Geopolitical uncertainty, inflationary concerns and rising interest rates in key markets have impacted global financial markets in the first quarter. Against this backdrop, gold shone in Q1, registering a 4% gain in Australian dollars. And the near future may bring additional challenges for investors such as heightened equity market volatility and a rising bond-equity correlation.
We examined gold’s role as an equity risk hedge and source of returns. Our analysis shows that:
The first quarter of 2022 had no shortage of financial markets volatility. In January, higher interest rate expectations, rising inflation and the Russia-Ukraine war all took a toll on global equity markets: the S&P 500 stock index saw its worst start to a year since 2009 and the ASX 300 index experienced the deepest January fall in 14 years.
Turbulence persisted through the quarter. The Russia-Ukraine war, coupled with the US Federal Reserve’s March rate hike, shook investor confidence and ensured that global equity market volatility remained elevated (Chart 1).
Other markets were also volatile. Crude oil and natural gas surged by 34% and 50% respectively in Q1, alongside similar jumps in commodities like wheat (+31%) and nickel (+55%)1 Meanwhile, rising yields and inflationary pressures have caused losses in the bond market: the Bloomberg Global Bond Index fell by over 6% in the quarter.
But factors churning financial markets fuelled gold (Chart 2). Primary drivers of the gold price rise in Q1 include soaring inflationary pressure and geopolitical risk. And it is worth noting that compared to most major assets, gold’s volatility was much lower during the quarter.
Just as most countries have been emerging from the COVID-19 pandemic saga, high inflationary pressures are lingering. As we shift from a prolonged period of range-bound inflation and low rates, it seems the next chapter has already begun.
Inflation remains elevated in many countries (Chart 3). Global money supply has climbed at an unprecedented rate since the outbreak of the pandemic, seeding higher inflationary pressure, and surging commodity prices have poured oil on the flame. In the US, y-o-y growth in the Consumer Price Index (CPI) reached 7.9% in February, the highest since January 1982. And in Australia, the Retail Price Index (RPI) surged to a record high in March.
And higher inflationary pressure may not be short-lived. With inventories of commodities such as industrial metals and crude oil at multi-decade lows, clogged ports and higher freight costs are keeping already-disrupted supply chains under pressure. These drivers are likely to keep the commodity market volatile and tight.2 Emerging demand – as COVID restrictions are gradually removed3 – could mean that higher-than-normal inflation lasts longer in some markets.
To contain rising inflation many central banks are raising rates. In March, the US Fed’s boot finally came down as it announced a 25bp rate hike, the first rise since March 2018.4 And the Bank of England also lifted its policy rate that month – the third increase since December 2021.5 The European Central Bank hinted at tightening its monetary policy too.6 And despite the relatively dovish recent statement from the Reserve Bank of Australia (RBA),7 local investors are expecting higher rates: this is partially reflected in the steadily rising 10-year government bond yield (Chart 4).
According to the latest data published by the Australian Prudential Regulatory Authority (APRA), Australian superannuation funds are heavily concentrated in bonds and equities (Chart 5). As we previously noted, Australian super funds increases their equity exposure throughout 2021; by the fourth quarter , the average super fund allocation to fixed-income assets and listed equities was 18% and 51% respectively. Compared to 2019 (i.e. pre-pandemic) averages, this represented a 4% decrease in bond allocations and a 5% increase in the weighting of listed equities, which came almost purely from international stocks.
Equity market valuations often fall prey to heightened inflationary pressure. First, investor expectations of companies’ future earnings – the denominator of the price/earning ratio usually rise with inflation. Another potential consequence of higher inflation is a reduced economic growth rate, which often translates into lower equity valuations under the Dividend Discount Model (DDM).8 As such, investors might need to watch out for valuation-led pullbacks in equity markets where inflationary pressure continues to rise.
Second, higher rates – or tightening monetary policy – may also contribute to greater volatility in the equity market. Higher funding costs could cause uncertainties in company earnings, increasing stock price volatility. And a higher discount rate in the DDM, which is typically based on the risk-free rate, could negatively impact equity valuations, leading to declines in equity prices. Other factors, such as contracting liquidity in the market as monetary policy tightens, could also contribute to increased equity market volatility. Analysing historical data in the Australian equity market we found a lagged positive relationship between ASX 300 market volatility and the local policy rate.
