is likely to outperform risky assets such as equity.
In fact, the yellow metal has already begun to outperform the equity markets. The gold prices in India are up 4 percent year to date against a 0.3 percent decline in the BSE Sensex. In the United States, gold prices are down just 4.5 percent YTD against a 17.5 percent decline in the Dow Jones index in the period.
The yellow metal started October positively and is now up 6.2 percent from its 52-week low in September. The recovery is likely to continue during the rest of the 2022 calendar year.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).
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