Gold reaches new high

In what has been an almost uninterrupted upward trend over the past year, gold has reached the price $2,700 dollar per ounce. It is up 31% since the beginning of the year and 37% since one year ago.

What is going on with gold?

Usually, gold price is inversely correlated with real interest rates (nominal interest rates – inflation).

Suppose that there is a decrease in real interest rates. This can be caused either by a reduction in nominal interest rates and/or by an increase in inflation.
Both cases are beneficial for gold. 

1. When interest rates are lower, the opportunity cost of owning gold decreases. The opportunity cost is the return that is forgone by holding gold, which notably does not pay interests or dividends, rather than an asset that provides a certain yield. Investors do not give up anything by holding gold when rates are near zero, while they forgo an increasing return when rates rise. Therefore, the lower the opportunity cost, the greater the demand for gold, and viceversa.
2. When inflation rises, the demand for gold as a store of value increases to safeguard the real value of capital, and viceversa.

Thus, both scenarios that lead to a reduction in real rates favor the demand for gold. The opposite occurs when real rates rise.

As you can see from the graph below, this negative correlation holds until 2022, then something happens and gold continues rising no matter what happens to real interest rates.

What happened after 2022?

There are two factors that contributed to drive gold prices upward. 

1. On one hand, the Russian invasion of Ukraine led to the freezing of the Russian central bank’s reserves by the United States and Europe. This had the effect of prompting all other countries not aligned with the West to decrease the percentage of reserves held in dollars and euros and to increase gold purchases. This resulted in unprecedented demand from central banks, which has steadily pushed gold prices higher.
2. On the other hand, the continuous increase in public deficits following the pandemic and the ongoing printing of money by central banks, have led to gold purchases as a defense against a potential loss of the real value of currencies, a phenomenon commonly referred to as debasement.

As far as this second aspect is concerned, gold has historical had a good success as a store of value. The reasons of his success over other commodities are: 

• Its scarcity, which does not mean a rarity that renders it unusable.
• Its high stock-to-flow ratio. This means that only a little percentage of the stock of gold in circulation (around 1.5%) can be mined each year. Despite technological advancements, it is therefore not possible to significantly increase the amount in circulation. You couldn’t consider a store of value a commodity of which you could mine, say 50% of the stock in circulation each year.
• Durability; does not deteriorate over time, and it serves well as a long-term store of value.

The function of gold within portfolios

Someone says that gold is not an investment, as it is not an activity that produces earnings or interests. The nature of the investment in gold can be debatable, but is anyway a fact that since when the price has been left free to float in the Seventies, gold has served well the function of diversificating portfolios, reducing volatility and drawdowns.

Gold, by nature, also provides a hedge against unexpected events of any kind, the so-called black swans. Given the rising geopolitical tensions and the great uncertainty surrounding the current social and economic outlook, the reasons to hold gold in a portfolio have increased.

As far as our portfolios are concerned, we allocate a percentage between 4 and 8% on our strategic and value ETF portfolios, and we believe this guarantees a good diversification strategy. As far as index funds are concerned, unfortunately there are at the moment no investing instruments in gold.