22 février 2017

Little to Lose, Much to Gain!

February 22, 2017, by Jean-Jacques Ohana, CFA and Dr. Christian Witt (YCAP Asset Management)

Gold is frequently mentioned as the number one asset for hedging political risks. Given the highly elevated global political risks today––by one measure the highest in two decades (see Figure 1)––it seems about time to revisit this hypothesis taking into account historical experience and the current setup of global markets. So, does gold really do a good job at insuring portfolios against extreme political risks?

For some historical context, we look at the relative price of gold and the S&P 500 Composite stock index since 1928. If the relative price is above (below) one, a unit of gold can purchase more (less) than a unit of the US stock market. As turns out, gold has frequently outperformed the stock market during periods of political uncertainty since the late 1920s. Not only was this the case during the turbulent 1930s (Great Depression) and 1940s (WWII) but also during the 1970s (Bretton-Wood era ends) and early 1980s (peak inflation). Hence, gold stands the test of time.

On the other hand, substituting stocks with gold comes at an opportunity cost because the precious metal tends to underperform stocks for extended periods of time. But if gold outperforms, it does so vigorously! Fortunately for investors, gold is relatively inexpensive today despite elevated political uncertainty. Therefore, in the current valuation set up, gold investors have little to lose but much to gain.

The current setup of capital markets is the other relevant factor. Only assets with a negative correlation to risky assets during periods of heightened political uncertainty (2008-09: Great Recession; 2011-12: European Sovereign Debt Crisis; 2016: Brexit and Trump) qualify as effective hedges against political risks. We therefore analyze the 250-days rolling correlation of gold with various assets over the previous decade (see Figure 3). Our results show that the prevalent market conditions traditionally favor using gold as a protection against political risks.

  • During episodes of uncertainty the correlation with stocks has been consistently negative. Thus, if the stock market breaks, gold benefits. What is more, this correlation is even lower today than during the worst part of the Great Recession.
  • The same is true regarding changes in US sovereign yields. Whenever yields fall––as is typical of periods of political uncertainty––gold tends to appreciate. To be fair, there may be undesired side effects. Because if the current secular bond bull market were to end, the hedging ability of gold may be diminished.
  • An appreciating USD typically coincides with declining gold––a pattern that usually intensifies during periods of uncertainty. This feature may make gold even more appealing to foreign investors because it may help to stabilize the value of gold in their home currency. Take the price of gold in EUR for example (see Figure 4). Since 2014, when the USD started to appreciate against the EUR, gold turned out to be more valuable for foreign investors than their US peers.
  • The stocks of gold miners move almost in lockstep with the spot price of gold. Hence, investors have the opportunity to replace gold with gold mining stocks gold if they have no access to the precious metal itself.

Gold has traditionally been promoted as the asset of choice to hedge political uncertainty. Our study of two important factors, the historical performance of the gold hedge and the current market setup, strongly corroborates this view. Moreover, the current valuation set up suggests it is relatively inexpensive to purchase gold.

Figure 1: Global Policy Uncertainty Index (Baker, Bloom, Davis)


Figure 2: Gold-to-S&P500 Ratio


Figure 3: 250-Days Rolling Correlation


Figure 4: Value of Gold in EUR and USD