The primary macroeconomic events that shaped Q1 2012 for gold were broad-based US economic data strength, China slowdown concerns, ECB (European Central Bank) bank loans and future European bailout potential. In an eventful quarter for the global economy that saw increased volatility in capital markets, gold finished the quarter materially higher despite a number of headwinds.
The key themes for gold during Q1 2012 were:
- Rising price in all major currencies with yen investors benefiting most:Gold prices climbed 8.6% QoQ in US$/oz on the London PM fix, despite a number of headwinds. Though the quarterly return was almost twice the ten-year average of 4.5%, similar gains in gold were seen across all major currencies with yen investors seeing a gain of 16.1% in local currency terms.
- Positive volatility for gold in stark contrast to negative volatility for commodities: While gold's price volatility was elevated, it continued to exhibit a positive (upside) skew. Gold's annualised volatility measured 20.4% during Q1, registering 21.8% on the upside and only 16.4% on the downside.
- Long-term correlation of gold to equities remains statistically insignificant: Despite higher than average short-term correlations to equities and other risk assets during the quarter, gold's performance remains independent of risk asset performance. Regression analysis shows that gold may, at times, move in the same direction as equities, but these moves are almost always related to other macro factors, such as, gold's negative correlation to the US dollar.
Gold's long-term price trend is maintained during Q1 2012
Q1 2012 saw the gold price rise 8.6% to reach US$1,662.50/oz on the London PM fix by quarter-end on 30 March (Chart 1). The average price for the quarter was marginally higher than Q4 2011 (+0.2%) and 22% higher on a year-over-year basis, as drivers of gold demand and supply continued to support its long-term trend. This performance was echoed in all major currencies. Local Japanese investors benefited the most as a weaker yen on investment outflows for foreign acquisition and a Bank of Japan commitment to quantitative easing saw gold rise 16.1% in local currency terms.
Q1 2012 was characterised by generally strong performance across multiple asset classes such as equities and commodities supported by a number of factors including broad-based strength in US economic data, ECB support for European banks through its longer-term lending programme, upward pressures on oil prices and portfolio re-allocation, primarily among fund managers.
During the first quarter, global developed market equities excluding the US returned 11.4%; The S&P 500 climbed 12.1%, US real estate rose by 9.8% (DJ US REIT Index) and commodities (S&P GSCI Index) rose 5% with strength in gasoline, oil, silver and soybeans and weakness in coffee and natural gas. By contrast, government bonds fell 0.9% with 10-year US Treasury bond yields leaping 33 basis points (almost 20% higher) during the quarter (Chart 2). However, while price moves suggest a decisive change in direction following poor risky asset performance in 2011, equity trading volumes underlying the returns were lower than multi-year averages partly reflecting only a tentative commitment to the renewed positive sentiment. Commodity moves, by contrast, were strongly supported with aggregate volumes in the constituent futures contracts of the GSCI Commodities Index at close to record highs. Allocations to commodities are likely the result of greater visibility of US growth following a revival in economic data, enduring pressures on supply in a range of commodities from soybeans to crude oil and a belief that any brief emerging markets slump will be mild - with a resumption of demand growth around the corner.
A challenging quarter for gold
While risky assets had plenty of supportive factors, shifting market opinion provided turbulence for gold. Economic data from the US on employment, housing, bank credit and consumer spending improved during the first three months of the year. In addition, several common measures of market risk aversion1 appeared to acknowledge that nascent risks of a new credit crunch and possible recession had been averted in the US, and a path to economic normalisation could be sustainable (Chart 3). Shifting market opinion regarding the continuation of loose monetary policy in the US led to some increased gold price volatility during the quarter. As of the January FOMC meeting, market opinion was consolidated on the view that easy monetary policy would continue. However, as market participants started to focus on improving economic data, opinion shifted prior to the March FOMC meeting. Participants inferred that no further quantitative easing would be imminent. More recently, after the end of the quarter, FOMC members have subsequently reiterated their commitment to keep its accommodative policy intact, stating that rates will remain close to zero until 2014. While monetary policy direction may have remained fairly consistent during this quarter, market opinions were very much in flux.
1LIBOR/OIS spread, EURIBOR/OIS spread, VIX index, CDS indexes and FX positioning
Many investors interpret a US economic recovery as an event with negative implications for gold through the normalisation of the real-rate cycle. This would, in their opinion and on the basis of relative yields, diminish the attraction of gold as an investment. While we acknowledge the historical relationship between gold and real rates, we also assert that rates are only one of several drivers of the gold price, and in a less US-centric world the significance of US real rates to the price may be very different to what it was two or three decades ago. Then, the majority of demand flows were primarily concentrated in the US and Europe. Now, gold demand is dispersed around the world with greater emphasis in countries like India and China, among others.
During Q1, events in both India and China increased some market concerns. In India, continued elevated rupee volatility and the government's announcement of import duty and jewellery tax hikes raised questions over future demand from the largest consumer of gold in the world.
The fate of China, as a primary component of global growth and a key market for gold demand, caused some consternation during the first quarter. Import, export and domestic property investment numbers, notwithstanding the positive seasonal period during the lunar New Year, were less than stellar, prompting worries of a tough landing for the economy and prospects for wealth-driven gold demand.
