People prize gold for a variety of reasons. Some are entranced by the mysterious, deep lustre. Sculptors prize its malleability and scientists its stability and conductivity. However the key characteristic for investors is gold’s inverse correlation to shares.
In investment terms inversely correlated assets are highly valuable, especially to long-only portfolios. An asset with an inverse correlation moves in the opposite direction to other assets. Historically, when shares go down, gold more or less goes up. This makes it a natural hedge. Holding gold in a portfolio can drag on returns in a strongly rising share market, but usually softens the blow when stocks stumble.
This is the central case for investors to hold shares in gold mining companies. Diversification is a powerful risk management tool available to all investors, large and small. However, diversification fails when all the assets in a portfolio move in the same direction at the same time.
Gold shares demonstrated the benefits of diversification as worldwide reports of the Covid19 outbreak first hit equity markets on 20 February. As the Australia 200 index halted its ascent, and rolled over, gold shares rose. A problem arose on 28 February, when Australian gold miners relinquished their immunity to the wholesale sell down that spread across asset classes, and the globe. Unfortunately this may become the new normal for gold shares in the current disrupted investment environment.
The trouble started in the underlying market for the metal. Gold is the most widely traded commodity on the face of the Earth. The standard for tradeable gold is universal, at a purity of 99.5% or higher. This means the spot price of gold (the price for immediate delivery) is a global market – usually. In March the price of gold in Chicago (to underpin gold futures trading) started to rise above the price in London. At one point, the same gold bar was worth US $70 per ounce more in the US than in the UK.
This divergence in prices is highly unusual. A number of factors contributed, including high demand for physical gold in the US and disruption to gold refiners, as they are not considered an essential industry. Traders reportedly hired cargo space on jets to fly gold to Chicago take advantage of this difference in prices. The spot price of gold became unstable, and the spread between the bid and offer blew out from the normal 30 to 50 US cents to $10 to $15.
The shutdown of refiners raises a major issue for gold miners’ revenues, even if gold prices go up. All activity in Switzerland, a major refining centre, has ceased after more than 10,000 reported Covid-19 cases. The Canadian Mint is running restricted operations. The Perth Mint reported record buying of bullion and silver. The combination of record demand for physical gold and restricted supply through a lack of refining capacity could see gold miners fall as gold prices surge.
There is another discomfiting scenario. Among share traders there is a legendary tale from 2008 about a Sydney based hedge fund. The traders running the fund anticipated the market rout, and profited as markets fell into disarray. They were amongst a handful of money managers globally that reported a positive return for the first half of 2008.
Yet by the end of the year they were out of business. The reason? As distress spread, investors were forced to sell what they could, not what they should. The hedge fund lost all of its funds under management because they remained liquid while many other funds froze redemptions.
If the current market disruptions continue this may see investors liquidating gold holdings, just because they can. If the gold price also loses its ability to shine while stocks fall, the impact on gold producers’ share prices is compounded. This could mean that not only will gold stocks fail to act as a hedge, they may decline at a faster rate than the rest of a portfolio.
