Investment update – The Case for Gold in DC Asset Allocations

Shortcomings of government bonds as a diversifier

For many DC investors, high quality government bonds, such as UK Gilts, have long fulfilled the traditional role of a diversifier in investment portfolios, offering protection during periods when risk assets have come under pressure. But the recent inflationary flare-up showed the limitations of such an approach. In fact, with major central banks turning decidedly more hawkish in 2022 as inflation proved far more persistent than predicted, traditional balanced portfolios suffered their largest losses in decades.

At present, the correlation between bonds and equities is positive, undermining fixed income’s value proposition as a portfolio diversifier. This has resulted in UK Gilts contributing a much larger share of total portfolio risk, i.e. nearly half of a balanced portfolio risk (Chart 1).

Chart 1: Contribution to portfolio risk

Portfolio allocation: 60% global equities, 40% UK Gilts*

Looking ahead, the upside to rates will likely be limited after the sharp rise in bond yields since early 2022. This has improved the return potential in many fixed income sectors but risks invariably exist. Persistent inflationary pressures remain the primary obstacle to monetary easing. This is what we witnessed over the last 21 months with a consistent upward recalibration of the terminal Bank of England policy rate (Chart 2). And a higher terminal rate from here (and its negative impact on fixed income assets) should not be ruled out.

Chart 2: Bank of England implied policy rate

The terminal rate has been repeatedly repriced up*

Inflation volatility may also be part of the medium-term inflation story. In fact, looking at the US experience where we have data going back to 1870, in periods when inflation has exceeded 7%, it has tended to see echo waves two and five years after the initial spike (Chart 3).

Chart 3: Inflation cycle in the US since the 1870s

US inflation experienced, on average, multiple bounces after the first spike above 7%*

Moreover, the combination of high wage growth, the green transition, deglobalisation and geopolitical uncertainties speaks to an environment of more frequent potential shocks to inflation. Recent inflation developments in the UK are certainly going in this direction. Total wage growth reached a staggering 8.5% in July (Chart 4). 

Chart 4: Record wage growth will worry the Bank of England

Total wage growth reached a staggering 8.5% in July*

Even stripping bonuses out, it reached an uncomfortable 7.8%. These growth rates do not suggest a return of inflation towards the target anytime soon, particularly with the ongoing rise in oil prices.

Indeed, short-term oil price fluctuations have a significant impact on long-term inflation expectations and inflation surprises (Chart 5).

Chart 5: The Bank of England may face additional challenges with the recent increase in oil prices*

And if a new inflation shock were to take hold, such an environment would require ongoing and fairly dramatic adjustments to monetary policy from the Bank of England, introducing volatility, potentially below-trend growth, and the possibility of negative returns in sterling fixed income allocations.

As Chart 6 shows, higher inflation weakens the appeal of government bonds as a diversifier. At inflation levels below 2%, the correlation between global equities and global treasuries has been negative, providing diversification. At levels above 2%, this relationship has historically started to break down.

Chart 6: Bond-equity correlations shift as inflation rises

Rolling 3yr correlation of global equity and global treasury bond returns vs. 3yr average G7 core inflation*

The lessons here are twofold:

• the contribution to portfolio risk from bonds is now much greater 
• there is no guarantee that bond and equity correlations will turn negative again and remain stable, particularly considering the potential for inflation volatility. 

It is important, therefore, to have assets that can help in these scenarios and not rely solely on government bonds as your diversifier.

Gold in DC investment portfolios

We have thus far outlined the challenges facing DC investors trying to design well-balanced portfolios. They need to be cautious of the risks of inflation and take account of the larger contribution to risk from bonds.

Our analysis shows gold is a clear complement to equities, bonds and broad-based portfolios. A store of wealth and a hedge against systemic risk, currency depreciation and inflation, gold has historically improved portfolios’ risk-adjusted returns, delivered positive returns, and provided liquidity to meet liabilities in times of market stress.

While effective diversifiers are sometimes hard to find, with many assets becoming increasingly correlated as market uncertainty rises, gold is different in that its negative correlation to equities and other risk assets, as seen in Chart 7, increases as these assets sell off.

