Here’s why the conventional wisdom on gold is right
In the world of investing, there is a lot of conventional “wisdom”. These are ideas so accepted they go unquestioned. But conventional thinking is often> READ MORE
In the world of investing, there is a lot of conventional “wisdom”. These are ideas so accepted they go unquestioned. But conventional thinking is often> READ MORE
“May you live in interesting times” is an old Chinese proverb. While it may sound like a blessing, the saying is actually a subtle curse, something you might> READ MORE
Black swans – events that are unpredictable and which have an outsized impact – are by definition unpredictable. But that doesn't mean you shouldn't still take> READ MORE
If just 2 percent of current Islamic finance assets are allocated to gold, a huge new source of demand – roughly equal to China's total purchases in 2015 – will> READ MORE
In the world of investing, there is a lot of conventional “wisdom”. These are ideas so accepted they go unquestioned. But conventional thinking is often wrong.
Take the idea of diversification, for instance. The cliché is “Don’t put all your eggs in one basket.” Is this good advice for everyone? Not necessarily, according to investing legend Jim Rogers. And viewing diversification strictly in terms of asset allocation – rather than a function of your “personal equity” – is maybe even more dangerous.
Another bit of conventional wisdom is that investors should follow their investments closely – watching prices like a hawk, tracking the latest news and developments. However, fixating on the “noise” in your portfolio can lead to bad and emotional decisions.
And here’s another bit of conventional investing wisdom we often hear (from me as well): In times of panic, gold is a safe haven. Gold in your portfolio can help insure against losses when the stock market falls.
As it turns out, this is one piece of conventional wisdom that’s correct. A recent study proved it.
Precious metals are safe havens
Two researchers in Ireland recently wrote a paper entitled Reassessing the Role of Precious Metals As Safe Havens – What Colour Is Your Haven and Why? They conclude that relative to many other assets, and in many countries, precious metals – including gold – act as safe havens in turbulent markets.
The researchers found that precious metals can indeed be portfolio “insurance” against unexpected events or “fat tail risk”. Fat tails are statistically rare events with bad consequences – like a hundred-year flood, or a once-in-a decade market crash, for instance. Even worse are Black Swans – catastrophic events with no precedence. Because they’ve never happened before, they blindside investors, causing extreme losses.
Especially during times of stress, gold marches to its own drummer
The researchers confirmed that gold is generally uncorrelated with most other financial assets. Correlation refers to the degree assets or securities have similar price moves. When two assets have a positive correlation (approaching 1), their prices tend to move in the same direction at about the same time. When assets have a negative correlation (approaching -1), they tend to move in opposite directions. A correlation close to zero means two assets move independently. As you can see in the chart below, gold’s correlation with other assets is very low. That’s exactly why gold works so well in a portfolio when markets are weak.
The researchers’ work confirms decades of academic research that gold and the other precious metals are uncorrelated both during normal times and during times of economic and market stress. Gold is a hedge – its price doesn’t usually follow other assets during normal times. It is also a safe haven – during abnormal times, when the prices of other assets crash, precious metals tend to rise.
Political uncertainty fuels the gold market
The researchers studied different kinds of economic and market events that cause precious metals to become safe havens. They identified three general types of market stress indicators: financial market stress, political stress and consumer sentiment.
They found that political and policy risk is “a positive and robust determinant across countries when precious metals are safe havens against stock and bond markets tail events.” In other words, in the many countries studied, precious metals tend to rise the most – offering the strongest safe haven protection – during market distress triggered by government policy uncertainty.
Both last year’s Brexit and the 2007-2008 global economic crisis are recent reminders of the value that gold holds during economic earthquakes.
Last June, Britain’s vote to exit the European Union caused unexpected, extreme economic policy uncertainty. On June 24, 2016, the day after the surprise vote, London’s FTSE 100 fell 12.5 percent, German DAX skidded 6.8 percent, the broad Stoxx Europe 600 index fell 7 percent and France’s CAC 40 was off 8 percent. Meanwhile gold was UP 5 percent.
