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Investment Strategy

Is it a golden era for gold?

Mar 13, 2024

  • The price of gold is often driven by a complex interplay of factors, including the U.S. dollar exchange rate, real yields, supply/demand dynamics and sentiment. In recent years gold has exhibited a tendency to react to real yields in an asymmetric manner, supported by strong central bank purchases.
  • We are constructive on gold given peaking real yields, elevated geopolitical uncertainties, robust central bank demand, and strong retail jewelry demand.
  • For long term investors, gold merits a position in a diversified portfolio, potentially serving as short-term protection against risk events, a reliable longer-term store of value, and most importantly as a portfolio risk diversifier.

Gold has been a sought-after commodity for centuries, and a popular component in investment portfolios in modern times. The metal has historically delivered attractive long-term returns, appreciating ~8% on an annual basis over the past 20 years. That said, its price has exhibited significant volatility – with prices tumbling around 40% from 2011 to 2015, before it fully recovered in 2020. At the time of writing, the metal is making new all-time highs, breaking $2,180/oz on Mar 11, 2024.

The price of gold is influenced by a complex interplay of macro factors as well as supply/demand dynamics. Understanding its unique characteristics and benefits is crucial for investors who look to establish portfolios that endure through cycles. This article aims to identify and analyze the key drivers of gold prices, how they evolved in recent years, and how an appropriately sized gold investment can add value to a portfolio from an asset allocation perspective.
 

1. The level of the U.S. dollar

Historically, it would be fair to say that the value of the U.S. dollar is often negatively correlated with gold prices, as the metal is priced in dollars. When the USD weakens, gold becomes relatively cheaper for holders of other currencies, leading to increased demand. And the opposite is often true, with gold weakening as the dollar strengthens. However, there can be extended periods when this relationship breaks down. In 2012-13, for example, gold lost -18% of its value when the USD was fairly stable – rising less than 1%.

Looking ahead, we think the dollar environment should be relatively supportive for gold prices. After a significant rally in 2022 and a flattish 2023, the dollar is currently trading 10-15% higher than its fair value, implied by interest rate differentials and its own long-term average. Over the medium term, we think the dollar will likely revert to mean, and its overvaluation should be ultimately unwound. This process could take some time, as the dollar could be supported over the near term by cyclical growth outperformance in the U.S. relative to other major economies. That said, further strength from current levels should be limited. We expect U.S. economic growth and interest rates to gradually “catch down” to the rest of the world as the labor market wage increases cool down and the Federal reserve begins cutting rates, likely starting in the 2H.

U.S. DOLLAR STILL SCREENS ~10% OVERVALUED AGAINST INTEREST RATE DIFFERENTIALS

DXY model based on 5-Y swap rate differentials

Source: J.P. Morgan Private Bank, Bloomberg Financial L.P., data as of February 23, 2024.
This line chart shows the DXY Index along with the 5-year swap rate differentials model from 2010 to 2024. The DXY (U.S. Dollar Index) is a measure of value of the U.S. dollar relative to a basket of foreign currencies. The 5-year swap rate is a rate paid by fixed-rate payer on an interest rate with maturity of five years. The aqua line shows the current dollar index relative to the dark blue line, which shows the dollar index model based on 5-year swap rate differentials. Comparing the two on the same chart, it shows that the DXY index is currently at around 105 while the model is around 95. This shows that the DXY index is currently 10% overvalued against interest rate differentials.

2. Change in real yields

Historically, gold prices have demonstrated periods of an inverse relationship with real yields (i.e. inflation adjusted interest rates). As gold itself does not generate interest income, real yields can be seen as the opportunity cost of holding it. When real yields go down, gold becomes more attractive relative to interest bearing assets such as cash and fixed income securities. This inverse relationship explains a large part of the price increase in gold since the 1990s, as real yields progressed lower, down a path of structural decline. Large gold rallies such as those from 2008-2012 and 2019-2021 can also be attributed to real yields falling into negative territory, as global quantitative easing and Zero interest rate policies severely depressed yields.

TRADITIONAL INVERSE CORRELATION BEFORE 2022

Gold prices vs 10-year U.S. real yields 1997-2022

Sources: Bloomberg Finance L.P.. Data as of December 31, 2022.
This line chart shows the historical correlation between gold price and 10-year real treasury yields from 1997 to 2022. The 10-year real rate is shown inversely on the right axis. From 1997 to 2022, the chart shows that there was an inverse correlation. As such, when gold price increased, real rate would fall. 2022 saw a break from that trend. During the year, when real rate increased, so did gold prices.

