Gold has been in the limelight for the past six months. This flashy commodity has rallied over 18% since the beginning of May, the biggest 6-month gold rush in more than 3 years. Gold prices have leveled off since August, trading around $1,500 an ounce for the past 2 months. Right now is the perfect opportunity to get a piece of this portfolio hedging commodity.
In this day and age, there is no need to go out and buy physical gold from your local jewelry store. You can simply purchase an ETF that tracks the underlying metal.
The largest and most liquid gold ETF is the SPDR Gold Trust (GLD), which has returned investors 17% so far this year. If you are looking for a riskier but potentially more rewarding ETF for this precious commodity, take a look at VanEck Vectors Gold Miner ETF (GDX). This ETF gives you exposure to the largest gold miners in the world and trends much faster than the underlying metal. GDX is up 33% so far this year.
How Gold works
Gold has many functions such as a store of value that is inflation-proof, a safe haven when the market experiences volatility, and can even be worn as a fashion statement. For the purposes of this article, I will ignore its use in fashion and discuss gold’s remaining functions.
Currency used to be entirely backed by gold with the gold standard, which promised every dollar to be worth some fraction of this precious metal that was held in a government vault. The system has been abandon across the globe and replaced with fiat money, which is backed by nothing but faith in the government.
Today the vestigial promise of the gold standard remains where a dollar is worth some fraction of a gold ounce (1/1500th). This fraction changes with inflation, interest rates, exchange rates, and market fear, to name a few key catalysts.
Typically golds drivers are correlated, and one critical thing that you need to understand when investing in gold are real interest rates (real interest rate= nominal interest rate (quoted rate) – inflation rate). As real interest rates fall, the value of gold increases. As you can see below, interest and inflation rates have converged this year. The inflation rate just surpassed the current 10-Year Treasury yield in September.
There is a strong inverse correlation between the real interest rate trend and gold prices, which means that when real interest rates fall, gold prices rise.
The relative value of a currency compared to a basket of other currencies is directly influenced by a countries real interest rate. The higher the real interest rate, the stronger the country’s fiat currency. Since the majority of gold is bought and sold in US dollars, the value of gold is inversely correlated with the dollar index.
The weaker the dollar gets, the lower the relative price of gold, making this precious metal a more attractive investment, driving the price up. The opposite also holds.
Gold is a commodity that has flight-to-quality characteristics, meaning that when riskier markets experience turmoil, investors will flock to the perceived safety of gold. This typically holds because of the intrinsic self-fulfilling prophecy. In times of economic distress, gold prices will rise.
Gold has a negative beta meaning that it naturally trades inversely with equity market though this correlation is far from perfect.
Why Buy Now?
The recent gold rally has been due to falling interest rates, which was driven by the Federal Reserve’s concern about recent market volatility connected with the US-China trade war. The global economic climate is significantly slowing down, and central banks around the world have dropped their rates, with some even falling below 0%.
Since the beginning of May, the 10-Year Treasury yield has broken down 35% pushing gold up to its current $1500 level for reasons I discussed above.
The Federal Reserve is expected to cut rates again at the end of October, and at least one more is priced in for the January meeting. I see real interest rates continuing to fall as the global economic slowdown, and the US-China trade conflict impacts the US.
Gold makes an excellent hedge for your portfolio, considering it usually moves inversely to the equity market. Holding a gold investment will lower your portfolio beta and protect against some market risk.
In this period of economic uncertainty it is crucial to have a hedging strategy to protect your portfolio against unwanted losses. Gold is poised to do so.
This glittery metal has been rallying since the end of 2018, and I see this trend continuing for the fundamental reasons I discussed.
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SPDR Gold Shares (GLD): ETF Research Reports
VanEck Vectors Gold Miners ETF (GDX): ETF Research Reports
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