Chart 7: Gold’s diversification benefits improve at times of market stress

Correlation of global equities vs. gold and UK Gilts in various environments* 

With few exceptions, gold has been particularly effective during times of systemic risk, generating positive returns in 8 of the 10 worst quarters of performance for the MSCI World index (Chart 8). Of the remaining two quarters, gold outperformed the MSCI World index in both cases reducing overall portfolio losses. 

Chart 8: Gold provides downside protection

Global equities, UK Gilts and gold returns (in GBP) during periods of systemic risk*

With inflation remaining at multi-decade highs, DC scheme members may be most concerned about increases to their cost of living, which are likely to outpace salary growth. Members in the early part of their savings journey will likely continue to focus on growth assets, but those closer to retirement may need guidance about what higher inflation means for their retirement plans and how their investment strategy can protect the real value of their savings. 

Gold has long been considered a hedge against inflation – and the data confirms this (Chart 9). What’s more, gold’s annualised return of 8.3% in GBP over the past 50 years has outpaced both the UK and world consumer price indices (CPI).

Chart 9: Gold historically performs well in periods of high inflation*

Case Study – The impact of gold in DC investment portfolios

From current levels, a traditional equity/bond portfolio may not deliver the type of diversification and returns achieved historically. As a result, we believe DC investors should consider alternative and complementary assets to high quality government bonds, such as gold. 

What is appropriate at different stages of DC investing and where could gold fit?

A core belief of the DC pension industry is that risk will be rewarded over long horizons, while effective risk management is needed to support good outcomes for those closer to retirement (Chart 10). As such, in the accumulation phase, members are a long way from retirement and have time to ride out the ups and downs of the stock market. In this phase, and despite the fact that gold has delivered some healthy returns over the last 50 years, short-term risk mitigation through diversification of asset classes, and the addition of gold, could be seen as a headwind to potentially higher long-term returns. We are, however, of the opinion that gold has a role to play in the consolidation and retirement phases, when protecting against market downturns is particularly important, given the relatively little time left to recover negative returns. 

Chart 10: Gold has a key role to play in the consolidation and retirement phases

Hypothetical retirement journey

With member outcomes being a key factor in setting all aspects of DC strategy, we assess how an allocation to gold can impact the future retirement incomes of investors.

Using long-term asset class forecasts (see Appendix for more details) and assumptions around starting salary, salary increases and contributions (Table 1), we’ve projected the range of potential pension outcomes for a glidepath with and without gold (Chart 12 and Chart 13, see Appendix for details). The glidepath with gold has a modest but meaningful 5% allocation to gold built over the consolidation phase of the retirement journey.      

Table 1: Monte Carlo assumptions

Source: World Gold Council

These forward-looking projections provide us with a number of key insights (Chart 11): 

• the distribution of outcomes at retirement (age 65) for a glidepath with gold is skewed towards the right-hand side, meaning the median portfolio at retirement is higher and the potential worst outcomes are reduced 

• a 5% gold allocation throughout retirement can also provide a more secure income in retirement, as a portfolio following a glidepath with gold will exhaust its assets later than a portfolio without gold. 

   

Chart 11: Glidepaths with gold consistently outperformed glidepaths without gold 

Difference in balance at retirement between a glidepath with gold and without gold*

Conclusion

In short, there are several advantages to diversifying the sources of safety in an investment portfolio beyond just high-quality government bonds. The way gold and government bonds perform going forward is likely to be different from one another. That feature alone should appeal to DC investors. 

As demonstrated in the case study, gold can help mitigate the key risks faced by DC investors – investment risk, inflation risk and longevity risk – by providing diversification that works, protection against high and extreme inflation, and enhancing risk-adjusted returns.

Appendix

Asset class forecasts:

• Gold: the World Gold Council has developed a framework to better understand gold valuation. Our Gold Valuation Framework powers our web-based tool, Qaurum, which allows users to assess the potential performance of gold under customisable hypothetical macroeconomic scenarios provided by Oxford Economics.
• Equities & bonds: we have used Blackrock’s long-term asset class forecasts. These forecasts are forward-looking estimates of total return, generated through a combined assessment of current valuation measures, economic growth, inflation prospects, yield conditions, as well as historical price patterns. 
   

Chart 12:  Target Date Fund – hypothetical glidepath example without gold* 

Chart 13:  Target Date Fund – hypothetical glidepath example with gold*