Why investors might consider gold as a separate and distinct asset class and not a bucket alongside other commodities?
Yes,commodities can help hedge against inflation, but does gold do it better alone?
Investment discussions and portfolio allocations often generically bucket gold alongside other commodities and broad commodity indices that include oil, copper, wheat and several others. This may make sense on the surface, given the fact that gold is mined, produced, and used for various consumer and industrial applications in a manner similar to that of other raw materials and commodities. But digging deeper, this basic grouping - along with exclusive broad index exposures - may overlook several of gold’s unique and distinct investment characteristics relative to the broader commodity complex.
Weighing gold’s characteristics against the current market backdrop further highlights several important factors that investors may want to consider when evaluating their commodity and gold exposures.
Lower Trend Inflation Favors Gold Over Many Other Commodities
A commonly cited motivation to invest in broad commodities is to combat inflation. Intuitively, this dynamic appears sound since commodities are important components, directly or indirectly, to typical consumer baskets that make up general price indices. The extent of broad commodities’ ability to offset inflation is actually more nuanced and dependent on the inflation regime. Historically, commodities have provided average positive returns across various inflation environments. But not all commodities perform similarly across all business cycles.
As shown below, during periods of low inflation1, gold’s average annual return outshined that of a basket of broad commodities. Furthermore, during periods of extreme inflation (6% or greater), gold was by far the preferred choice, outpacing commodities by more than double the average annual return. Although this level of US inflation was mostly contained to the 1970s - during a period of stagflation and revaluation of the US dollar following the end of Bretton Woods - it highlights that gold has historically aided against these limited, yet extreme, price levels. During periods of moderate to high inflation (3% to 6%2), gold still provided an offset against high inflationary periods, but other commodities posted better returns.
Source: Bloomberg, State Street Global Advisors. Data from 1/1/1970 – 12/31/19. Inflation is represented by the US Consumer Price Index (CPI) Index. Gold Price = LBMA Gold Fix PM Index. Commodity prices are represented by an equal-weight average of monthly returns for the Bloomberg Commodity Price Index and S&P GSCI Price Index. Past performance is not a guarantee of future results.
The Here and Now on Inflation
Turning to today’s market, investors are contending with a subdued inflationary environment. Realized inflation - along with current inflation expectations - remains below 3% (see below). Deflationary headwinds emanating from technology, aging global demographics, and slowing global growth have made stoking price inflation back to trend level a challenge, much to the chagrin of policymakers’ efforts. With the risk of trend inflation rising still broadly contained, investors may consider evaluating their overall commodity exposure based on gold’s positive historical performance during periods of relatively low inflation.
Volatility Is The Risk at Hand, Not Inflation
Diversification is another investor motivation for including broad commodity exposure within portfolios. This strategy dovetails well with the heightened risk of macro-induced volatility shocks this year due to stretched valuations in stocks and bonds.
Gold’s track record of providing diversification against equity market pullbacks and a historically low correlation to financial assets is well documented. In a similar manner, exposure to a broad commodity index may offer portfolio diversification benefits, but potentially not to the extent - or in as efficient a manner - as that of gold in the current market climate (see below).
Source: Bloomberg, State Street Global Advisors. Data from 1/31/1990 to 1/31/2020. BCOM = Bloomberg Commodity Total Return Index. GSCI = S&P GSCI Total Return Index. 60/40 Portfolio represented by 60% MSCI World Index and 40% Bloomberg Barclays US Aggregate Total Return Index. Past performance is not a guarantee of future results.
The power of gold in this capacity can be further demonstrated when comparing its up-capture and down-capture of equity returns with individual commodities and broad commodity indices. Commodities such as oil, copper, and even silver are inherently more cyclical than gold and tend to have a higher correlation to market and economic cycles because their demand depends more on pro-cyclical consumption. As a result, commodities historically capture more of the upside movements in global
equities compared with gold. Conversely, they also experience more of the downside when equities fall. The end result is that commodities’ up/down capture ratio of equity returns is less than 1.0, on average, and results in a less effective portfolio diversifier (see chart below). Gold, on the other hand, may not outpace commodities when equities rise, but provides significant protection by averaging a slight positive return of 0.4% during negative global equity returns.
In an environment of elevated equity valuations, increasing exposure to assets with low correlation and attractive downside capture are key to generating truly diversified portfolio allocations that result in an asymmetric total portfolio return experience over time.
Source: Bloomberg, State Street Global Advisors. Data from 1/31/1990 to 1/31/2020. BCOM = Bloomberg Commodity Total Return Index. GSCI = S&P GSCI Total Return Index. Past performance is not a guarantee of future results.
Broad Commodity Indices May Provide Suboptimal Gold Exposure
Investors commonly access the commodity asset class by using broad commodity indices and passive strategies. This approach, however, should not be viewed as a proxy or substitute for an allocation to gold. Based on three of the more prominent broad commodity indices, the gold allocation ranges from 4% to 14% (see below).
For a diversified portfolio with a 10% allocation to broad commodities, this translates to only a 0.4% to 1.4% allocation to gold at the total portfolio level. Comparing this with our Global Market Portfolio (GMP), which estimates the current market capitalization weighting of gold at approximately 3%,3 this highlights an inherent issue when exclusively using a broad commodity exposure as a proxy for a portfolio’s total gold allocation. Overall, a broad commodity index allocation on its own may leave a portfolio underexposed to gold and some of its beneficial investment characteristics.
At a practical level, as investors look to build a portfolio for 2020 – where inflation is likely to remain low, but macro risks continue to rise – they may find overall benefits to reevaluating their commodity exposure, potentially calling out gold as a separate and distinct asset class that can serve as an effective and unique portfolio diversifier against growing risks and evolving macro trends this year and beyond.
1Low inflation is determined as US CPI YoY rate being equal to or below its long-term median of 3%.
1High inflation is determined by approximately one standard deviation above the US CPI YoY long-term median.
3What is the Portfolio of Assets Held by the World? State Street Global Advisors, Investment Solutions Group (ISG). September 2019. 3% is based on known physical gold holdings in investment holdings and official sector.
Bloomberg Barclays U.S. Aggregate Bond Index TR — A benchmark that provides a measure of the performance of the US dollar denominated investment grade bond market, which includes investment grade government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities.
Bloomberg Commodity Index - A broadly diversified commodity price index distributed by Bloomberg Indexes that tracks 22 commodity futures and seven sectors. No one commodity can compose less than 2% or more than 15% of the index, and no sector can represent more than 33% of the index.
CPI, or Consumer Price Index – A widely used measure of inflation at the consumer level that helps to evaluate changes in cost of living.
MSCI World Index- The Index captures large and mid-cap representation across 23 Developed Markets. With 1,644 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Rogers International Commodity Index - The Index represents the value of a basket of 36 commodity futures contracts. The Index is a composite, United States dollar based total return index launched by James B. Rogers on July 31, 1998. The Index represents the value of a basket of futures contracts on commodities consumed in the global economy, ranging from agricultural to energy and metals products.
S&P Goldman Sachs Commodity Index, or S&P GSCI - A production-weighted index launched in 1992 that tracks the performance of 24 commodity futures contracts. The index, tilts to commodities that are more heavily produced globally, so its weights more heavily to crude oil than say to cocoa.
Up Market Capture – is the percentage return that an asset captures when a market benchmark is up.
Down Market Capture – is the percentage return that an asset captures when market benchmark is down.
Commodity funds may be subject to greater volatility than investments in traditional securities. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors, such as weather, disease, embargoes, and international economic and political developments.
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