As we enter the later stages of the current economic cycle, the importance of effective portfolio diversification and defensive positioning is paramount. In our portfolio management services at BFI, we have been incorporating downside protection actively since the first quarter of the year. In that same context, we have increased our cash positions and our allocations in alternatives, including gold.
Clearly, gold fits favorably within this overall idea of taking out risk and adding “Downside Protection”. Therefore, I am pleased to share a few insights from a special report published by J.P. Morgan on September 26th. The private bank paints a very positive picture for gold – and a not so positive picture for the global economy…
“Gold is money. Everything else is credit.” ~ John Pierpont Morgan
According to J.P. Morgan, the current macro environment should allow for gold prices to continue to rise as lower US interest rates, rising macro risks, and strong central bank demand should continue to offer support. Moreover, gold has historically outperformed equities as recession probabilities rise and contributed to higher risk-adjusted portfolio returns over both the short and long term.
J.P. Morgan expects that gold prices will end 2019 at $1,500 per ounce and reach $1,600 per ounce by mid-2020. Although at BFI we are always hesitant to make these kinds of projections into the future, I would agree with a generally very positive outlook for gold, and for silver too. All the signs are “green” for precious metals.
Gold prices have rallied nearly 20% year-to-date against a backdrop of falling yields and rising risks.
Gold Price and 10-Year Real Yields
Source: J.P. Morgan, Bloomberg
We expect this environment to persist in the months ahead. We believe lower US interest rates are the key driver of higher gold prices. The Federal Reserve has begun easing and we’d still expect to see lower yields even if the Fed underdelivers on market expectations of future rate cuts.
Central banks are back it – printing more “cheap money” as they realize that the party train is slowing down, and much faster than they had hoped. As the real opportunity cost of holding gold, a non-yielding asset, decreases, the price of gold should increase. In a world of nearly $15 trillion (!) of negative-yielding debt, gold now has actually become a “positive” yielding asset.
Recent developments in the US Repo market are also certainly worth considering. The Fed has been injecting liquidity into the US banking system as if there is no tomorrow. Clearly, one or more US banks are having problems.
Meanwhile, in several parts of the world, including China, inflation is on the rise. Looking at the world today, I cannot help but be reminded of 2007, but I also think of the Weimar Republic now and then... History does indeed tend to repeat.
Gold has historically outperformed US stock markets as recession probabilities rose. J.P. Morgan estimates that the probability of a recession in 12 months currently sits around 45%, which is the highest level since the Global Financial Crisis.
Probability of recession in one year’s time
Source: J.P. Morgan, September 16, 2019
Historically, gold has served well as a stabilizer in diversified portfolios. It is for this reason that at BFI we may well be somewhat different in the level of precious metals our clients currently find in their portfolios. Equally importantly, we go out of our way to ensure our clients have PHYSICALLY ALLOCATED GOLD in their portfolios.
Average Monthly Percent Return by Quartile of Recession Probability Over Past 35 years
Source: J.P. Morgan, Bloomberg
As broader macro risks are on the rise, assets with low correlations to the stock markets are highly attractive to us. Therefore, gold is an attractive investment in our portfolios as we near what looks very much like the end of the last economic cycle.
Annual Central Bank Purchases of Gold, Tonnes
Source: J.P. Morgan, World Gold Council, December 2018
As we all know, central banks around the world have significantly increased their gold purchases over the past few years. Last year, central banks purchased over 650 tonnes of gold, which was the largest single year of purchases since President Nixon suspended convertibility of gold in the early 1970s. This trend has continued into 2019, with a rolling 4-quarter sum of central bank reserve purchases that is the largest on record.
According to J.P. Morgan, last year’s purchases were not just isolated to a few buyers. To the contrary, the number of individual sovereign buyers of at least one ton of gold matched an all-time high. Buyers like Hungary and Poland returned to the market after multi-year absences. In 2018, Poland bought 25 tonnes of gold – the country’s first purchase in 20 years. In 2019, they nearly quadrupled their gold purchases.
This, of course, provides a strong support for gold prices, one that I don’t expect to fall away anytime soon. It is one of the key reasons why we don’t anticipate gold prices to fall much further after this recent “breather” we saw in gold’s upward trajectory.