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Investments & Financial Planning

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2020 has been an extraordinary year. The onset of COVID-19, consequent lockdown, payroll cuts, retrenchments, and bankruptcy of companies like JC Penney, Hertz etc has been the new normal and guess what, the year is not over yet!

Financial markets have been on a roller coaster ride. A steep slide in March followed by fiscal stimulus / liquidity measures and the strong pull back in financial markets. Among all this mayhem, gold has become the new darling of investors outperforming all asset classes over the last three years delivering compounded return of over 16%.

Other than doomsayers, it has taken all the analysts by surprise.

So, what is fueling the rally in gold? I have tried to enumerate some of the key drivers of the rally which should provide some color to the future outlook of the asset class as an investment proposition –     

  • Gold is traditionally considered as a hedge against inflation and a safe haven for investors in times of uncertainty. Gold has a negative correlation with REAL interest rates in US. REAL Interest rate refers to the difference between US Treasury yields and inflation. Gold as an asset class gains when interest income does not compensate for the loss of purchasing power due to inflation. When the REAL interest rates fall, gold goes up in value and vice versa. Below is a chart of REAL interest rates and gold prices over the last 40 years.
Gowth Graph of Gold Price Rate
Graph showing inverse relationship between Real interest rates (red line) and Gold prices (yellow line)

Central banks have been on a spree of money printing in the aftermath of COVID-19 to provide liquidity to businesses to survive the downturn. Fed Bank alone has printed 3 trillion US Dollars in the aftermath of Corona. Interest rates have been maintained near zero to provide relief to businesses to enable them to raise money to tide over shrinking cash flows / service existing loans. Low interest rates also provide relief to Central banks to service sovereign debt which has ballooned due to fiscal stimulus.

Injection of money in the economy coupled with supply chain disruptions due to lockdown have raised inflationary expectations. US Treasury yields are at historic lows pushing REAL Interest rates below zero sparking a rally in gold.

  • Goldman Sachs in its report released in July ‘20 has warned that the U.S. dollar may lose its status as the world’s reserve currency. To quote from the report of Goldman Sachs “The resulting expanded balance sheets and vast money creation spurs debasement fears. a greater likelihood that at some time in the future, after economic activity has normalized, there will be incentives for central banks and governments to allow inflation to drift higher to reduce the accumulated debt burden.”  With US Treasury yields falling to all-time lows, fear of loss of faith in Greenback, Central banks may look at gold as the favoured asset class to diversify their holdings.
  • Monetary and fiscal stimulus by Central banks helped in avoiding another Lehman brothers and a repeat of 2008. It implies that there is more money chasing financial assets than ever before. With world economy shrinking in the aftermath of lockdown, debt yields falling to all-time lows, there exists incentive to shift allocation in favour of gold. Geo-political challenges, pandemic and intensifying trade war strengthens the choice of gold as an asset class.

Future outlook in the rally in gold

While the above arguments sound convincing than ever before, we need to closely look at some more data points to see whether rally in gold is sustainable.

Gold does not generate cash flows and has minimal utility as an asset class except towards jewellery. Therefore, traditional models of estimating the fair value of the asset by estimating / discounting cash flows do not work in case of gold.

There is a traditional belief that gold does not fall in value. If we go back into history, gold made a high of $1800 in 2011 only to fall below $1100 levels in 2015. So, gold DOES fall in value and the fall could be steeper than we might think.

Gold Pieces
Investing in gold without understanding other economic indicators could be gamble

There does exist a distinct risk that dollar may lose its status as the world’s reserve currency. Money printing by US Fed, debt at 107% of GDP and the world’s largest trade deficit at USD 616 billion, could be the harbinger of a fresh world order. While the collapse of US dollar and the rise of alternative currencies may be inevitable, there is nothing to indicate that we are about to breach the tipping point for it to be imminent. There goes a saying that markets may remain irrational much longer than we can remain solvent. For all we know, US dollar may continue to hold fort as the reserve currency in the absence of alternatives for few more cycles of rise and fall in gold prices. 

Let us look at some data points on the real demand for gold in Q2, 2020. Consumer demand for gold jewellery fell by 53% in Q2, 2020 due to lockdown and buying by Central banks fell by 50%. So, what is driving the spike in gold prices? Investment demand for gold increased by 98%. Rally in gold prices is therefore due to Investment demand which is feeding upon itself and is reminiscent of the tech bubble of 2000 before its collapse. 

Most investment houses & analysts are bullish on gold today. But were they bullish on the yellow metal when it began its upward trajectory in the last quarter of 2015? Unfortunately, the answer to this question is NO. These voices tend to follow not predate the rally in an asset class and become louder when the asset class gets nearer to peak ( highest point in prices) than trough (lowest point). And then they pick another asset class citing it to be the next wealth creator and then another.

Today skepticism runs high over investment in equities while there is herd buying happening for gold. It normally pays to play contrarian in markets and resisting doing what is common sense.