Australian super fund's portfolio and Gold

Australian super fund's portfolio and Gold!

Geopolitical uncertainty, inflationary concerns and rising interest rates in key markets have impacted global financial markets in the first quarter. Against this backdrop, gold shone in Q1, registering a 4% gain in Australian dollars and the near future may bring additional challenges for investors such as heightened equity market volatility and a rising bond-equity correlation.

Gold’s role as an equity risk hedge and source of returns shows that:
• a representative hypothetical super fund portfolio would have experienced lower volatility and losses with a 10% allocation to gold during the first quarter.
• over the past 15 years, a hypothetical average super fund portfolio with 10% gold would have seen a higher return, lower volatility and less dependency on global equities compared to a portfolio without gold.

The first quarter of 2022 had no shortage of financial markets volatility. In January, higher interest rate expectations, rising inflation and the Russia-Ukraine war all took a toll on global equity markets: the S&P 500 stock index saw its worst start to a year since 2009 and the ASX 300 index experienced the deepest January fall in 14 years.Turbulence persisted through the quarter. The Russia-Ukraine war, coupled with the US Federal Reserve’s March rate hike, shook investor confidence and ensured that global equity market volatility remained elevated. Other markets were also volatile. Crude oil and natural gas surged by 34% and 50% respectively in Q1, alongside similar jumps in commodities like wheat (+31%) and nickel (+55%). Meanwhile, rising yields and inflationary pressures have caused losses in the bond market: the Bloomberg Global Bond Index fell by over 6% in the quarter.
Factors churning financial markets fuelled gold. Primary drivers of the gold price rise in Q1 include soaring inflationary pressure and geopolitical risk. And it is worth noting that compared to most major assets, gold’s volatility was much lower during the quarter.

Just as most countries have been emerging from the Covid 19 pandemic saga, high inflationary pressures are lingering. As we shift from a prolonged period of range-bound inflation and low rates, it seems the next chapter has already begun. Inflation remains elevated in many countries. Global money supply has climbed at an unprecedented rate since the outbreak of the pandemic, seeding higher inflationary pressure, and surging commodity prices have poured oil on the flame. In the US, y-o-y growth in the Consumer Price Index (CPI) reached 7.9% in February, the highest since January 1982. And in Australia, the Retail Price Index (RPI) surged to a record high in March and higher inflationary pressure may not be short-lived. With inventories of commodities such as industrial metals and crude oil at multi-decade lows, clogged ports and higher freight costs are keeping already-disrupted supply chains under pressure. These drivers are likely to keep the commodity market volatile and tight. Emerging demand, as COVID restrictions are gradually removed, could mean that higher-than-normal inflation lasts longer in some markets.

To contain rising inflation many central banks are raising rates. In March, the US Fed’s boot finally came down as it announced a 25bp rate hike, the first rise since March 2018. And the Bank of England also lifted its policy rate that month, the third increase since December 2021. The European Central Bank hinted at tightening its monetary policy too and despite the relatively dovish recent statement from the Reserve Bank of Australia (RBA), local investors are expecting higher rates: this is partially reflected in the steadily rising 10-year government bond yield.

Implications for Australian super funds: According to the latest data published by the Australian Prudential Regulatory Authority (APRA), Australian superannuation funds are heavily concentrated in bonds and equities. As previously noted, Australian super funds increases their equity exposure throughout 2021; by the fourth quarter , the average super fund allocation to fixed-income assets and listed equities was 18% and 51% respectively. Compared to 2019 (i.e., pre-pandemic) averages, this represented a 4% decrease in bond allocations and a 5% increase in the weighting of listed equities, which came almost purely from international stocks.

Equity market valuations often fall prey to heightened inflationary pressure. First, investor expectations of companies’ future earnings, the denominator of the price/earnings ratio usually rise with inflation. Another potential consequence of higher inflation is a reduced economic growth rate, which often translates into lower equity valuations under the Dividend Discount Model (DDM). As such, investors might need to watch out for valuation-led pullbacks in equity markets where inflationary pressure continues to rise.

