[LehmanBr]

Over the past year, interest in precious metals—and in particular in gold—has increased. The reasons are not surprising. In the tumult of the past twelve months gold has held its value better than many assets. Moreover, this decade gold has performed strongly. Finally, interest in gold has spawned the
development of exchange-traded gold funds and other vehicles that enable investors to gain exposure to gold at low cost, with improved liquidity, and without having to take physical delivery.

Research finds that over the period during which gold prices have freely fluctuated (i.e., since the early 1970s) gold has produced sub-par risk-adjusted returns. That is mainly due to its high volatility. However, gold’s ‘optimal’ weighting in multiasset portfolios varies considerably according to the ‘state’ of the world. Gold has done best when inflation, risk aversion and/or interest rates were high (and rising), or when the dollar was trending lower. Gold has underperformed when economic and financial conditions were broadly stable. The evidence offers support, therefore, for the notion that gold’s chief attribute may be to offer portfolio protection against ‘tail risk’.

A brief history
Gold prices have been trending upwards for most of the past ten years, rising from around $250 per ounce early this decade to a peak of just over $1000 this year. Over the past twelve months, gold prices have remained broadly stable against the backdrop of heightened market turbulence and subsequent recovery. In short, gold has maintained its value over the past year despite—or perhaps because of—the volatility of markets.

Gold’s up-trend since 1999, however, masks its lacklustre performance in the preceding two decades, when gold significantly underperformed other liquid assets and even cash. Moreover, although spot gold prices are near their highest levels since the abolishment of fixed gold prices in 1971, real (i.e., inflation adjusted) gold prices have yet to recoup their peak levels of early 1980s.

Gold has returned around 7% per year since the early 1970s, under-performing other liquid asset classes, and marginally above average cash returns. Moreover, lower returns have been accompanied by high volatility, producing a significantly lower Sharpe ratio (return/risk) for gold. On the other hand, negligible correlations to other assets make gold an attractive proposition, insofar as weak correlations are beneficial for portfolio diversification.

Gold’s performance during inflationary episodes has been strong, outweighing its high volatility. In disinflationary environments, however, gold underperformed significantly. Long-term disinflation brought about lower interest rates, supporting fixed income performance. Also, falling interest rates and risk premiums provided a boost for risk assets like equities and REITs.

Notably, the strong relationship between gold and inflation has broken down in recent years. This decade gold has marched toward record highs spot prices against a backdrop of subdued inflation. In the past two years, extraordinary fiscal and monetary stimuli have been cited as possible catalysts behind gold’s rally, prompted perhaps by concerns about higher inflation. However, inflation expectations have remained subdued, as evidenced by the inflation-linked bond market or surveys of inflation expectations. Although it may be possible that the variance of future inflation outcomes has increased and may be a factor behind rising gold prices, some suspect that gold’s traditional rationale as an inflation hedge has not been the main driving force of late. Rather, dollar trends appear to have been more prominent.

Over time, the US dollar has played a role in driving gold prices. Apart from the period of currency stability between the late-1980s and early-1990s, the dollar has experienced broad fluctuations since the early 1970s.

During weak dollar episodes, gold returns have tended to be far better than other assets, offsetting the precious metal’s high volatility. As a result, optimal portfolios during those periods would have tended to be heavily weighted towards gold.

Strong dollar regimes, on the other hand, have resulted in minimal gold holdings in optimal portfolios. Gold volatility remained high but, generally, gold prices fell when the dollar was weak. Instead, optimal portfolios favoured assets such as REITs and equities during dollar weakness, but the reasons are not likely related to causal. More likely, dollar weakness simply coincided with periods of strong equity and REIT market performances.

The strongest correlation between gold prices and the US dollar occurred when the US currency experienced distinct trends. Over the past decade, the correlation has been particularly strong as the dollar depreciated against a basket of major currencies. To be sure, other factors may have also played a role in gold’s strength throughout the past ten years (such as equity risk premiums). Nevertheless, a weak dollar/strong gold relationship has been consistent with patterns observed over since the 1970s.

Interest rates
Rising Fed funds rates have usually coincided with rising gold prices. Most likely, this was a result of interest rates being set in reference to inflation, and owes to gold’s high correlation with inflation.

Conversely, falling interest rates usually accompanied easing inflation and, therefore, falling gold prices. Optimal gold weights were low during periods of lower interest rates. Since government bond yields have a strong tendency to move alongside policy rates, their returns were high as inflation and short rates came down. As a result, bonds accounted for majority holdings in optimal portfolios during those periods.

As in the case of inflation, the relationship has broken down this decade. Near record gold prices have accompanied extraordinarily low interest rates, particularly over the past year.

Equity risk premium
Another and strong influence on gold prices has been investor risk aversion. During times of heightened risk aversion, gold has appealed to investors as an attractive safe-haven asset, despite its historically high volatility.

Conclusions
In sum, gold’s high volatility implies that it has been worthwhile to hold significant gold allocations only when returns are expected to be high or when the benefits of low correlation were most highly prized:

• Historically, long-term gold returns have been modest but volatility has been very high. Thus, gold has shown poor risk-adjusted returns over the period of freely fluctuating gold prices.

• Gold has performed best when inflation, risk aversion and interest rates were rising and when the dollar was depreciating in trend fashion.

• Gold returns were poor when economic and financial conditions were broadly stable.

• Overall, one of gold’s main attributes is that it held its value best during periods of macroeconomic and market extremes. Accordingly, gold has offered diversification benefits when they were most coveted.