Third, the role of bonds as an equity market hedge could be weakened as the nominal interest rate climbs. As previously mentioned, the impact of rising interest rates is at least two-fold:
Therefore, bonds and equities are likely to share more common ground when the interest rate is rising. This was particularly evident in Q1 2022 when bonds and stocks around the globe plunged in unison (Chart 2). And we discuss this topic in more detail in our recent blog.
Going forward, the average super fund portfolio could face headwinds. Fixed income assets and equities both experienced sizable retreats in the first quarter of 2022. The possibility of higher equity market volatility and a change in the bond-equity correlation could be problematic for Australian super funds, making it even more imperative to include an effective portfolio risk diversifier.
Gold performs well during equity market pullbacks. Investors often rush to gold, a safe-haven asset, during times of crisis, exactly as we saw in response to the Russia-Ukraine crisis. Historical data shows gold has a proven record of being an effective tail risk hedge (Chart 8).
“As a tail risk hedge gold is able to protect portfolios from unpredictable events”
And despite rate changes, gold’s relationship with equities has been relatively consistent. For instance, gold in Australian dollars has exhibited a persistent negative relationship with the local equity market since 2000 (Chart 9).
“Gold continues to offer equity market downside protection even when yields are higher”
Gold can help portfolios outrun inflation too. It’s effectiveness as an inflation hedge is partially underpinned by its stable and relatively limited supply, as well as by the fact that real interest rates (the opportunity cost of holding gold) are generally low when inflation is high.
“Gold has outperformed consumer price indices in the past 50 years”
To demonstrate gold’s ability to protect investors from uncertainties, we created two portfolios: the ‘average super’ and ’super gold‘ as shown in Appendix I. We initially asked ourselves this question: would an average super fund portfolio with gold have performed better in the turbulent Q1? To find the answer we assumed a 10% gold allocation in the average hypothetical super fund portfolio and proportionally decreased other asset weightings:
Performances of "Average super” and “Super gold”*
| Average super | Super gold | |
|---|---|---|
| Return | -5.12% | -3.73% |
| Annualised volatility | 8.92% | 6.88% |
| Portfolio β with global equities | 40.20% | 24.84% |
| VaR @ 99% | -20.78% | -16.02% |
*Based on daily data between 1 January 2022 and 31 March 2022. Global equity is based on MSCI All World Index. Beta values are calculated as covariance between the two series divided by portfolio standard deviation squared. VaR is calculated by the corresponding Z score times annualised volatility. All calculations are in AUD.
Source: Bloomberg, Australia Prudential Regulatory Authority, World Gold Council
As shown above, a 10% allocation to gold cushioned loss and reduced portfolio volatility during Q1. In fact, our analysis shows that any amount of gold would have limited losses and reduced risks to some degree in the Q1 scenario. Also, a partial replacement of bonds with gold and a decrease of equities could offer at least two benefits for an average super fund portfolio:
Gold’s ability to improve a portfolio’s performance is manifold. For instance, our analysis has shown that gold measured in Australian dollars has provided an average annualised return of 8% over the past two decades, higher than equities, bonds and commodities (Chart 11).
And we took a long view of the difference gold can make for an average super fund portfolio (Table 2). During the past 15 years – limited by data availability of indices used – we found that gold’s presence helped reduce the average hypothetical super portfolio’s risk and β against global equities, similar to previous results. More importantly, as a long-term return generator gold also lifted the average super’s Compound Annual Growth Rate (CAGR).
| Average super | Super gold | |
|---|---|---|
| Return | 3.74% | 4.30% |
| Annualised volatility | 7.54% | 6.40% |
| Portfolio β with global equities | 37.32% | 24.99% |
| VaR @ 99% | -17.58% | -14.90% |
*Based on monthly data of the two portfolios' performances between March 2007 and March 2022. All calculations are in AUD.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
Gold’s superior performance compared to other assets can also help with the required super fund performance test: a key part of the Your Future, Your Super (YFYS) reform, which came into effect in 2021. Generally speaking, super fund performance is now compared against various asset class benchmarks set by the APRA annually. Failing to past this test leads to severe business impacts such as the prohibition of new members.