During the global economic crisis, gold was also a safe haven. From June 2007, when the financial crisis first broke, to the March 2009 bottom, the U.S. Dow Jones Industrials dropped about 45 percent. Many global stocks markets were down over 50 percent. However, during that period, the price of gold rose from about US$670 to US$938, for a gain of about 40 percent, as shown below.
The winning metals
You might be surprised to learn that while gold, silver, platinum and palladium all typically provided safe havens against severe market declines, silver was often a better safe haven than gold.
According to the researchers, in many countries, silver has been the best safe haven against stock and bond market falls, followed by palladium, then gold and platinum. As we’ve written before, when gold goes up, silver tends to rise even more. Likewise, when gold declines, silver tends to fall more. (Not long ago we wrote a special report about investing in silver that you can access… here.)
We’ve discussed both platinum and palladium in the past. These metals also provide safe haven during turbulent times. However, given their easy accessibility and superior liquidity, gold and silver are probably the better options for most investors.
Why gold is golden during periods of uncertainty
While this paper establishes that precious metals have been a good place to park your money during turbulent times, it doesn’t address why this should be the case. Why aren’t – say – oil or wheat safe haven assets?
The main reason for this is that physical gold has been used as a currency for thousands of years – whereas paper, or “fiat money,” is a historically recent experiment. In 1971, the U.S. abandoned the gold standard – the last country to do so. Since then, all global currencies are backed by nothing more than faith in the government that prints the money.
Thus, when there’s heightened uncertainty about global economic policy, and faith in government falls, gold as the unofficial world currency rises. Contrary to paper currencies, gold is a tangible asset which cannot be printed or destroyed. To use yet another saying that is (true) conventional wisdom, gold is a “currency of last resort.”
As we wrote about recently, fear among investors has recently hit all-time lows. This is in sharp contrast to rising uncertainty related to economic policy in the world. Now is a good time to purchase some gold insurance for your portfolio.
This latest piece of research confirms what wise investors have known for hundreds of years: In times of trouble, precious metals are safe havens.
(In the latest issue of the Asia Alpha Advisory – which was released yesterday – I delve into gold… and talk about two ways to invest in gold. One of them even allows investors to buy gold at a discount to its market price. If you’re not a subscriber, click here to learn more.)
“May you live in interesting times” is an old Chinese proverb. While it may sound like a blessing, the saying is actually a subtle curse, something you might wish upon an adversary. The implication is that “interesting times” are chaotic and painful.
2017 is shaping up to be very interesting. Since the victory of Donald Trump in the U.S. presidential elections in November, global stock markets have surged higher, with the S&P 500 up about 8 percent since the U.S. election and 2.6 percent year-to-date. Meanwhile, the MSCI Asia ex-Japan index, after dropping in the wake of Trump’s victory, has reversed course and is up 6.7 percent in 2017 so far.
However, as I’ve written before, I think that the so-called Trump rally is due to reverse soon, as mean reversion comes into play. And with high levels of uncertainty in markets, now is also a good time to buy one of the assets that performs best during times of uncertainty – gold.
As the graph below shows, gold prices are up nearly 6 percent so far in 2017. Precious metals had a bout of weakness after Trump’s surprise victory. Global investors bought U.S financial and manufacturing stocks and sold “defensive” assets like gold.
From the election to mid-December, gold dropped about 13 percent. However, since then, it’s rallied to about US$1220, a gain of 9 percent. Gold remains nearly 8 percent below its highs from June of last year – a level it’s likely to revisit before long. It’s not going to happen immediately, but I don’t think it’s a stretch for gold’s 2011 highs – of US$1,837/oz, or about 50 percent above current levels – to be in sight.
