A time of tension, a time for the precious metal?

While industrial and consumer demands are common to most commodity assets, safe-haven demand is unique to gold. Safe-haven demand is typically most prominent during times of crisis. As investors become concerned about a decline in the value of paper assets, they often turn to physical assets and gold. This kind of demand has the positive effect of providing price support for gold precisely when most other assets are suffering, and it is the one reason gold may serve as a powerful diversifier within a portfolio. 

In recent years, safe-haven investment demand has grown significantly. Alternative-currency demand stems mostly from central banks curtailing activity in their sizeable reserves in US dollars and other prominent currencies. The reasons for central banks shifting more towards gold include the expansion of US public debt and unprecedented fiscal and monetary policies, which cause a reduction in the value of the dollar. As such, the global financial system is gradually reducing its reliance on the dollar as the main reserve currency. 

While there is current discussion on the US tapering its expansionary fiscal and monetary policy, it is still early days. In particular, we have seen a surge in the demand for gold by the world’s fastest-growing economies, including China, India, and Russia. Purchases of gold by these countries indicate a steadily increasing allocation to gold as a percentage of their overall reserves, and a downward trend in the percentage allocated to paper currencies. 

Gold benefits in periods of inflation from its ability to maintain its purchasing power even as prices for other goods and services rise. The value of paper currencies is not tied to tangible assets, leaving this money vulnerable to declines in purchasing power. In the early 1970s, gold’s price was pegged to the dollar at $35 an ounce. Since that de-peg, the value of the dollar (and all paper currencies) has declined sharply relative to the precious metal. In other words, gold provides some certainty in inflationary periods when the value of paper currencies – and assets priced in them – is declining. 

Contributing to gold’s strong performance in the past decade was the rapid growth of emerging economies, whose citizens tend to put their savings in the precious metal, partly because of cultural factors, but also because of a comparative lack of alternative savings products. 

In addition, strong income growth in emerging markets such as India, where gold is a symbol of prosperity, provides a key price support for gold as consumers find the precious metal increasingly within their reach. 

Finally, there were a number of political and economic shocks that sent investors looking for the safety of gold. Even in periods of relative economic stability and prosperity, potential geopolitical shocks make gold attractive for its safe-haven attributes.

In particular, gold has fared well in periods of stress in the political and financial system – especially when mainstream financial assets struggle. This can be seen clearly in gold’s performance amid both legs of the financial crisis, first in the US in late 2008 and in Europe in early 2010. 

Gold has low, or in some cases negative, correlation with traditional financial assets. As a result, it can provide a powerful diversification for a portfolio. While returns for stocks and credit-sensitive bonds are tied to improving business conditions, gold actually tends to do better during periods of economic and political uncertainty, providing diversification when you want it the most. 

Gold is an asset class unto itself. It is not only a barometer of confidence in governments and the financial system, but also a reserve asset, an alternative currency, and a store of value. Those characteristics make gold an ideal diversifier because it has low |correlation to most financial assets, both in expansionary and recessionary periods. 

As geopolitical tensions persist and the global financial situation continues with sovereign government debts and deficits threatening entire economies and currency regimes, now may be the time to consider adding a modest allocation of gold to a diversified portfolio.