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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a senior fellow at the Council on Foreign Relations
Investors who had recently jumped on the gold bandwagon learned a painful lesson on Tuesday when prices posted their largest one-day fall in 12 years. It’s a lesson they should remember for when the broader equity market cycle eventually turns: gold’s diversification benefits rarely come without some bumps along the way.
While this week’s sell-off is unlikely to change the more structural reasons investors have been adding gold to portfolios, that doesn’t mean a repeat won’t happen. Indeed, history shows a consistent pattern in which gold prices fall alongside stocks before decoupling and usually heading higher. Those who want the benefits of portfolio diversification through gold need patience.
Looking at the last six instances where the S&P 500 fell by 15 per cent or more, gold prices initially declined as well. By the time the S&P troughed, however, gold had outperformed by a noteworthy average of 40 percentage points and with absolute positive returns in four of the six instances.
The correlation, and admittedly small sample size behind this conclusion, is less important than understanding why gold behaves this way. That’s especially true today with equity prices near record highs and growing investor questions about how much longer the rally can continue.
When sustained equity drawdowns start, investors begin to prioritise increasing cash holdings. This often means not just selling what you want but what you can, since periods of market stress often limit the ability to sell less liquid assets at reasonable prices. Gold, a relatively liquid commodity, tends to get caught up in this dynamic. As a result, it often sees lower prices alongside equities for days or even several weeks.
For those new to gold investing, those initial losses on gold holdings can feel like a betrayal. How did this asset that was supposed to cushion a portfolio not work the way they expected?
What’s important to know is that these gold-price pullbacks usually prove less extreme than those in equities, both in degree and duration. There are a few reasons for this. First, central banks respond to financial instability by lowering interest rates, which in turn reduces the opportunity cost of owning assets like gold that do not offer a yield.
Second, as investors reassess the market environment and adjust portfolios, they usually reduce risk assets like equities and credit and add safer ones, including longer-duration government bonds and gold.
Gold prices are also supported by their limited supply and an expectation that key holders of gold — namely, central banks — are unlikely to suddenly sell reserves given their long-term investment horizon focused on liquidity and stability.
Today, conditions appear to be building for a repeat of this historical pattern, in which gold might see a period of negative returns before once again showing its diversification ability. Such risk seems relatively more likely after a run-up in gold prices of more than 57 per cent this year alone (including the recent sell-off).
Even if some of the shine wears off gold in this potential scenario, there is good reason to expect the price decline will once again be shorter and less deep than that in risk assets.
First, central banks are adding to gold reserves as a way to reduce exposure to US dollar-denominated assets. This trend is likely to continue, with nearly a third of 75 central banks surveyed by the Official Monetary and Financial Institutions Forum saying they plan to increase gold holdings in the next 1-2 years.
Gold may also appear relatively more attractive in a world where both fiat money and low and stable inflation are increasingly questioned. Gold is seen as an alternative to fiat money as a store hold of wealth, if not an efficient payment vehicle.
One factor that could limit gold’s outperformance in the next potential equity bear market is the Federal Reserve. Back in 2022, when the S&P fell in part because of fears that Fed tightening would weigh on earnings growth, gold prices declined as well. Higher interest rates reduced its relative attractiveness. But even then, gold still managed to buffer overall portfolio returns, outperforming US equities over the pullback by more than 18 percentage points.
When equities eventually take a step down from their current heights, history suggests diversifying assets such as gold will help limit portfolios losses. Investors should know what to expect before that period arrives if they are to avoid tactical mistakes along the way.