Gold is the best effective commodity investment, 2021

Gold is the best effective commodity investment, 2021!

Commodities like reflation and this could be even better for gold. The current global eco-nomic landscape indicates improving economic conditions, higher inflation and rates expec-tations, as well as commodity supply shortages which are likely to support commodity per-formance. This is reinforced by the fact that investors are increasing their allocation to commodities. While broad-based commodity investments are often used as a source of re-turns and diversification, the benefits tend to be tactical. Gold deserves to be seen as a dif-ferentiated asset as it has historically benefited from six key characteristics:

- It has delivered superior absolute and risk-adjusted returns to other commodities over multiple time horizons,
- It is a more effective diversifier than other commodities,
- It outperforms commodities in low inflation periods,
- It has lower volatility,
- It is a proven store of value.
- It is highly liquid.

Gold is a commodity that has always stood apart, but there have been recent market devel-opments that build on its existing differentiators while illustrating the importance of its role in a portfolio.

- The commodity reflation trade is in full effect, which can negatively impact risk-on assets and could suggest a larger allocation to gold
- Gold’s weight in commodity indices is increasing, and should continue to increase for a strategic allocation
- Gold’s volatility has been stable despite the variability in equities, bonds, and alterna-tive assets.

Commodities can be tactically relevant investments, but a strategic gold allocation on its own can supplement or replace a broad-based commodities investment.

Understanding historical asset performance during reflationary periods is relevant for un-derstanding how assets could perform during the current period. We examine the perfor-mance of various assets during the last two periods of reflation, i.e., Consumer Price Index (CPI) trough to peak, and compare this to the current environment.

The results confirm the idea that assets like Real Estate Investment Trusts (REITs) and Treas-ury Inflation-Protected Securities (TIPS) were solid performers, with commodities and gold performing well. Additionally, it confirms gold’s meaningful outperformance over equities and bonds.

But what it also suggests is the potential upside in gold compared to how broad commodities have performed during the recent reflationary period. In the previous two periods, gold outperformed broad commodities. However, in the current environment, gold is down 10% compared to commodities, which are up substantially.

Gold lagged other commodities beginning in May 2020, and has continued through the first half of 2021, but this is not unusual in commodity-led reflationary periods historically. Histor-ically, gold lags initially, but catches up to most major commodity groups by the second and third years of a reflationary period.

Volatility increased across major assets and commodities in 2020, driven by COVID-19-induced uncertainty, but less so for gold comparatively. A key reason for gold’s relative sta-bility stems from its role as a diversifier in turbulent markets, as well as stronger left-tail cor-relation between many other commodities and risk-on assets.

It is interesting to note that the increase in the volatility of the broader Bloomberg Commod-ity Index (BCOM) in 2020 was not as substantial as one may have expected. This is largely a function of the significant dispersion of commodity performance, particularly with oil per-forming so poorly, and other commodities like gold performing so well, evidenced by overall commodities returns of -24% and -3%, compared to a gold return of 25%. Simply put, com-modities as a whole exhibited lower volatility than gold, but they did not protect the portfo-lio as well as gold.

Gold is not your typical commodity.

Gold allocations of 2%–10% in an average institutional portfolio have provided better risk-adjusted returns than those with broad-based commodity allocations.

Investors have long recognised the benefits of investing in commodities. Over time, they have been shown to improve portfolio risk-adjusted returns, offering diversification, infla-tion protection, and an element of smoothing across economic cycles.

Most investors access this asset class via commodity indices, which invariably include gold.

But gold’s weighting within these indices undervalues its importance as a strategic portfolio component. Gold is, of course, a raw material used in the production of manufactured goods – the very definition of a commodity. But gold is much more than that. As both an in-vestment and a consumer good, it is a multi-faceted asset that enjoys diverse supply and demand dynamics that play an important role in gold’s performance.

Gold has performed broadly in line with the S&P 500 over the long term, delivering average annual returns of 10.8% since the elimination of the gold standard in 1971 and a compound annual return of 7.9%.

But when compared to commodities, gold has outperformed not only broad-based indices but sub-indices and most individual commodities too. Nearly all sub-indices have fallen over the past five years. But gold has risen during that time. Gold has also outperformed ma-jor commodity sub-indices over the past 10 and 20 years and outperformed most individual commodities, many of which have delivered negative returns in recent decades.

Gold has important diversification properties that come into their own during periods of sys-temic risk.

Gold has little to no correlation with many other assets, including commodities during times of stress. Crucially, however, the correlation is dynamic, changing across economic cycles to the benefit of investors.

