Precious Metals: Negative-yielding bonds drive demand for gold

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on March 9, 2020 - March 15, 2020.

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Investors should consider increasing their holdings of safe-haven assets such as gold as there is less of an opportunity cost in holding the precious metal compared with bonds in the current low interest rate environment. This is one of the key drivers of gold prices in the short to medium term, according to the World Gold Council’s (WGC) 2019 Annual Review.

The low interest rate environment may even provide the precious metal with a positive “cost of carry” relative to sovereign bonds, says the Feb 24 report. A positive cost of carry is where the income generated from an investment is higher than the financing or holding costs required to hold that position.

“Unlike bonds, gold does not pay interest or dividends because it does not have credit risk. This perceived lack of yield often deters some investors. But in an environment where a quarter of the developed market sovereign debt is trading at negative nominal rates — and once adjusted for inflation, a whopping 70% of trades with negative real rates — the opportunity cost of gold almost goes away,” says the report.

Historically, gold has performed well in the year following shifts in fiscal policy, from tightening to “on hold” or “easing”, it adds. Whenever real rates have been negative, the precious metal has generated twice as much returns annually as the long-term average.

“Even low positive real rates produce higher average returns. Effectively, it has only been in periods with significantly higher real interest rates — an unlikely outcome, given the current market conditions — that gold returns have been negative,” says the report.

“This is further supported by the surge in negative real-yielding debt as evidenced by the strong positive correlation between the amount of debt and price of gold over the past four years. To some degree, this illustrates the erosion of confidence in fiat currencies related to monetary interventions.”

The current landscape has pushed investors to increase their portfolio risk by buying longer-term bonds, lower-rated riskier bonds or simply replacing them with riskier assets such as stocks or alternative investments. This environment makes gold more effective than bonds at mitigating stock-market risks, providing portfolio diversification and helping investors achieve their long-term investment objectives, says the report. Hence, investors have been steadily adding gold to their portfolios. 

According to the report, central banks bought the most gold in history in 2018. They continued their robust purchases in 2019 and were net buyers of the precious metal for a 10th consecutive year. 

Global gold reserves grew 650.3 tonnes last year, the second highest annual total in 50 years. A total of 15 central banks — all in emerging markets — increased their gold reserves by at least one tonne, highlighting the breadth of buying, says the report.

Gold-backed exchange-traded fund (ETF) holdings reached an all-time high as global investors responded to the high-risk, low-rate environment. Investments in these products increased by 401.1 tonnes in 2019, up 426% year on year. North American funds saw the most substantial net increase at 206 tonnes, followed by European funds with 188 tonnes.

“The very low interest rates worldwide will likely keep stock prices high and valuations at extreme levels. Within this context, we believe there are clear reasons to have higher levels of safe-haven assets like gold,” says the report.

Softer consumer demand

Consumer demand for physical gold declined by 11% last year, says the report. Global demand for gold jewellery fell 6% to 2,107 tonnes while retail investments slumped to a 10-year low. 

Gold demand across the board fell 1% to 4,355.7 tonnes in 2019 as the price-driven slump in consumer demand matched the surge in investment inflows into gold-backed ETFs.

The report describes this softer consumer demand as a by-product of geopolitical, macro-economy and monetary policy uncertainties, which resulted in gold price volatility. Higher gold price volatility combined with expectations of weaker economic growth have resulted in softer consumer demand for gold in the near term.

According to the report, consumer demand still accounts for a significant portion of the total annual demand for gold, an average of 75%. Based on the multi-country survey of 18,000 people, gold ownership levels are high and many respondents displayed a keen interest in investing in gold.

However, 38% of the respondents had never bought gold before, but were considering doing so in the future. That is because about a quarter of them were concerned about mistakenly buying counterfeit gold and that the purity of the yellow metal purchased is not guaranteed.

The report points towards gold-backed ETFs as a growth area going forward. The holdings of gold-backed ETFs closed the year at 2,885.5 tonnes, with monetary easing and geopolitics being the main drivers of this demand in 2019 coupled with the price rally, which drew some momentum inflows.

About 40% of retail investors cited ease of purchase as a key requirement when investing in gold products. Last year, 26% of retail investors globally invested in gold-backed ETFs via online platforms, compared with only 9% and 6% in gold coins and jewellery respectively.

As at Jan 31, the largest gold-backed ETF in the world — SPDR Gold Shares — had generated an annualised return of 19.25% for the past year and an annualised return of 8.88% for the past three years.

Gold versus climate change

According to the report, gold is likely to play an increasingly important role as investors consider how to adjust their portfolios to account for a climate-impacted economy. In another report, titled Gold and Climate Change, also released by the WGC, it was estimated that the total value of global investment portfolios would likely fall between US$4.2 trillion and US$13.9 trillion due to inaction on climate change. 

This report includes a study conducted by the WGC to assess and evaluate climate-related implications on asset classes based on their sensitivity to risk factors and scenario pathways. In its findings, gold is likely to exhibit a relatively robust performance across all climate scenarios in relation to other asset classes such as equities and real estate, due to their traditional role and safe haven qualities.

The report also points out that unlike most metals, the demand for gold is diverse and does not concentrate in any particular sector or geographic region. It also has cultural significance as a luxury good and monetary asset.

Climate-related physical risks are less likely to threaten the relative stability of the overall gold supply, which is likely the case for most other commodities, says the 2019 Annual Review. “In contrast to many other mainstream asset classes, gold is likely to be more resilient and less volatile as climate change impacts the global economy.

“While there is more to do to fully understand how to construct an investment portfolio that is robust, given a changing climate, it is evident that gold will play a leading role, particularly given that ongoing emissions associated with gold bullion are negligible.”

According to the WGC’s analysis, the total carbon emissions associated with the global gold market is equivalent to the global economy as a whole, with the vast majority of emissions concentrated in the gold mining phase. Other emissions associated with gold are limited to the transformation of gold ore into bullion and then into jewellery and other fabricated products such as bonding wire for electronics. This makes gold different from other commodities, of which the scope of emissions can be significant.

“Climate change is recognised not only by companies but also their investors and clients as being material to operations and of potential impact on both the asset and liability sides of their balance sheets. Financial regulators are increasingly formalising these requirements for greater disclosure, with the expectation that investors will consider the materiality of climate-related risks as a core component of their fiduciary duties. There are strong indications that climate-related financial disclosures are likely to become mandatory over time,” says the report.