There was greater economic optimism in Europe during Q1, but perhaps due to a sense of relief that the worst had passed. The ECB's recent liquidity infusion for European banks (known as the LTRO - long-term repo operations) alleviated a potential credit crunch and indirectly lowered the debt servicing costs of troubled euro area economies. In addition, a second bailout for Greece - announced in the eleventh hour - averted a messy default, but has set the country on what is likely an unsustainable path of austerity. Gold is a proven hedge against both strong asset devaluation and potential inflation, and both risks will remain prominent as euro area sovereign issues remain.
Gold, as an inflation and deflation hedge also benefited from the strong rise in the oil price and a slight fall in the US dollar as many currencies around the world recovered from the steep depreciation they experienced during the previous quarter.
The US dollar declined on a broad trade-weighted basis by 2% during Q1.2 However, the strength of the drop, often synonymous with improving global risk sentiment (a flight to the US dollar generally follows rising risk aversion) has been somewhat mitigated by the relatively solid US economy. Gold's relationship with the US dollar is more complex than often perceived. While holding all else equal, gold tends to rise when the US dollar falls. Gold is best understood more broadly as a currency hedge. The relationship between gold and the US dollar is less stable when both benefit from investors looking to preserve capital as seen in 2008, 2009 and 2010. In addition, the growing importance of other currencies for gold such as the Indian rupee, Chinese yuan and Russian rouble has increased the significance of gold as a global currency hedge.
Gold price volatility: elevated but positively skewed
Gold's annualised volatility measured 20.4% during Q1, higher than the long-run average of around 16%. However, more importantly and consistent with its historical profile, it was skewed to the upside, registering 21.8% on the upside and only 16.4% on the downside (Chart 4). In other words, gold prices typically fall less sharply than they rise. By contrast, commodities had a negative volatility skew with upside volatility of 12.21% and downside volatility of 13.4%. Higher upside volatility is consistent with gold's attribute of providing fewer large losses and a greater number of larger gains, in contrast to equities and commodities, promoting gold's role in a portfolio. This aspect of gold ensures that as a component of a diversified portfolio, it reduces value-at-risk.3
2 Federal Reserve 3 See Gold: hedging against tail risk for explanation and analysis
One contributing factor to gold's higher volatility during the quarter was increased volumes in derivatives markets. Derivatives typically represent the more speculative end of investment as they tend to be leveraged. In particular, the ratio of volume in future contracts to ETF shares (per unit of gold) was substantially higher than previous months and led to short-term price trends being more heavily influenced by derivatives trading (Chart 5). Although gold ETF volumes were relatively lower than futures volumes, the ETFs that the World Gold Council tracks added 57 tonnes to existing holdings during the quarter, supporting further strategic investor allocations.
Gold's performance is independent of risk asset performance
Put simply, gold has not had a significant relationship with equities. The price of gold is driven by a unique set of factors, often quite at odds with those driving other assets, particularly equities. Infrequently these factors coincide, and also equally infrequently, equities and gold will move in the same direction, but not for the same reasons.
While the short-term daily correlation between gold and the S&P 500 might indicate a slightly positive correlation in the recent period, long term correlations remain at or close to zero. In other words, the inclusion of the US dollar as an explanatory variable to gold prices makes the S&P 500 beta insignificant.
We used a linear regression model on weekly returns for gold (US$/oz) with returns on a dollar index4 (X ) and the S&P 500 (X ) as explanatory variables:
y = a+?1X1+?2X2+?
4 Dollar index is an index of currency pairs with the following weighting: 57.6% euro, 13.6% yen, 11.9% pound sterling, 9.1% Canadian dollar, 4.2% Swedish krona and 3.6% Swiss franc. It is used as a proxy for the performance of the US dollar.
The results indicate that the beta between gold and the dollar returns was significantly different from 0 at the 99% confidence level. Meanwhile, the results in Table 1 also show that the S&P 500 beta is not statistically different from '0'. In other words, the US dollar has a statistically significant (negative) long-term relationship with gold while equity returns typically do not explain any variation in the gold price.
Table 1: Results from regression of gold price on S&P 500 and the US dollar*
These regression coefficients quantify the long-term relationship between variables, but they do not describe the behaviour of the relationship over time. Chart 6 shows the rolling 3-year beta, using weekly returns, between the S&P 500 and gold. The chart illustrates that the beta has remained close to zero historically since 1978.
Chart 6: Rolling 3-year beta between gold (US$/oz) and S&P 500, trade-weighted dollar
Investment statistics commentary archive
The quarterly Investment Statistics Commentary succeeded the Gold Investment Digest (GID), which was published between Q3 2006 and Q2 2011 and examined trends in price, investment markets and the macro-economy relating to gold and other assets typically found in an investor portfolio.
Shayne Heffernan oversees the management of funds for institutions and high net worth individuals.
Shayne Heffernan holds a Ph.D. in Economics and brings with him over 25 years of trading experience in Asia and hands on experience in Venture Capital, he has been involved in several start ups that have seen market capitalization over $500m and 1 that reached a peak market cap of $15b. He has managed and overseen start ups in Mining, Shipping, Technology and Financial Services.Read the Terms of Service