Three reasons why 2017 could be a big year for gold
The U.S. dollar is likely to weaken
Trump recently said the U.S. dollar is “too strong.” He has accused China of manipulating the yuan lower relative to the dollar to benefit China’s exports. The dollar is up 2 percent since the election, but for Trump to bring manufacturing jobs back to America, he will need it to weaken. As gold and the dollar usually trade in opposite directions, a softening dollar will be positive for gold.
The “Trump Rally” will eventually succumb to mean reversion
As I mentioned, global stocks have been strong since the election. Investors have been anticipating Trump’s anti-regulation, pro-growth plans will stimulate global corporate profits. But these policies face political obstacles and will take time – if they are ever enacted. It’s only a matter of time until the current “risk-on” environment turns to “risk-off.” Gold—the fear asset – will benefit.
Odds of a “Black Swan” event that will ignite gold prices are increasing
Black swan events are unexpected events that have outsized and serious ramifications – such as the global economic crisis of 2008, for example. The unpredictability of some of President Trump’s early actions in office, and the poorly thought-out implementation of some of the new government’s policies, suggest that a black swan (which by definition is almost impossible to predict) may emerge from the depths. (Last week we talked about another possible black swan, here.)
I believe it’s crucial as an analyst and investor to be objective. Letting your political views cloud investment decisions is a good way to go broke. It makes a lot more sense to position your portfolio to profit from what may happen (see here for one idea that’s working out) – and protect it at the same time.
Fresh demand from Islamic Investors is hitting the gold market
As we discussed here and here, Islamic investors in modern times have shied away from gold-related financial products. This is because the legality of gold investments has long been unclear under Islamic Finance law.
However, as anticipated, a Sharia Gold Standard was approved on December 5. The Accounting and Auditing Organization for Islamic Financial Institutions and the World Gold Council teamed up to clarify the rules for Islamic gold investing under Sharia Law.
The Standard allows gold-based Sharia-compliant products, like ETFs, to be offered throughout the Muslim world. Indications are that the SPDR Gold Trust – the largest gold ETF in the world – qualifies under the guidelines.
The Sharia Gold Standard will stimulate gold demand across Muslim markets like Malaysia, the UAE and Saudi Arabia, where Islamic Finance is well established. Indonesia and Pakistan are pushing for Islamic Finance to play a greater role in their economic infrastructure.
Islamic savers and investors currently hold almost US$2 trillion in assets, an amount that is expected to grow to US$6.5 trillion by 2020, according to the Islamic Finance Stability Board.
President Trump’s ban of immigrants from seven predominantly Muslim countries, and the ensuing backlash, underscores the uncertainty many Muslims face around the globe. The world’s 1.6 billion Muslims may increasingly be able to invest in gold as a hedge.
Just a 1 percent allocation to gold among Islamic investors would equate to nearly US$65 billion, or 1,700 tonnes, in new demand. That’s almost double China’s estimated total 2015 demand for gold.
So as the Trump rally loses steam, and investors get a reality check from political and geopolitical risks, expect risk-on to become risk-off. Meanwhile, the chances of a black swan of some sort are rising. Finally, a major new source of gold demand is arriving via Islamic Finance.
One easy way to own gold is through the SPDR Gold Shares Trust ETF (code O87 in Singapore; ticker GLD on the New York Stock Exchange) or the Value Gold ETF on the Hong Kong exchange (code: 3081).
Black swans – events that are unpredictable and which have an outsized impact – are by definition unpredictable. But that doesn’t mean you shouldn’t still take steps to protect your portfolio against them.
Black swans aren’t usually mentioned in the same breath U.S. Treasuries, which are one of the basic building blocks of modern finance. U.S. government debt is viewed as the one truly “risk-free” asset (although it actually isn’t, as we wrote here). The cost of capital for almost every asset in global markets is linked to U.S. Treasuries – making them the oxygen of the global economy.
U.S. President Donald Trump, though, suggested on the campaign trail the idea of reducing government debt by getting creditors to accept less. It’s unlikely that President Trump will go down this path, which would unleash a black swan to end all black swans.
