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Gold Could Be the Poster Child of the Reflation Trade

The world has entered a reflationary environment amid the improving economic conditions, which is usually good for commodities. In fact, reflation could be even better for gold, according to one recent study.

Closeup of a large gold nugget. stocks under $10

Source: Shutterstock

The World Gold Council (WGC) argues that the metal is the most effective commodity in a portfolio because it stands apart from all other commodities. According to the council, gold has offered superior returns on both an absolute and risk-adjusted basis compared to other commodities over multiple timeframes.

Further, the organization said the yellow metal is more effective at diversifying a portfolio than other commodities. The WGC also said the metal outperforms commodities when inflation is low and has less volatility. The metal is also a proven store of value and is extremely liquid.

The council noted that the commodity reflation trade is in full swing, which can negatively impact risk-on assets and push toward higher allocations for gold. Additionally, the weight of the metal in commodity indices is growing and should keep increasing. Gold has also been less volatile even though equities, bonds and alternative assets have been seeing volatility.

Performance During a Reflationary Period

The WGC studied the performance of various asset types during past reflationary periods, as measured by the Consumer Price Index from trough to peak. It found that assets like real estate investment trusts and Treasury Inflation-Protected Securities (TIPS) performed well during reflation, as did commodities and gold.

The council also confirmed that gold outperformed equities and bonds meaningfully during times of reflation.

However, its study also suggested that gold could offer upside compared to the broader commodities asset class. In the last two reflationary periods, gold outperformed a broader commodities strategy. However, this time around, gold is down 10%, while commodities are up significantly.

Gold started to lag other commodities in May 2020 and continued to do so through the first half of this year. The WGC said it’s not unusual for that to happen in commodity-led reflationary periods. In the past, gold has lagged other commodities initially, but it catches up to most major commodity groups by the second and third years of reflation.

Volatility

Volatility increased in commodities and other major assets last year on the back of uncertainty caused by Covid-19. However, volatility for gold increased less, making it a more stable asset than most others. The organization said the primary reason for the metal’s relative stability comes from its diversification role when markets are choppy. Other commodities and risk-on assets are also more correlated with the left tail than gold is.

In November, the WGC pointed out that major commodity indices would boost their weightings for gold for a second consecutive year. That suggested that index providers could be acknowledging increased importance for the metal within a portfolio and a broader commodity index.

In 2019, the council said it believed that gold was underrepresented in the broader commodity indices. Some reasons for its argument included the diversity of gold’s liquidity, a lack of understanding of gold trading volume, capped weights in certain sub-sectors, the economic significance of gold, the size of the market, and the diversification benefits of the yellow metal.

Gold Outperformed a Broader Commodity Portfolio

The WGC also looked at the precious metal and compared portfolios with allocations to it and those with allocations to a broader commodity portfolio. It said allocating 2% to 10% of an institutional portfolio to gold offered better risk-adjusted returns than allocating to a broader range of commodities.

The council explained that most investors invest in commodities via indices, which do include gold. However, the council believes the weighting of the metal within such indices undervalues its importance as a strategic part of the portfolio.

Gold is used for components of manufactured goods, just like other commodities, but it is much more than that. The yellow metal is both an investment and a consumer good, which makes it a “multi-faceted asset that enjoys diverse supply and demand dynamics that play an important role in gold’s performance,” the council explained.

Better Performance and Diversification

The council said the metal had performed roughly in line with the S&P 500 in the long term, with an average annual return of 10.8% since the gold standard was eliminated in 1971. The metal’s compound annual return stands at 7.9%.

Gold has outperformed not only a broad range of commodities but also most individual commodities. Almost all sub-indices are down over the last five years, but the metal is up. The yellow metal has outperformed major commodity sub-indices over the past 10 and 20 years as well and outperformed most individual commodities, many of which are in the red for the last one or two decades.

The World GC added that gold has little to no correlation with other assets during times of market stress, although it is positively correlated to stocks during times of economic growth.

What Does All This Mean Right Now?

There are two big questions right now. Investors are watching for the Federal Reserve to talk about tapering its asset-buying program and news about inflation. Underneath both of those umbrellas lies the regular releases of economic data like unemployment numbers and nonfarm payrolls.

Economic data provides clues about whether the Fed could start talking about tapering and how much inflation there will be. Gold has ticked higher over the last several weeks as investors digest the reports of an economic slowdown with higher inflation.

It’s no secret that inflation is usually good for the metal, as is a weakening economy. Gold stands at a crucial juncture right now with the potential to keep rising to $1,850 or to fall to $1,750. It looks like the yellow metal is moving along nicely for bulls, but that could change with any of the economic reports we have coming out soon.

It seems clear that we’re in a reflationary environment right now, so even if there is a blip in the near term, it could mean good things are on the horizon for the yellow metal.

On the date of publication, Michelle Jones did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Michelle Jones is editor-in-chief for ValueWalk.com and has been with the site since 2012. Previously, she was a television news producer for eight years. She produced the morning news programs for the NBC affiliates in Evansville, Indiana and Huntsville, Alabama and spent a short time at the CBS affiliate in Huntsville. She has experience as a writer and public relations expert for a wide variety of businesses. Email her at Mjones@valuewalk.com.


Article printed from InvestorPlace Media, https://investorplace.com/2021/09/gold-could-be-the-poster-child-of-the-reflation-trade/.

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