However, over the past two years there has been a notable divergence between movements of gold prices and real interest rates. In early 2022 the Federal Reserve embarked on an aggressive tightening cycle at an unprecedented pace, under the backdrop of stubbornly elevated inflation and exacerbated global supply disruptions following the outbreak of the Russia-Ukraine war. Real yields rose aggressively from deeply negative territory to the highest levels seen since the Global Financial Crisis of 2008. 10-year U.S. real yields rose by a historic 250bps over the course of 2022, followed by another 20bps rise in 2023. In this environment gold prices remained very resilient. Prices were mostly unchanged in 2022, although with significant volatility, and in 2023 posted a +13% return, ending the year at a record high of $2,068/oz.

Has the correlation permanently broken? We believe it has temporarily shifted, and will likely reestablish itself at some point. We find that for now, gold still reacts to the movements in real yields, only in an asymmetric manner – it declines less when rates go up and rises more when rates move down. Why? The answer to that is largely related to a recent shift in supply and demand dynamics.

SINCE 2022, GOLD PRICES STAYED INCREDIBLY RESILIENT DESPITE MUCH HIGHER REAL YIELDS

Gold prices vs. 10-year U.S. real rate

Sources: Bloomberg Finance L.P.. Data as of February 28, 2024.
This line chart shows the correlation between gold prices and 10-year U.S. real rates from 2018 to 2024. The dark blue line represents gold prices, and the aqua line shows real rates. From 2018 to 2021, correlation between gold prices and real rates adhered to their traditional inverse relationship. After the onset of COVID in 2020, real rates remained at ultra-easy levels while gold prices also sustained high levels due to uncertainties in the market. After the Fed started to increase real rates in 2022, real rates skyrocketed to historical high levels. However, gold prices stayed relevantly resilient and maintained prices.

3. Supply and demand dynamics

All commodities, at their core, are driven by supply and demand. The price of gold is affected by other drivers, as discussed above, but supply and demand is a key factor. Global mining of gold has been fairly stable for many years, and so the demand profile is particularly important and unique. This sets it apart from other commodities. There are several key sources of demand for gold, which can be categorized into three groups: industrial, investment and reserve management.
 

  • Jewelry fabrication. Jewelry demand accounts for around 50% of total annual gold consumption. As a beauty, permanence and status symbol, gold is highly coveted with demand particularly strong in Asia, especially from India and China.
  • Technology. Around 10% of gold demand comes from industrial and technology uses, in industries including electronics, dentistry, aerospace and others.
     

While investment and reserve management demand accounts for a smaller portion of total gold consumption, they can periodically be a more significant driver of gold prices. The impact of reserve managers or Central Banks has been more evident in recent years.

• Central banks

Central banks have been significant buyers of gold for decades. In the 19th Century most countries fixed the value of their currencies to gold, and this became known as the Gold Standard. Central banks were required to hold sufficient gold reserves to back their currencies and allow convertibility of currency into gold. This system was highly disciplined, but proved to be unworkable during times of crisis. Eventually governments found the need to expand monetary supply beyond the restrictions of the gold standard, and the system was abandoned after the Second World War to be replaced with the Bretton Woods System. This system fixed the dollar to gold at a set price and fixed international currencies to the dollar. Unsurprisingly this too proved to be unworkable, and as the United States began to run large deficits, strains began to emerge. Eventually the U.S. fully abandoned the link to gold in 1971, leading to the collapse of Bretton Woods. This allowed the price of gold to float freely on international markets. Although the need to hold gold as a reserve asset was now removed, the scarcity of gold inherently made it appealing to Central Banks as a store of value. This role has waxed and waned over the years, but as can be seen in the chart below – over the past 20 years, central banks worldwide now keep around 20% of their Foreign Exchange reserves in gold.

CENTRAL BANKS HOLD ~20% OF FX RESERVES IN GOLD

Composition of total central bank foreign exchange reserves, %

Sources: IMF, World Gold Council, J.P. Morgan Private Bank. Data as of December 31, 2022.
This chart shows the composition of central bank foreign exchange reserves in percentages from 2010 to 2022. Unsurprisingly, the chart shows that on average more than 50% of the world’s central bank’s foreign reserves are in US Dollars. Euro makes up the second largest currency reserve composition at 20%. Gold is the third largest holding on average, totaling around 20%.