(To read our free special report on how to protect your portfolio under a Trump presidency, click here.)
Applying Trump’s business approach to government debt
Donald Trump, the businessman, declared bankruptcy four times. In American business, declaring bankruptcy – which often leads to paying creditors only a fraction of what is owed – is widely viewed as just another tool in capitalism’s toolbox. Trump appeared to look at debt repayment as optional, and subject to negotiation. And unfortunate creditors paid the price.
So it’s not surprising that Trump sent jitters through the financial world when he told CNBC during his campaign in on May 5, 2016:
“I would borrow, knowing that if the economy crashed, you could make a deal.” He added, “And if the economy was good, it was good. So, therefore, you can’t lose.”
As Bloomberg explained, Trump was suggesting that “he might use his business skills to reduce America’s debt burden by pushing creditors to accept write-downs on their government holdings.”
U.S. debt default would be unprecedented
Countries have been insolvent around 800 times over the centuries. Argentina, Puerto Rico and Greece are some of the many countries currently operating under debt repayment plans that were installed after they were unable to make good on what they owed. The International Monetary Fund (IMF) recommends that if a country can’t pay what it owes, that it pay back less.
But the world’s economy didn’t depend on those countries’ debt repayments like it does on U.S. debt today. As the New York Times explained, “Such remarks by a major presidential candidate have no modern precedent. The United States government is able to borrow money at very low interest rates because Treasury securities are regarded as a safe investment, and any cracks in investor confidence have a long history of costing American taxpayers a lot of money.”
The prevailing opinion is that since the U.S. government can print more money or raise taxes when needed, the chances of the American government defaulting on its loans is almost nil.
Trump later “clarified” his statement with a suggestion that was no more palatable. When asked if he was talking about renegotiating issued sovereign debt, he said,
“No, I don’t want to renegotiate the bonds, but I think you can do discounting. I think depending on where interest rates are, I think you can buy back… at discounts, you can do things at discounts. I’m not even suggesting that we don’t borrow money at very low rates long term so we don’t have to worry about when they come due.“
Where investors can find solace
Although the U.S. making good on its debt is viewed as sacrosanct, there have been some close calls. In August 2011, partisan infighting in Congress nearly resulted in a default on government debt. During the episode, one-month Treasury bill yields climbed to a 29-month high. Thus, as U.S. government debt was viewed as riskier, investors demanded a higher yield to hold it – and prices of bonds fell. (For bonds, the yield increases when the price falls, and vice-versa.)
In times of uncertainty, investors and traders have historically sold their higher-risk assets, and “fled to safety.” Usually, this means U.S. Treasuries, as the only “risk-free” asset. But when Treasuries themselves are the subject of uncertainty, there’s another asset that has traditionally been a safe haven: Gold.
In the summer of 2011, as the political dispute that led to the standoff over government debt simmered, the price of gold soared 25 percent from early July through mid-August. In the following month, the price of gold hit its highest level since 1980.
It wasn’t a coincidence that the price of gold spiked as uncertainty over the notion of risk-free became a topic of debate. As we’ve written before, there are plenty of reasons to own gold… and Donald Trump just happens to be another catalyst to support the argument. With President Trump, there is a greater-than-zero chance that U.S. debt is viewed as subject to a deal. If this were to happen, the price of gold would move up fast.
Investors looking to gain exposure to the precious metal can easily do so with the “equity-like” SPDR Gold Trust ETF (ticker: GLD on the New York Stock Exchange; code: O87 on the Singapore stock exchange; and 2840 on the Hong Kong Stock Exchange).
For other ways to invest in gold, click here to download our free special report.
If just 2 percent of current Islamic finance assets are allocated to gold, a huge new source of demand – roughly equal to China’s total purchases in 2015 – will soon enter the market. And this could push gold prices higher… a lot higher.
