Gold ETFs Take A Bow

[This article appears in the June issue of ETF Report.]

When the stock market crashed in March, gold prices rallied, one of the few markets higher in the first quarter.

That’s exactly how a safe haven investment should act in times of turmoil. What makes this hunk of metal such a good hedge? Here are a few reasons: historical significance, no counterparty risk and a liquid market.

Sell-Off, Then A Bounce

Gold prices were on a slow and steady upward climb since late 2018. But the yellow metal’s surge began when global markets started to take the coronavirus threat much more seriously. Even though China locked down the city of Wuhan in late January, it wasn’t until late February when small towns in the northern Italian Lombardy region were quarantined with the virus that markets got an inkling of the disease’s economic toll.

The initial 2020 gold rush started in late February on pandemic fears as stocks and bond yields started to crack. When the Federal Reserve slashed rates in an emergency meeting on March 2 as debt markets froze and liquidity dried up, panic selling ensued, causing all assets—gold included—to fall as investors unwound positions and sought cash.

While the S&P 500’s fall into bear market territory was the fastest ever, gold’s drop was short-lived. It slid from a high of $1,707 an ounce on March 9 to a low of $1,453 on March 16. The yellow metal began its rebound March 24 and hasn’t looked back since, with prices around $1,725 at the end of April, a 7 ½-year high.

Source: Bloomberg, 12/31/2019-4/30/2020

Recovery For Gold

Gold is repeating its 2008 playbook, explains Will Rhind, CEO of GraniteShares and issuer of the $861 million GraniteShares Gold Trust (BAR).

“In that kind of environment, you're not looking to make money, per se; you're more interested in not losing money,” Rhind said.

Gold and gold stocks typically have a V-shaped recovery once the panic-selling is over, notes Joe Foster, portfolio manager and gold and precious metals strategist at VanEck. “That’s exactly what happened this time,” he noted.

VanEck issues the $13.6 billion VanEck Vectors Gold Miners ETF (GDX) and the $4.6 billion VanEck Vectors Junior Gold Miners ETF (GDXJ).

Investors Driven To Gold

Juan Carlos Artigas, head of research at the World Gold Council, a gold industry group and owner of the massive $57 billion SDPR Gold Trust (GLD), says that starting in late 2019, the WGC began to see greater interest in gold as a hedge.

2020 Physical Gold ETF Inflows

Source: FactSet

In its 2020 outlook published in January, the WGC cited financial and geopolitical uncertainty and low interest rates among reasons to own gold. Since gold pays no dividend, many investors shy away from using the metal when other safe havens like U.S. Treasuries offer a yield. But with low rates and the S&P 500 coming off a 20% return in 2019, gold looked attractive again as a hedge, according to conversations the WGC had among some investors, Artigas remarks.

“They wanted to make sure that they still got exposure to the very strong stock market at the time, but they were concerned about the situation [of a potential correction] and therefore they were adding hedges to their portfolio. One of those was gold,” he said.

During the first quarter, WGC said gold demand rose 1% year over year, fueled by safe haven demand. Inflows into global gold-backed ETFs rose more than 298 metric tons in the first quarter, pushing global gold ETF holdings to a record high of 3,185 tons, a sevenfold year-on-year increase.

History As A Hedge

Gold has a few factors in its favor when to comes to being an insurance policy. The first is centuries of use as a currency and a store of value. Rob Haworth, senior investment strategist at U.S. Bank Wealth Management, points out that, unlike other metals, gold’s primary uses are for jewelry or as an alternative currency. Global central banks hold gold as part of reserves. The U.S. has the world’s greatest gold reserves, which gives markets confidence in it as a secondary store of value or a currency, he explains.

Artigas comments that the gold market is also liquid enough to handle sizable orders. Last year, gold traded more than $145 billion daily, rivaling the liquidity seen in short-term U.S. Treasuries.

“That’s relevant because in a period where you have a lot of volatility and uncertainty, you want to be able to look for assets whose bid/ask spreads are not completely blowing up or are mispriced,” he added, noting that gold also has no counterparty risk.

As a hard asset, there’s a finite amount of gold, unlike with fiat currencies, Foster remarks. Supplies are limited to how much is above ground and how is mined annually, which usually adds only about 1% to the total supply, he notes.

Relationship To Interest Rates

Gold also correlates strongly to “real” interest rates, the sources all say. Real interest rates—also called inflation-adjusted rates—are calculated using the U.S. Treasury 10-year yield minus the consumer price index. Using this measure, “real” interest rates are negative, which makes gold more attractive as a store of value, despite paying no dividend.

Rhind says that during 2008, inflation-adjusted interest rates also turned negative, which helped gold rally from a low of around $680 in October 2008 to just over $1,900 by September 2011.

With the initial panic selling over, buyers likely own gold for its role as a potential inflation hedge, the sources say. The concern isn’t for near-term inflation; the current economic situation is deflationary despite the amount of liquidity the Fed and other central banks pumped into the markets in March.

“We’re not going to get inflation without restarting the economy or unless there’s demand growth,” Haworth said.

Inflation Concerns

The fear is what may happen with inflation in the future and the possibility the Fed won’t be able to control it. “The bull case certainly has to do with what many people are thinking will be a very large Federal Reserve balance sheet, a Fed that is buying assets prodigiously, so there is a fear for forward inflation,” Haworth explained.

And Rhind points out that while the economic damage from 2008 was limited to the financial sector, the current economic collapse touches many more sectors: “It’s a lot more widespread, and the amount of the monetary response or money printing is exponentially larger as well.”

This time around, not only is the economic impact more widespread, the Fed’s monetary stimulus is being met by congressional fiscal stimulus. “It’s not just money printing. The government is giving stimulus checks, paying individual citizens directly and injecting money into small businesses,” Rhind said.

Deflation Risk

While the Fed and other central banks have tried to increase inflation since the 2008 global financial crisis, it hasn’t shown up in traditional areas such as wages, which may have some investors thinking the long-term inflation outlook some gold bulls expect won’t materialize. Inflation hasn’t appeared in traditional areas, Foster admits, but he counters that the monetary stimulus led to asset price inflation of stocks, bonds, art and other investment vehicles.

He agrees that for the next few years, deflation is more of a risk than inflation, but “with all the liquidity that's being pumped into the financial system, both on the fiscal and on the monetary side, that could be set setting us up for some high levels of inflation.”