After a long hiatus, central bank purchases have risen notably in recent years. According to statistics compiled by the World Gold Council, net purchases by central banks around the world reached a record 1,082 tonnes in 2022, more than doubling the average annual purchase over the previous 10 years. This strong purchase momentum continued in 2023, maintaining a breakneck pace of 1,037 tonnes. This is now acknowledged to be a main driver of gold price resilience during the recent rise in real yields.

There are various reasons for Central Bank increases in the accumulation of gold. However, it has become apparent that in some cases, nations that are not allied with the United States have begun to look to reduce their reserve mix away from dollars, as they perceive the risks of keeping these reserves vulnerable to sanctions. Other governments aim to add some protection against higher and more volatile inflation worldwide, as the developed world exits the era of ultra-low inflation post-GFC. The scarcity of gold sometimes allows it to play a role as an inflation hedge, although this is often transitory.

STRONG GOLD DEMAND FROM GLOBAL CENTRAL BANKS

Central bank gold reserve, million troy ounce

Source: Haver Analytics, Bloomberg Finance L.P. Data as of December 2023.
This graph shows the central bank gold reserve levels from 2016 to 2023 in million troy ounce The bar graph shows the breakdown of gold reserve from emerging market central banks while the line shows world central bank gold reserve holdings. Both EM markets and global markets trends show pick-ups in central bank gold reserve holdings since 2016. Within EM markets, China and Russia make up the largest holders of gold in their central bank reserves. Global gold holdings in central banks have increased from 970 million troy ounces in 2016 to 1,057 troy ounces in 2023.

• Retail and institutional investors

Many investors hold positions in gold as part of an investment portfolio. These investments can be made via exchange-traded funds (ETFs), futures markets, options or structured notes. Many investors prefer to hold the physical metal – and invest in bars, coins and claims linked to individually-numbered bars.

Holdings of gold ETFs have become more popular with retail investors since their inception in 2004 and hit a record in 2020 when the Covid pandemic caused worldwide lockdowns. Since then, holdings have been on a gradual decline, and now are back to pre-pandemic levels. Retail ETF flows in gold are often seen to be driven by fears of inflation, conflict or crisis, and the relative level of interest rates. These investors tend to be short term, but can be effective drivers of price.

Institutional investors are more long term and often hold the metal physically. Pension funds and Foundations, in particular, tend to hold the metal for decades.

Hedge Funds and Commodity Trading Advisers are more speculative in their approach, but can have prolonged impacts to price movements.

GOLD ETFS HAVE BECOME POPULAR AMONG RETAIL INVESTORS

Total known Gold ETF Holdings, million of troy ounces

Sources: Bloomberg Finance L.P.. Data as of February 28, 2024.
This line chart shows total known gold ETF holdings from 2003 to early 2024 in million of troy ounces (oz t). As a whole, this graph shows that gold ETFs have exploded in popularity since the early 2000s – growing from under 1 million oz t in 2003 to more than 82 million oz t just 20 years later. Within this time frame, 2003 to 2012 marked a rapid expansionary period. Holdings in gold ETFs declined from around 82 million oz t in 2012 to 45 million oz t in 2015. Gold ETFs popularity grew again in the second half of the 2010s and reached peak popularity at 110 million oz t in 2020. Since 2020, holdings in ETFs have been slowly declining.

We have a constructive outlook on gold over the next 12 months. We currently expect that the Federal Reserve will begin to cut interest rates in the United States – likely beginning in June, subject to revision. In our opinion this should set the stage for gold appreciation. A persistent theme of geopolitical tension should continue to drive Central Bank reserve diversification. In addition, 2024 will see over 60 countries – representing around half of the world’s population – heading to the polls for national elections. Tragically, two regional conflicts are still ongoing, and these may have an impact on global supply chains.

We look for more Central Banks to add to their buying momentum this year and assume these buyers may be less sensitive to prices. We look for retail ETF investors to come back to the market and begin accumulating gold once again as yields fall. Gold investment is not currently a crowded position. Investors have been lured by high cash interest rates – and we are particularly interested in this development. Under-owned and under-appreciated investments are often ripe for appreciation. Our current outlook for year-end 2024 is $2,250-2,350.
 

