ONE of the best performing asset classes in recent months is gold and gold-related equities.
Since collapsing six years ago and reaching close to US$1,045 per ounce in late-2015, gold prices in US dollar terms have been fluctuating in a range and staying below US$1,365 per ounce until the recent rally that commenced in June. Prices have rallied 20.0 per cent (in US dollar terms) to US$1,550 per ounce since then.
Gold prices have recently outshined other asset classes with the return of volatility in equity markets following economic growth concerns in developed economies and escalating trade tensions between the Trump Administration and America's major trading partners.
Geopolitical tensions
Geopolitical tensions and pressures from the negative yielding fixed income world has also contributed to make owning it increasingly attractive. The recent trend in breakeven rates has also confirmed the uptrend in gold prices, as shown in the chart above.
When analysing gold, it is meaningless to look at the real supply and demand dynamics. This is because almost all of the gold ever mined out of the earth over the recorded history of human civilisation is probably still in circulation, and only a small amount of that is held in investment form.
Instead, studies have shown that over the long term:
(i) the price of gold will approximate the total amount of money in circulation divided by the size of the total stock of gold, and
(ii) the expected return from other asset classes like bonds and equities influences the performance of gold. Namely, the performance of gold is typically inversely correlated to the rate of return available on other asset classes, as monetary and investment demand for gold tends to turn positive when the expected returns for financial assets dwindle.
When it comes to point (i): the persistent fear of deflation that major central banks worldwide have will continue to drive their reaction function of pumping more liquidity into the system (adding to the global money stock), and this impulse may get drastic when economic growth slows down further and policymakers fear that they are running out of ammunition to achieve their mandated objectives.
With regards to point (ii), the real return forecasts for major asset classes around the world do not look too promising at this juncture, given that equity market multiples are fairly valued for the developed markets and nominal bond yields have been falling and are extremely low. Our internal estimates project a mere 3.0 per cent annualised return for US equities by the end of 2021, which is not particularly enticing.
Although there are pockets of value in some emerging equity markets, it would be stretching it to say that everything is generally attractive from a pure valuation standpoint.
With these two necessary ingredients currently in place, there is a strong foundation being laid for the segment. To play this trend, investors can own gold-related equity funds. These funds invest in the securities of companies engaged in the gold industry (like mining companies).
Typically, operating costs are high for mining companies, and their profit margins are leveraged off the price of the commodity that they sell. A rise in the commodity price usually flows through to the bottom line once it is above breakeven costs. Operational leverage is very high in such circumstances, and that is why mining companies usually see a huge expansion in valuation multiples when the price of their related commodity experience sees a run-up in price.
Their share prices are thus highly correlated to the general direction of the price of gold and are typically more volatile than the metal itself.
Funds that interested investors can consider include the likes of Schroder ISF Global Gold and FTIF - Franklin Gold & Precious Metals Fund. These funds invest in gold-related equities like gold miners and their performance are benchmarked to that universe. Most of the gold-related shares held by these funds are shares of big miners based in Canada, Australia and the United States.
Both funds have performance track records of more than three years, with the former fund launched since the summer of 2016 and the latter around since May 2010.
Bigger picture view
Although gold-related equity prices have been relentlessly rising, I think the bigger picture view is positive for this market segment.
Investors are right to feel concerned that policymakers may be running out of options to shore up growth as it seems central banks these days are 'pushing on a string' after a decade of unconventional stimulus programmes. I have also noticed that the populist movements to the left or the right in Western developed economies are building up pressure for fiscal stimulus and a change to current economic policy-making, epitomised by the rising interest in Modern Monetary Theory.
From a portfolio perspective, gold equity funds are a great diversifier within a portfolio of funds that invest in traditional asset classes of fixed income and equities. Exposure should be best kept within the supplementary portion of a portfolio.
Should there be a sell-off in both the shiny yellow metal and gold equities over the near term, it's possible that we may look back at this time in the years ahead and realise that it was a fantastic time to get exposure to this market segment.
- The writer is the unit trust research manager of the research & portfolio management team at FSMOne.com.
FSMOne.com is the Business-to-Consumer (B2C) division of iFAST Financial Pte Ltd, the Singapore subsidiary of SGX Mainboard-listed iFAST Corporation Ltd.
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