Gold's role in a changing Japanese macro environment

Farewell to negative interest rates 

The Bank of Japan (BoJ) waved goodbye to its negative interest rate policy on 18 March 2024, lifting its interest rate to a range of zero to 0.1%, the first rate hike since 2007.¹ In addition, the BoJ scrapped its yield curve control (YCC) program, first introduced in 2016 to hold bond yields down. Behind this decision were the highest inflation level since the 1990s and the fastest wage increase in 31 years, among other factors.²

And while interest rates in Japan are likely heading up (Chart 1), the BoJ may act cautiously to avoid shocks to global markets as well as its own economy. Following the rate hike, BoJ Governor Ueda noted that they will keep financial conditions easy for now and continue to purchase Japanese Government Bonds (JGBs) via scheduled outright purchases at a similar pace as before (six trillion yen per month). And the BoJ’s meeting in April confirmed that stance: rates were held steady as expected and the meeting noted no rush to tighten. Meanwhile, core inflation outlook was revised higher for both 2024 (to 2.8% from 2.4% in January) and 2025 (to 1.9% from 1.8%). 

Implications for local assets? 

There is no denying that risk assets in Japan, such as equities, are attractive prospects for investors: improved corporate governance, a weak yen that benefits exporters, and structural changes all support local equities. In fact, the Nikkei 225 Index surged by 12% over the first four months of 2024.³

But as the BoJ ends its ETF purchase program and interest rates move higher, albeit gradually, equities could come under pressure in the longer run. A Bloomberg survey shows 44% of respondents anticipate the ‘beginning of the end’ amid the BoJ’s monetary normalisation and 11% say it will end the bull run. In the short term, current valuations seem stretched and may induce volatility (Chart 2). 

Meanwhile, the possibility of a stronger yen warrants attention. With a global monetary easing cycle close at hand and Japanese yields heading higher, the yen may appreciate in the longer run; it may also bring headwinds for equities as a chunky portion of Japanese companies’ revenues or production comes from overseas (Chart 3). And a weaker yen has been an important contributor to the recent rally in the Nikkei 225 Index.

Japan’s fixed-income assets will be vulnerable to any uptick in yields and reduced bond-buying by the BoJ, while institutional investors with significant asset holdings in Japanese bonds could face losses if rates move higher. 

More broadly, as we move into a somewhat challenging investment environment – one with the potential for greater geopolitical instability (Chart 4) – we believe investors should consider ways to protect their portfolio. 

Gold’s role in Japanese portfolios

Gold has a role as a portfolio risk diversifier in Japan. With few exceptions, gold has been particularly effective during periods of systemic risk, generating positive returns in nine of the 13 quarters when the Nikkei fell more than 10% (Chart 5). In the remaining four quarters gold outperformed Japanese equities. 

Gold’s performance is mainly driven by its low correlation with risk assets, such as Japanese equities, which averages around zero in the long run (Chart 6). The diversified drivers of gold’s performance, independent of the Japanese economy, underpin its role as an effective diversifier for Japanese investors.

The unique diversifying and risk-mitigating effects of gold within an investment portfolio are evident when comparing downside risk and returns of various asset classes. There is generally a positive relationship between downside risk and return, i.e. less downside risk means less return and vice versa (Chart 7). Gold, however, is an exception. Over the past 20 years, gold has achieved an average return of just over 10% per year, making it one of the best-performing investment categories. But importantly, gold also exhibited limited downside risk. This is in stark contrast to other high-quality fixed income assets, which, like gold, provide downside protection but do so at the expense of lower returns.

The timing, magnitude and duration of any geopolitical crisis are always uncertain and virtually impossible to position for in advance. In a year when major elections take place in the US and worldwide, such uncertainties can only be exacerbated. For that reason, long-term strategic portfolio diversification is essential, and gold can play a key role as a geopolitical risk hedge (Chart 8).

Is gold still a good catch?

Gold has delivered a staggering performance so far in 2024 (Chart 9). Driven by the prospect of lower rates from major central banks and elevated geopolitical risks, derivative market positioning improved markedly in March, pushing the gold price higher. And the record-breaking Q1 central bank purchases and strong physical gold demand in key regions super-charged gold’s rally. While the LBMA Gold Price PM in USD increased 11% during the first four months of 2024, gold in yen surged 24%. 

In our Gold Outlook 2024 we discussed three possible economic scenarios and their potential impacts on gold’s performance. We also noted that continued central bank purchases and elevated geopolitical risks likely provide additional boosts – which has been the case so far this year. As our recent Gold Demand Trends mentioned, we expect global central banks to maintain above-trend gold purchases in 2024, which should continue to support gold’s performance. 

Short-term factors, such as investor positioning in the derivatives market, have sent gold prices to record highs and led many to believe the market is overbought. But our analysis shows gold’s ownership is near its lowest on record (Chart 10). Combined with robust fundamentals including strong physical demand, lower US Treasury yields as the Fed begins its easing cycle sooner or later, and elevated geopolitical risks suggest that gold is not currently overvalued.

Conclusion

As the BoJ ends its negative interest rate policy, the future looks uncertain. Short-term concerns, such as the overvaluation of Japanese equities and longer-term risks – including negative impacts on stocks and fixed-income assets brought by higher interest rates and a stronger yen – may hurt local portfolios. Our analysis shows that gold, in yen, is able to protect Japanese investors from local stock market drawdowns and geopolitical shocks. More importantly, gold’s unique characteristic – low downside risk but robust return – makes it an ideal portfolio risk diversifier and return enhancer. 

But as gold surges, recently refreshing its all-time-highs, investors may be hesitant around gold allocations. In our view, above-trend central bank gold purchases and widespread geopolitical risks should continue to increase gold’s allure to investors in a world buzzing with chaos. And looking at gold’s total ownership, which remains around all-time lows, we conclude it does not look overvalued. 

While short-term imbroglio may bewilder investors, there is a longer-term perspective on which investors should focus: as fiat money supply continues to increase and global government debts teeter on the brink of collapse, gold may well offer the hedge and value preservation portfolios need. 

Footnotes

¹Monetary policy release, ‘Changes in the Monetary Policy Framework’, Bank of Japan, 19 March, 2024.

²Japanese workers secure biggest pay rise in three decades|(ft.com).

³Navigating Japan Equities: Monthly Insights from Tokyo (February 2024) | Nikko AM Insights.