Stock Market Volatility Is Good For Gold by by Russ Koesterich, CFA – BlackRock
The recent rise in market volatility has been good for gold. Russ discusses why be believes gold is likely to continue to provide an effective hedge against equity market risk.
Following a more than four year slide with a 45 percent decline, gold has rallied. Spot gold prices are up over 15 percent from their January lows, according to Bloomberg data (as of 3/1/16), and the precious metal has dramatically outperformed both stocks and bonds. It has also outperformed the broader commodity complex; the CRB Commodity Index is down approximately 8 percent year-to-date (as of 3/1/16).
What accounts for this rally? More importantly, how should investors be thinking about gold in their portfolios?
The short answer is this: In a regime of heightened and rising volatility, gold has re-established its role as a potentially effective hedge against volatility.
The story behind gold’s comeback
Before enumerating what has caused gold to bounce, it is worth highlighting what has not: rising inflation fears, a classic trigger for a gold rally. Although U.S. realized inflation has firmed, inflation expectations have been falling. Instead, the recent rebound in gold can be attributed to several factors: falling real interest rates (i.e. after inflation), prices falling towards production costs and higher volatility.
To my mind the latter factor is particularly important and marks a critical shift for the asset class from the period following the financial crisis. Between the 2009 market bottom and the end of 2013, when the Federal Reserve (Fed) started to taper, gold had a modestly positive correlation with stocks. In short, both gold and stocks were responding to the same stimuli during that period: The Fed. In those years gold was more of a trade on reflation rather than a classic “safe-haven” asset.
However, over the past year the correlation between gold and stocks has turned decidedly negative. Based on weekly data the correlation is now roughly -0.30, as of 3/1/16. (Remember: a correlation of one means asset classes move in lock step, a negative correlation means asset classes move in opposite directions). One argument for this shift is that the Fed’s move towards higher interest rates removes the monetary tailwind that had supported both gold as well as stocks. But now, with markets under pressure, investors appear to be once again buying gold on the expectation that the precious metal will help insulate portfolios from rising volatility.
Putting it all together: gold, equities, high yield spreads and volatility
What does this look like in practice? In our opinion, gold is more likely to outperform U.S. equities (measured using monthly returns on the S&P 500) when volatility is rising. I looked at this through two separate but related prisms: the VIX Index, which measures equity volatility, and high yield spreads (the difference between the yield of a high yield bond and a comparable Treasury). Changes in either factor explain roughly 15 percent of the relative return between spot gold prices and the S&P 500 Index according to historical data, February 1990 through February 2016.
Historically in months when the VIX rose, indicating rising volatility, gold outperformed the S&P 500 Index by approximately 2 percent during the aforementioned 1990-2016 period. Conversely, in months when the VIX fell, signaling declining volatility, U.S. equities outperformed gold by a similar margin, according to Bloomberg data.
The same relationship holds when looking at changes in high yield spreads, a useful proxy for financial market conditions. When conditions are tightening, evidenced by widening spreads, gold (as represented by spot gold prices from Bloomberg) has historically outperformed the S&P 500 index by 1.6 percent a month on average. Again, the relationship reverses itself when credit conditions are becoming more benign, evidenced by tightening spreads (again based on 1990-2016 data).
For investors, the takeaway is that gold is reasserting its role as a potential volatility hedge. To the extent that the recent fall in volatility over the last couple of weeks proves transitory, gold could continue to act as an effective hedge.