Gold has been making the headlines recently as it reached all-time highs in both nominal and real terms. Besides the use for jewellery and industrial use, gold features prominently in many investors’ portfolios, and so we need to think about how to model its investment properties.
How should we think about gold as an investment?
Despite narratives and theoretical justifications (e.g. limited supply) for gold providing an inflation hedge, there is still a lack of consensus on the extent to which this is the case. This is understandable for two reasons. First, one needs accurate measurements of inflation expectations across horizons and at a high frequency. Second, changes in the price of gold are driven by factors that go beyond inflation. One obvious candidate driver is real interest rates. Gold does not produce any cash flows, and to the extent that gold competes with other asset classes that produce cash flows - “carry” - the attractiveness of gold moves inversely to the carry of these other assets. In a “high carry” environment, usually characterized by high interest rates, investors require higher expected return on gold.
While there are other drivers of returns on gold, macro forces such as changing inflation expectations and real rates are key drivers. When using carefully defined factors that capture real rates and inflation expectations, we can explain a significant amount of variation in gold returns, with relationships that align with the intuitions outlined above. It follows that these two macro drivers should therefore also be key determinants of expected returns on gold. Higher real rates push the expected return on gold upwards and higher inflation increases the attractiveness of gold, hence it pushes its expected return downwards.
The expected return on Gold
As part of our Capital Market Assumptions, we produce estimates of expected returns on gold that derive from transitory and persistent components of real interest rates (monetary policy and equilibrium real rates), and inflation expectations (business cycle and long-term trends). Both components of real rates and inflation expectations are estimated daily using our in-house term structure models.
The chart below shows the daily estimates of one-year and 30-year expected returns on gold over the last two decades. We estimate the expected return on gold across horizons, where at the short horizon both transitory and persistent components of inflation and real rates play a role. At the long horizon, in contrast, the equilibrium real rate and inflation trend play dominant roles. One benefit of estimating short-horizon expected returns is that we can evaluate predictive power of the estimates. Our one-year estimate robustly predicts the subsequently realised returns and outperforms other predictors such as short-term nominal interest rates.
The expected return on gold remains high even after the run up in the price over the recent past. A large increase occurred in 2022, driven by the large increase in real rates. Since then, the expected return has remained elevated, in line with real rates remaining high and inflation being volatile and above central bank targets. In these conditions, higher gold prices can co-exist with higher expected returns on gold, and this has remained the case during the further increases in gold prices over the last several months.
To further explore the recent gold price moves, we can complement the expected return picture with market-implied probabilities extracted from options on gold futures. The chart below shows snapshots of the option-implied distributions for gold futures at the one-year horizon, the night before the US presidential election, prior to ‘Liberation Day’, and at end-April. The distribution has been not only shifting to the right but also getting wider. An interesting aspect of the distribution, as of the 30 April, is that there remain significant probabilities assigned to further gold increases, consistent with the level of gold expected returns remaining elevated.
Gold in a multi-asset portfolio
Gold shares common drivers with nominal government bonds, but its exposures to real rates and inflation drivers are very different. An increase in real rates reduces the price of both gold and government bonds, and increases the expected return on these assets. An increase in inflation expectations, however, reduces the price of government bonds but it increases the price of gold and simultaneously reduces its expected return.
The inflation-hedging properties of gold, and its significant exposure to real rates, make gold more similar to real estate investments, with the key difference being the lack of carry. This has interesting implications for how to allocate to gold in a multi-asset portfolio. It implies that any asset allocation analysis needs to properly incorporate these common exposures. We have previously published research on the macro exposures of real estate investments and their role in the multi-asset portfolio in a dedicated article. To fully explore the role of gold in a multi-asset portfolio, we include gold in our simulation-based macro finance model and relate returns on gold to its underlying macro drivers. This allows for testing of alternative asset allocations, where the rewards and risks of different portfolios can be evaluated against investor objectives and constraints.
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