Is it wise to add #Gold to your investment portfolio?

Gold's recent rise has been astonishing, climbing from NPR 116,500 per tola (11.66 grams) in mid-February to NPR 1,39,000 on April 12th.

Domestic gold prices reflect international prices (denominated in the US dollar), which are on a tear.

A confluence of factors can explain this escalation in price. Prolonged instability in the Middle East and mounting geopolitical tensions among major global powers have contributed to rising demand for gold as a safe-haven asset.

A robust retail demand in emerging markets for the precious metal and rapid purchases by central banks in the wake of Western sanctions on Russia for invading sovereign Ukraine are helping propel gold prices to new highs.

Whereas central banks were net sellers of the yellow metal before the 2008 global financial crisis, they have since become net buyers, says the World Bank.

The share of US dollar reserves of global central banks declined from 71% in 2000 to 56% in 2022, reckons the IMF. Central banks doubled down on gold purchases between 2022 and 2023, buying 1,060 tonnes on average versus 509 tonnes bought between 2016 and 2019, according to Goldman Sachs.

China is the top-heavy buyer (followed by Turkey, Poland, and India) as it diversifies its reserves after America weaponized the dollar, which is the world's reserve currency, in its sanctions against Russia for invading Ukraine. Gold made up 4.31% of China's total reserves last year, up from 1.65% in 2015.

China is also motivated in part by concerns over possible US sanctions if it invades Taiwan, a self-ruled Island China claims as its own (President Xi Jinping has ordered the People’s Liberation Army to be ready for an invasion by 2027).

Countries like India, Turkey, Russia, and Poland have also been buying gold with a focus on reserve diversification.

Over the past year, gold has gained another tailwind from prodigious purchases by Chinese retailers hunting a safe haven to park their money after a crash in property prices and stock markets wiped out trillions of dollars of wealth. Last year gold was one of the best-performing assets in China, while other asset classes suffered badly.

The yellow metal has historically played a critical role in the international financial system. Its appeal is rooted in its time-tested properties as a hedge against inflation, high liquidity, and resilience during geopolitical havoc.

These traits make the investment side tempting, but the industrial and retail consumption side is immensely significant: around 60% of gold demand originates from jewelry and industrial applications, reckons the World Gold Council.

According to the IMF, the United States holds 23% of total official gold reserves, while members of the Euro Area collectively control over 50% of the total.

The dominance of the United States and the Euro Area in gold holdings ensures that US monetary policy remains a focal point for global participants, shaping expectations for future market conditions.

On the supply front, China and Russia are major gold producers, according to 2022 data from the World Gold Council. Both countries are viewed as prominent challengers to US financial hegemony, and are determined to reshape the global order.

Is it wise to add gold to an investment portfolio?

As the price of gold soars, every investor stands to reason whether to include gold in their portfolios. We don't endorse a universal approach to gold investments, and each investor should evaluate their objectives and risk tolerance to build an optimal investment portfolio.

From 2010 through Jan 2024, gold slightly outperformed NEPSE stocks. During this period, gold returns saw a compound annual growth rate (CAGR) of 10.09%, while the NEPSE index recorded a CAGR of 9.9%. This marginal edge highlights gold's potential to offer investors a steady return -- in addition to stocks.

On the flip side, gold's lack of cash flows differentiates it from other asset classes. As a result, its valuation is anchored to the US dollar and real yields on US treasury notes. In calmer market conditions, gold prices tend to show higher volatility compared with bonds and treasury securities.

In Nepal the absence of investment instruments such as gold ETFs leaves physical holding as the only avenue for gold investment. Hence, investors must factor in transaction costs, storage expenses, and bid-ask spreads in their returns assessments, which can chew away gains.

According to portfolio simulations conducted by the World Gold Council, small allocations of gold (less than 10%) in a portfolio can increase risk-adjusted returns over short-term investment horizons.

This conforms to Morningstar's recommendation of having gold exposure at or below 15% of total committed capital. In contrast, long-term investors exposed to fluctuations in long-term interest rates may benefit from larger gold positions, as the asset serves as a potent diversification tool.

Given these findings, investors should tailor their gold allocations to their investment horizon, risk tolerance, and long-term financial goals. By doing so, gold can be leveraged to provide stability and diversification in an overall portfolio.

The Markowitz optimization framework also provides a theoretical perspective on goal-based proportions of gold in a portfolio. For example, under certain assumptions such as allocating 5% of assets to cash, the framework suggests a 95% allocation to gold for maximizing the Sharpe ratio, 0% allocation to gold to minimize variance and conditional value-at-risk (CVaR), and a 12% allocation to gold to maximize diversification. However, these proportions should be interpreted as theoretical guidelines rather than practical recommendations.

While adding gold to a portfolio may boost returns in certain scenarios, investors must weigh this benefit against the asset's inherent volatility and risk. The balance between risk and return and the chances for negative returns must be considered in light of individual investment objectives and risk appetite.

Can't get enough of the rally

Multiple indicators suggest an optimistic outlook for gold in 2024. Current geopolitical tensions, such as the ongoing conflict between Hamas and Israel (and the possibility of spreading the war across the Middle East) and rising friction between China and the United States, create an environment conducive to gold as a safe-haven asset.

In addition, the US presidential election in November and concerns about its ramifications have increased uncertainty in the markets. Given the banking crisis in the US and Europe, gold's defensive characteristics may come to the fore, especially if the banking sector requires bailouts running into hundreds of billions of dollars from the Federal Reserve.

Meanwhile, the probability of a Federal Reserve rate cut in June appears to have reduced due to stubborn inflation and a strong labor market. Market analysts such as David Rosenberg project that gold prices could reach $3,000 per ounce if the Federal Reserve lowers interest rates.

However, in a less likely worst-case scenario where the Federal Reserve opts to raise interest rates further, the appeal of holding gold could diminish due to its non-yielding nature.

Source: Ansu Investment