Like other commodities, gold is positively correlated to stocks during periods of economic growth when equity markets tend to rise. However, gold is also negatively correlated with other assets during risk-off periods, protecting investors against tail risks and other events that can have a significant negative impact on capital or wealth, a protection not always pre-sent in other commodities.

This dynamism reflects gold’s dual nature as both a consumer good and an investment. When economic conditions are benign, expenditure tends to increase on items such as jew-ellery or technological devices, and this works in gold’s favour. During times of systemic risk, however, market participants seek high-quality, liquid assets that preserve capital and mini-mise losses. This can also benefit gold by boosting investment demand and driving up prices.

Gold is also a more effective diversifier than other precious metals. While gold’s correlation to silver and platinum has been positive during periods of growth, it has decreased during market downturns as these other metals depend, to a greater extent, on industrial demand. Also, when compared to other metals, gold is much less dependent on the technolo-gy/industrial areas of the market in terms of demand, which can be highly cyclical.

Gold behaves and is used as a safe-haven in periods of systemic risk.

Gold and oil prices are not correlated, contrary to popular belief. Part of this misunderstand-ing is related to the size and scope of both assets, their global importance, broad commodi-ties grouping, and the fact they are both generally priced in US dollars. At times, the two commodities move in the same direction, at other times in opposite directions, but there is no consistent relationship between the two. Oil tends to behave more like a risky asset, while gold is widely regarded as a risk-off asset.

Gold is less volatile than most individual commodities and broad commodity indices. It is also less volatile than equities: from individual stocks and industry sectors to indices such as the Global MSCI World Index. As such, gold can enhance portfolio stability and improve risk-adjusted returns.

Commodities are often used for diversification during periods of high inflation. While it is true that commodities have performed well during inflationary periods, gold has performed better. And in periods of low inflation, commodities delivered negative nominal returns, while gold posted positive returns, reflecting increased demand when economic conditions are robust.

This behaviour is particularly relevant today. Despite a recent uptick, current inflation expec-tations are low from a historical perspective, so gold should outperform other commodities. Future expectations suggest a growing risk of higher inflation; this should also drive demand for gold, as it has outperformed commodities in both moderate- and high- inflationary periods.

Gold has a long and influential role as a monetary asset. Other metals, including silver and copper, have historically been used as currency but gold’s role in the monetary system is far more extensive as it has been used for thousands of years. Considered a rare and precious asset for centuries, gold was a logical choice as a currency anchor, and it performed this role until the US came off the gold standard in 1971. As such, gold made an important contribu-tion to global economic architecture and, to this day, is considered a valuable international asset. Namely, it protects against currency declines and is the only precious metal used as a reserve asset. Prior to 1971, major commodities enjoyed periods where their value in gold terms reflected inflation and increased, while the price of gold was pegged to the US dollar. After 1971, when the price of gold was able to float, the value of commodities in gold terms fell sharply.

Although gold no longer plays a direct role in the international monetary system, central banks and governments still hold extensive gold reserves to preserve national wealth and protect against economic instability. Central banks are buying gold at an ever-increasing pace. In 2018 alone, they purchased more gold than at any time since the end of the gold standard, and they have been net buyers for 11 straight years. Today, gold is the third larg-est reserve asset globally, following US dollar- and euro-denominated assets.

Gold is liquid and less impacted by futures storage and roll costs.

Most commodities trading is dominated by futures trading, while physical delivery is ex-tremely low. In the gold market, by contrast, around 60% of trades are conducted via OTC or on exchanges usually linked to physical delivery, with gold futures representing less than 38% of all gold volume.

Gold is efficient, effective, and under-represented.

Despite gold’s unique and differentiating properties, investors often cluster it into a com-modities bucket that frequently represents a small allocation within their overall portfolio. Furthermore, the amount of gold allocated to this smaller commodities bucket is usually just a fraction of the bucket itself, further diminishing the weight.

A commodity is defined as an economic good, which is valued and useful and has little or no difference in composition or quality regardless of the place of production. While gold fits this definition, its market dynamics and the diversity of its application make it very different from other commodities.

This difference is underlined by gold’s robust performance profile in terms of returns, vola-tility, and correlation. Taken together, these characteristics produce a more diversified port-folio than one with a simple, broad-based commodities exposure.

Looking at other commodities, some can be considered luxury goods, some have technolog-ical applications, and some are basic, everyday products. Some are used to hedge against inflation, some protect against currency devaluation, and all provide a degree of diversifica-tion in an investment portfolio. However, only gold performs all these functions.

For more information contact us through our web page, www.liemeta.com.cy