Why Gold Often Glitters

By Lori Zager & Lisa James

While gold has a role in a diversified portfolio, it is far from universally embraced by investors and wealth managers. Even former Federal Reserve Chairman Ben Bernanke once remarked:

"Nobody really understands gold prices, and I don't pretend to understand them either."

Economist John Maynard Keynes was even more dismissive, famously referring to gold as a "barbarous relic."

In today's market environment, however, we would not be so quick to dismiss gold as an investment.

A Brief History of Gold as an Investment

Ben Bernanke's skepticism may be influenced by gold's historical role in international monetary policy.

For much of modern history:

• Gold prices were fixed for currency purposes.
• Central banks used gold to stabilize exchange rates.
• Gold was relatively illiquid as an investment asset.

That changed in 1973 when gold prices were allowed to float freely. Then, in 2003, the introduction of gold-backed exchange-traded funds (ETFs) made investing in gold significantly more accessible and liquid.

Investor interest has grown substantially since then. Through mid-September 2019 alone, more than $8 billion flowed into U.S.-based gold ETFs.

Gold's Relationship with Other Markets

Despite criticism that gold produces no cash flow, it has performed surprisingly well alongside other financial assets since 1973.

Historically, gold tends to perform best during periods of:

• Stagflation
• Geopolitical uncertainty
• Currency instability
• Severe stock market downturns

Conversely, gold often underperforms during periods characterized by:

• Strong economic growth
• Stable markets
• Low inflation

The Connection Between Gold and Real Interest Rates

One of the most important drivers of gold prices is the level of real interest rates—interest rates adjusted for inflation.

Research suggests that gold prices often:

• Rise when real interest rates fall
• Fall when real interest rates rise

According to Digital Asset Research, declining real yields have explained roughly 20% of gold's positive price movement since 1997.

More recently, Kitco data showed a much stronger relationship, indicating a 71% negative correlation between gold prices and U.S. 10-year real interest rates over the previous five years.

Why Real Rates Matter

The relationship makes intuitive sense.

Unlike stocks, bonds, or income-producing real estate, gold does not generate cash flow. The same can be said for assets such as:

• Bitcoin
• Fine art
• Collectibles
• Undeveloped land

When real interest rates are low—or even negative—the opportunity cost of holding non-income-producing assets declines.

Investors become more willing to hold assets like gold when traditional fixed-income investments offer little return after inflation.

With large portions of the global bond market offering negative yields, many investors see gold as a more attractive alternative.

Gold Doesn't Always Follow Conventional Wisdom

While gold often performs well during crises, its behavior is not always predictable.

The 2008 Financial Crisis

During the second half of 2008, amid the credit crisis and the collapse of Lehman Brothers, many investors expected gold prices to surge.

Instead, gold prices declined.

Why?

Rising real interest rates likely outweighed the usual "safe-haven" demand that would typically support gold prices.

The Summer of 2019

Another interesting example occurred in 2019.

Normally, a strong U.S. dollar puts downward pressure on gold prices. However, despite dollar strength, gold prices rose.

Falling real interest rates likely had a greater influence than currency movements, pushing gold higher even as the dollar strengthened.

The Practical Case for Gold

Unlike paper currencies, gold has a finite physical supply.

Governments and central banks can create additional currency, but they cannot simply create more gold. This scarcity gives gold the potential to preserve value over long periods.

As government debt levels continue to rise globally, many central banks have been increasing their gold reserves.

Despite the U.S. dollar remaining the world's primary reserve currency, central banks have increasingly diversified into gold.

Why Central Banks Buy Gold

According to the World Gold Council, central banks hold gold for several reasons:

• Safe-haven protection
• Portfolio diversification
• Improved risk-adjusted returns
• Valuable collateral during financial stress

In the first half of 2019 alone, central banks purchased 374.1 metric tons of gold.

Notable buyers included:

• Russia
• China
• Poland

In addition, Germany's Bundesbank increased its gold reserves in September 2019 for the first time in 21 years.

While the increase was relatively modest at approximately 90,000 troy ounces, it highlighted growing concerns about the global monetary system and the long-term stability of major currencies.

Data from the International Monetary Fund (IMF) also showed continued gold purchases by:

• United Arab Emirates
• Kazakhstan
• Belarus
• Turkey

Gold in Today's Environment

We initially incorporated gold into client portfolios in September 2018 for many of the same reasons that central banks have been accumulating gold reserves.

Following gold's recent pullback, largely driven by technical market factors, we believe it is worthwhile to revisit the investment case.

Today's environment includes:

• Rising global debt levels
• Expanding government deficits
• Continued monetary stimulus
• Historically low real interest rates

If real yields remain low for an extended period, gold may continue to serve as a valuable component of a diversified investment strategy.

The Bottom Line

Gold may not generate income, and its price movements can sometimes appear difficult to explain. However, its unique characteristics continue to make it attractive during periods of economic uncertainty, monetary instability, and low real interest rates.

While gold should not be viewed as a replacement for productive investments, it can serve as an important diversifier within a broader portfolio strategy.

And we'll leave you with one final thought:

If investors weren't concerned about the long-term value of traditional currencies, why was Bitcoin invented?