As we’ve discussed previously, Islamic investors have shied away from gold-related financial products. This is because religious laws have been offering conflicting advice about gold investments. As a result, Islamic financial institutions – which hold over US$2 trillion in assets – don’t have a lot of money invested in precious metals.
However, a “Sharia Gold Standard” – which will clarify and streamline Islamic gold-investing rules – is on track to be implemented by the end of the year. This means that the approximately 100 million active Muslim investors will soon have gold as an investment option.
Once the Sharia Gold Standard is adopted, it’s very likely asset managers in key Islamic finance countries like Bahrain, Qatar, Indonesia, Saudi Arabia and Malaysia will start aggressively offering gold investment products like ETFs – which are already wildly popular in the rest of the world.
If only a small percentage of the US$2 trillion in Islamic finance assets move into gold products in 2017, the gold market – currently undergoing a pullback in its ongoing bull market – will have a huge new source of demand.
An October 10 press release by the developers of the gold standard – the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the London-based World Gold Council (WGC) – announced the release of the standard’s “exposure draft.” After accepting public feedback and suggestions, the organisations will meet in mid-November to finalise the gold standard draft, and set the implementation schedule, expected to be around year-end.
Muslim gold buyers have the potential to be a force in the global gold market
For comparison, in 2015 China was a huge gold buyer. The Chinese government is secretive about exact numbers, but gold imports verified to pass through Hong Kong last year into mainland China amounted to nearly 1000 tonnes.
At current prices, if Islamic financial institutions allocate to gold just 2 percent of the assets they manage, it would equal roughly 1000 tonnes of extra demand. So that would be equivalent to another China – for starters. This new demand could help push gold prices higher in 2017.
And while this initial allocation may be a one-off event, Islamic finance is growing rapidly. It will be an ongoing source of gold demand into the future. Standard and Poor’s projects the industry could reach US$5 trillion by 2020. Some industry forecasts say that the number will be as much as US$6.5 trillion in four years.
Yet despite this rapid expansion, Islamic banking only accounts for a small fraction of the world’s investment assets – even though Muslims account for nearly 1/3 of the world’s population.
A big problem has been the lack of standardisation in the products available due to different interpretations of what’s acceptable under Sharia law. The new Sharia gold standard, along with other investment standards in the works, should help.
Under Sharia law, gold is generally considered a “Ribawi item,” meaning Muslims can’t trade it for future value, or for speculation. They can, however, use gold as a currency and own it as jewelry. Whether Muslims can trade gold as a commodity has been an ongoing source of debate among Islamic scholars. The new standard seeks to solidify agreement among scholars.
As Yusuf DeLorenzo, an AAOIFI member, told me in July, “The hesitation about investing in gold when credible Sharia standards are unavailable is nearly universal in the Islamic world. On the reverse side of the equation, however, gold has historically been the choice of individual Muslims desirous of preserving wealth and value.”
Given its long history as a currency and storehouse of wealth among Muslims, expectations are high that the Islamic finance industry, and Muslim investors, will quickly embrace gold investments. This would include gold savings plans, gold certificates, physically-backed gold ETFs, certain gold futures and gold mining equities.
Gold’s pullback to its 200-day moving average offers a good entry point
The added demand expected from Islamic investors comes as gold has pulled back from a big 2016 rally. It was consolidating around its 200-day moving average – a popular measure of a market’s long-term trend – last month. But it has since climbed above the 200-day moving average and is now up 23 percent for the year.
The catalysts for gold to climb higher are still there. Central banks’ zero interest rate policies and bouts of global currency instability are driving investors to gold’s stable embrace. Also, global political uncertainty – like the Brexit vote and the crazy U.S. election – has added to gold’s allure.
All indications point to gold’s 5 percent correction since mid-summer as a pullback in an ongoing, and historic, bull market.
The fundamental reasons for gold’s long-term bull market remain in place. And 100 million Islamic gold investors are waiting in the wings to start buying. So, investors should buy gold at these lower prices while they still have the chance.
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