Gold has outperformed its benchmark set by the APRA which is the “other assets” as detailed in Table 3. And according to the APRA’s calculation method, gold’s average annual return has been 1% higher than the benchmark over the past eight years – the required YFYS performance test period (Chart 11). Applying a similar calculation, using the average super fund asset allocation weightings and benchmarks set by the APRA as noted above, we found that a 10% allocation to gold would have outperformed the benchmark over the past eight years.
Gold’s performance in Q1 2022, compared to other major assets such as bonds and equities, has proven its role as an effective risk diversifier. Our tests show that a hypothetical average super fund portfolio’s loss and volatility during this quarter would have been lower with the inclusion of gold.
But gold is more than simply a loss cushion during uncertain times. Data from the past 15 years shows that the hypothetical super fund portfolio’s return improves with gold’s presence. And gold reduces a portfolio’s risk and dependency on global equities – an adjustment institutional investors might desire given future possible heightened stock market volatility.
And by outperforming its benchmark set by the APRA, gold can also play a role in helping super funds pass the YFYS performance test.
There is also evidence suggesting that gold, priced in Australian dollars, is a highly efficient risk diversifier for assets in that currency.9 This could be of vital importance for local investors as the majority of their portfolios are exposed to Australian dollar volatilities.
The recent geopolitical events and financial market volatilities have made a compelling case for gold. And in a world with no shortage of unpredictable events, arming your portfolio with gold could provides assurance.
To properly account for gold’s impacts on Australian super funds, we constructed our hypothetical average super fund portfolio based on the average super fund portfolio’s asset weightings in Q4 2021 published by the APRA, the latest data available. Indices for these asset classes are based on the YFYS performance test’s requirement. The ‘Super gold’ portfolio contains a 10% allocation to gold, from proportionally decreasing other assets’ weightings (Table 3).
| Asset class | Index used | Average super | Super gold |
|---|---|---|---|
| Cash | Bloomberg Ausbond Bank Bill Index | 9.00% | 8.10% |
| Australian fixed income | Bloomberg Ausbond Composite 0+ Index | 9.70% | 8.73% |
| International fixed income | Bloomberg Barclays Global Aggregate Index | 7.90% | 7.11% |
| Australian listed equity | S&P/ASX 300 | 28.15% | 25.34% |
| International listed equity | MSCI All World ex-Australia with Special Tax | 28.15% | 25.34% |
| Property | 50% S&P/ASX 300 A-REIT Index, 50% FTSE EPRA/NAREIT developed ex-Australia | 8.30% | 7.47% |
| Infrastructure | FTSE Developed Core Infrastructure Index hedged to AUD | 6.30% | 5.67% |
| Other | 50% International Equity, 50% International Fixed Income | 2.50% | 2.25% |
| Gold | LBMA Gold Price AM | 0.00% | 10.00% |
| Total | 100.00% | 100.00% |
Source: Australian Prudential Regulatory Authority, World Gold Council
1Based on active future contracts of WTI and Natural Gas at the New York Mercantile Exchange, Wheat at the Chicago Board of Trade and Nickel at the London Metal Exchange. All calculations are in USD.
2For more information, please visit: Global Supply Chain Pressure Index: March 2022 Update - Liberty Street Economics (newyorkfed.org) and "Under pressure": this is why inflation is incredibly high | World Economic Forum (weforum.org)
3For more information, please visit: ‘Take back life’: More nations ease coronavirus restrictions - ABC News (go.com)
4For more information, please visit: Federal Reserve Board - Monetary Policy
5For more information, please visit: Interest rates and Bank Rate | Bank of England
6For more information, please visit: ECB has 'extra space' before first rate hike, Lagarde says (cnbc.com)
7For more information, please visit: 2022 | Monetary Policy Decisions | RBA
8For more information, please visit: Inflation and Economic Growth | NBER
9For more information, please visit: Is Gold a Safe Haven in all Currencies? by Dirk G. Baur :: SSRN