The best possible reason to own gold in our view is as a diversifier in a portfolio. This was perfectly illustrated in 2022 as global equity markets lost -19.46%, global bonds lost -16% and Gold rose 3%.  The diversification benefits are amplified when viewed through the lens of modern portfolio theory, which holds that diversifying across lowly-correlated assets can improve overall risk-adjusted returns. Historically, gold has exhibited a low, or sometimes negative correlation to traditional asset classes, such as equities and bonds. In our view, having gold as a part of your asset allocation makes sense as a portfolio ballast that helps to enhance the risk-return profile.

All market and economic data as of March 13, 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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With respect to countries in Latin America, the distribution of this material may be restricted in certain jurisdictions. We may offer and/or sell to you securities or other financial instruments which may not be registered under, and are not the subject of a public offering under, the securities or other financial regulatory laws of your home country. Such securities or instruments are offered and/or sold to you on a private basis only. Any communication by us to you regarding such securities or instruments, including without limitation the delivery of a prospectus, term sheet or other offering document, is not intended by us as an offer to sell or a solicitation of an offer to buy any securities or instruments in any jurisdiction in which such an offer or a solicitation is unlawful. Furthermore, such securities or instruments may be subject to certain regulatory and/or contractual restrictions on subsequent transfer by you, and you are solely responsible for ascertaining and complying with such restrictions. To the extent this content makes reference to a fund, the Fund may not be publicly offered in any Latin American country, without previous registration of such fund´s securities in compliance with the laws of the corresponding jurisdiction. 

References to “J.P. Morgan” are to JPM, its subsidiaries and affiliates worldwide. “J.P. Morgan Private Bank” is the brand name for the private banking business conducted by JPM. This material is intended for your personal use and should not be circulated to or used by any other person, or duplicated for non-personal use, without our permission. If you have any questions or no longer wish to receive these communications, please contact your J.P. Morgan team.

JPMorgan Chase Bank, N.A. (JPMCBNA) (ABN 43 074 112 011/AFS Licence No: 238367) is regulated by the Australian Securities and Investment Commission and the Australian Prudential Regulation Authority. Material provided by JPMCBNA in Australia is to “wholesale clients” only. For the purposes of this paragraph the term “wholesale client” has the meaning given in section 761G of the Corporations Act 2001 (Cth). Please inform us if you are not a Wholesale Client now or if you cease to be a Wholesale Client at any time in the future.

JPMS is a registered foreign company (overseas) (ARBN 109293610) incorporated in Delaware, U.S.A. Under Australian financial services licensing requirements, carrying on a financial services business in Australia requires a financial service provider, such as J.P. Morgan Securities LLC (JPMS), to hold an Australian Financial Services Licence (AFSL), unless an exemption applies. JPMS is exempt from the requirement to hold an AFSL under the Corporations Act 2001 (Cth) (Act) in respect of financial services it provides to you, and is regulated by the SEC, FINRA and CFTC under US laws, which differ from Australian laws. Material provided by JPMS in Australia is to “wholesale clients” only. The information provided in this material is not intended to be, and must not be, distributed or passed on, directly or indirectly, to any other class of persons in Australia. For the purposes of this paragraph the term “wholesale client” has the meaning given in section 761G of the Act. Please inform us immediately if you are not a Wholesale Client now or if you cease to be a Wholesale Client at any time in the future.

This material has not been prepared specifically for Australian investors. It:

  • may contain references to dollar amounts which are not Australian dollars;
  • may contain financial information which is not prepared in accordance with Australian law or practices;
  • may not address risks associated with investment in foreign currency denominated investments; and
  • does not address Australian tax issues.

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JPMorgan Chase Bank, N.A. and its affiliates (collectively "JPMCB") offer investment products, which may include bank-managed accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC ("JPMS"), a member of FINRA and SIPC. Insurance products are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. JPMCB, JPMS and CIA are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states. Please read the Legal Disclaimer in conjunction with these pages.

INVESTMENT AND INSURANCE PRODUCTS ARE: • NOT FDIC INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED

Bank deposit products, such as checking, savings and bank lending and related services are offered by JPMorgan Chase Bank, N.A. Member FDIC. Not a commitment to lend. All extensions of credit are subject to credit approval.