Gold's Opportunity Cost Becomes “Opportunity Benefit”?

This post was written with contributions from the SPDR Gold Strategy Team: Maxwell Gold, CFA (Head of Gold Strategy), Diego Andrade (Senior Gold Strategist), Robin Tsui (APAC Gold Strategist).

With the gold price up 18% year to date,¹ there’s no shortage of headlines earmarking its positive performance to geopolitics, the Federal Reserve (Fed), or growing recessionary fears—to name just a few catalysts floated. In actuality, there is a confluence of short-term and long-term macroeconomic drivers working together that influence gold’s fundamentals (both cyclical and counter-cyclical sectors) which in turn impact the gold price (see Chart 1).

Sinking Global Interest Rates Help Push Gold’s Opportunity Costs Lower

While gold’s performance is the result of interactions between all of the above strategic and tactical drivers, gold’s recent rally has seen solid support from falling interest rates over the course of 2019. In fact, lower real rates are significantly changing the opportunity cost picture for gold investors, particularly as competing assets like bonds provide lower yields and returns for investors seeking shelter from growing macroeconomic uncertainty.

Heading into 2019, market implied US real interest rates were hovering around 1.0%,³ and both the Fed and European Central Bank (ECB) were projecting multiple interest rate hikes coupled with reductions of their balance sheets. But lower global growth expectations, a prolonged trade dispute between the US and China, and an inversion of the yield curve have shifted the positive interest rate trajectory 180 degrees. Since the start of this year, real interest rates have collapsed (dipping below zero in Q3 2019), with the Fed and ECB changing course back to accommodative monetary policies.

The Bond Market Conundrum Helps Gold Shine in 2019

Against this interest rate backdrop, defensive positioning by investors is on the rise, which is supporting gold’s upward price movement in several ways (see Chart 2 and Chart 4). As global uncertainty has risen, investors have responded according to conventional wisdom, turning to fixed income markets for both safety and stability. But with continued low rates, the traditional playbook may not best serve investor objectives going forward. From this perspective, gold’s rally may continue to find support from the attractive relative valuations and improvement in opportunity cost associated with gold.

As investor demand for bonds has risen, it has helped bid up bond prices, putting further pressure on yields. Globally, negative yielding debt has climbed from $7 trillion to $13.4 trillion over the last 12 months,⁴ while gold sentiment has also risen (see Chart 2). This quick growth in negative yielding debt has created an attractive carry for gold, despite it not offering a yield in the traditional sense. On a relative basis and in face of continued negative rates—both real and nominal—gold’s opportunity cost is rapidly converting into an “opportunity benefit.”

Unprecedented Times Drive New Investor Strategies

With elevated bond valuations, investors are quickly adjusting their forward-looking return expectation for bonds. Furthermore, high valuations, rising deficits, and unprecedented monetary intervention by global central banks over the last decade have increased the risks to many segments of the bond market. Much like bonds, gold has historically demonstrated the potential to serve as an effective diversifier and a store of value, especially during turbulent markets. Given the high current cost of bonds, many investors and speculators have shifted to a more positive outlook for gold, which may provide a more beneficial complement to bond allocations in the lower rate environment.

A similar dynamic is also at play in equity and currency markets, where relative high valuations are making gold an attractive option. Currently, the price to earnings (P/E) ratio for both US and global equities, while not in bubble territory, remain stretched compared to the average level over the last 10 years (see Chart 3).

Since the market bottom on March 9, 2009, US and global equities have risen 17.5% and 13.5%, respectively, while gold has seen a 4.6% annual return over the same period.⁵ Based on current elevated valuations, weakening currencies, and a decade-long rally in the US equity market, gold appears attractive on a relative valuation basis, as well as a cheap hedge against a potential rise in market volatility. Additionally, gold price in other global currencies, including the British pound, Japanese yen, Canadian dollar, and Australian dollar, have reached all-time highs in local terms this year,⁶ another reflection of currency devaluation concerns lowering the opportunity costs of investing in gold.

Still More Room to Run For Gold Investors

Defensive positioning in conjunction with attractive relative valuations to bonds, equities, and currencies are mobilizing investors to gold. In September, holdings in global gold backed exchange trade funds (ETFs) hit an all-time high of 2855 metric tons of gold, exceeding the previous high in 2012.⁷

From a mean reversion perspective, gold ETF holdings reaching a new high may appear to some as a potential headwind for gold’s outlook. However, with gold’s price still more than 20% below its all-time high of US $1900/oz, this may actually provide a tailwind. Investors shifting allocations back to into gold (from an underweight position) are doing so at a lower average price compared to the run up in gold ETF assets and price between 2010–2012. As a result, investors may need to continue to increase gold holdings to match the commensurate appreciation of equities and fixed income in portfolios over the last decade. Based on this view, flows into gold ETFs may continue to rise and gold’s rally may continue to find support from its current attractive valuation and diminishing opportunity costs.

The opportunity costs of holding gold are rapidly transforming into benefits. As bond yields get pressed lower and investors look to other, less traditional assets to navigate volatility and lower return expectations of their “go-to” traditional fixed income and equity solutions, gold may play a more prominent role in portfolios.