Second, higher rates, or tightening monetary policy, may also contribute to greater volatility in the equity market. Higher funding costs could cause uncertainties in company earnings, increasing stock price volatility. And a higher discount rate in the DDM, which is typically based on the risk-free rate, could negatively impact equity valuations, leading to declines in equity prices. Other factors, such as contracting liquidity in the market as monetary policy tightens, could also contribute to increased equity market volatility. Analysing historical data in the Australian equity market we found a lagged positive relationship between ASX 300 market volatility and the local policy rate.

Third, the role of bonds as an equity market hedge could be weakened as the nominal interest rate climbs. As previously mentioned, the impact of rising interest rates is at least two-fold:
• lower bond values
• a higher possibility of equity market pullbacks.

Therefore, bonds and equities are likely to share more common ground when the interest rate is rising. This was particularly evident in Q1 2022 when bonds and stocks around the globe plunged in unison.

Going forward, the average super fund portfolio could face headwinds. Fixed income assets and equities both experienced sizable retreats in the first quarter of 2022. The possibility of higher equity market volatility and a change in the bond-equity correlation could be problematic for Australian super funds, making it even more imperative to include an effective portfolio risk diversifier.

Gold as a risk diversifier and inflation hedge performs well during equity market pullbacks. Investors often rush to gold, a safe-haven asset, during times of crisis, exactly as we saw in response to the Russia-Ukraine crisis. Historical data shows gold has a proven record of being an effective tail risk hedge. As a tail risk hedge gold is able to protect portfolios from unpredictable events and despite rate changes, gold’s relationship with equities has been relatively consistent. For instance, gold in Australian dollars has exhibited a persistent negative relationship with the local equity market since 2000. Gold continues to offer equity market downside protection even when yields are higher and can help portfolios outrun inflation too. It’s effectiveness as an inflation hedge is partially underpinned by its stable and relatively limited supply, as well as by the fact that real interest rates (the opportunity cost of holding gold) are generally low when inflation is high.

Gold has outperformed consumer price indices in the past 50 years and beyond limiting losses, gold is also a long-term strategic asset and its ability to improve a portfolio’s performance is manifold. For instance, gold measured in Australian dollars has provided an average annualised return of 8% over the past two decades, higher than equities, bonds and commodities.

During the past 15 years, limited by data availability of indices used, it shows that gold’s presence helped reduce the average hypothetical super portfolio’s risk and β against global equities, similar to previous results. More importantly, as a long-term return generator gold also lifted the average super’s Compound Annual Growth Rate (CAGR).
Gold also has outperformed its benchmark set by the APRA which is the “other assets”. And according to the APRA’s calculation method, gold’s average annual return has been 1% higher than the benchmark over the past eight years, the required YFYS performance test period. Applying a similar calculation, using the average super fund asset allocation weightings and benchmarks set by the APRA as noted above, we found that a 10% allocation to gold would have outperformed the benchmark over the past eight years.

Gold’s performance in Q1 2022, compared to other major assets such as bonds and equities, has proven its role as an effective risk diversifier. Our tests show that a hypothetical average super fund portfolio’s loss and volatility during this quarter would have been lower with the inclusion of gold. But gold is more than simply a loss cushion during uncertain times. Data from the past 15 years shows that the hypothetical super fund portfolio’s return improves with gold’s presence. And gold reduces a portfolio’s risk and dependency on global equities, an adjustment institutional investor might desire given future possible heightened stock market volatility. There is also evidence suggesting that gold, priced in Australian dollars, is a highly efficient risk diversifier in. This could be of vital importance for local investors as the majority of their portfolios are exposed to Australian dollar volatilities.

The recent geopolitical events and financial market volatilities have made a compelling case for gold. And in a world with no shortage of unpredictable events, arming your portfolio with gold could provide assurance.

For more information contact us on www.liemeta.com.cy