Gold - Fundamental Drivers and Asset Allocation

50 Pages·2013·1.18 MB·English

Gold - Fundamental Drivers and Asset Allocation
Dirk G. Baur∗
Business School - Finance
University of Technology, Sydney
First draft: February 28, 2013
Abstract
In this paper we perform a theoretical and econometric analysis of the fundamen-
tal drivers of gold. We demonstrate that gold is significantly influenced by inflation
changes, interest rates, currency changes and central bank reserve policies. A key
findingisthattheinfluenceofthedriversvariesthroughtime,e.g. inflationisamajor
driver in the 1970s and in the late 2000s but not in the 1980s and 1990s. We also
examine the role of gold in asset allocation and show that gold can significantly en-
hance the risk-reward ratio in a portfolio comprised of stocks, bonds and cash. We
argue that there are several factors that have the potential to support a historically
high price of gold.
Keywords: gold; fundamental drivers; risk factors; gold in asset allocation; gold
standard
∗
address: PO Box 123, Broadway, Sydney, NSW 2007, Australia. Email: [email protected]. Re-
search support from Melbourne Mint Australia is gratefully acknowledged. I also want to thank Isaac
Miyakawa for excellent research assistance.
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Electronic copy available at: http://ssrn.com/abstract=2240831
Introduction
The repercussions of the subprime crisis in 2007 and the sovereign debt crisis which
followed have increased the role of the government, fiscal and monetary policy. Gold
may play a key part in this new environment because it is not dependent on any single
government and does not require a credit rating. The sovereign debt crisis and Eurozone
crisisin particularhashighlightedtheroleof“safeassets”(e.g. seeGortonetal., 2012and
IMF, 2012). Gold is an almost natural candidate of a“safe asset”due to its store of value
and safe haven properties. It may function as an anchor of stability for central banks,
governments and individual investors. Despite its potentially stabilizing role, the price of
goldis volatileandinfluencedbymany“riskfactors”. Onequestionthatweaddressinthis
study is whether all these factors are indeed fundamentaldrivers or whether some drivers
are, in fact, only coincidentally related to gold and the true driver is highly correlated
with this variable.
We analyze these factors both theoreticallyand econometricallyand show that gold is
onlyinfluencedbysomefactorsbutnotall. Somefactorshaveanunconditionalcorrelation
with gold but this correlationis spurious in the sense that it disappears if the true drivers
are included in the analysis. For example, inflation rates and interest rates are generally
associated with changes in the price of gold. Since both inflation rates and interest rates
are highly correlated it is not clear which of the two variables is more important and
actually influences the price of gold. Furthermore, we distinguish between traditional
drivers and new drivers which have only emerged recently.
There is a large and diverse literature on gold. The role of gold during the Gold
Standard has been studied by Barsky and Summers (1988) and Bordo (1981) among
others, the literature has analyzed gold as an investment asset (Conover et al., 2006,
Jaffe, 1989 and Riley, 2010) , a portfolio diversifier (Davidson, Faff and Hillier, 2003 and
Sherman, 1982), an inflation hedge (e.g. Beckmann and Czudai, 2013, Blose, 2010 and
Ghoshetal., 2002),acurrencyhedge(e.g. Capie,Mills andWood, 2005)andasafehaven
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Electronic copy available at: http://ssrn.com/abstract=2240831
(e.g. Baur and Lucey, 2010 and Baur and McDermott, 2010). Psychological factors have
been analyzed (e.g. Aggarwal and Lucey, 2007), the efficiency of the gold market (e.g.
Aggarwal and Soenen, 1988), anomalies and seasonality of gold (e.g. Ball, Torous and
Tschoegl, 1982 and Lucey and Tully, 2006), the volatility of gold (e.g. Batten, Ciner and
Lucey, 2010 and Baur, 2012) and the co-movement of gold with other assets (e.g. Baffes,
2007 andEscribanoand Granger,1998). The role of centralbanks andgold is analyzedin
AizenmanandInoue,2012)andgoldandminingin BrennanandSchwartz(1985),Tufano
(1996), Tufano (1998) and Twite (2002) among others.
We contributetotheliteraturewithabroaderanalysis. Insteadof focussingonmerely
one property of gold we analyze all (common) properties and the key drivers. We can
thus identify differences among the drivers and assess their relative importance. We also
examine the possibility that gold constitutes a single asset class and study the effects of
an inclusion of gold on the efficiency of differently weighted equity-bond-cash portfolios.
Weidentifysevenmajordriversofgold: (i)inflation,(ii)currencychanges,(iii)interest
rates, (iv) commodity prices, (v) stock prices, (vi) safe haven demand (uncertainty) and
(vii) central bank demand.
One important part of this study is the theoretical description and discussion of the
drivers and their interactionswith each other. For example, we demonstratetheoretically
that inflation and currency changes have the same impact on the price of gold. Another
exampleisthelinkofnominalandrealinterestrateswithothervariables. Nominalinterest
rates are strongly related to inflation rates, currency values and stock returns and it is
not clear which economic variable is more important for the price of gold. Thus, a single
variable focus, i.e. a univariate analysis, is neglecting all other factors and abstracting
from their existence. We show that the isolated estimation leads to different estimates
than a multivariate analysis which integratesall variables in one model and thus does not
neglect the interaction of the drivers.
Our main findings can be summarized as follows: Gold is mainly influenced by“tra-
ditional”drivers like inflation, currency changes and interest rates and“new”drivers like
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centralbankgold demand. Anotherkeyfinding is thatthe strengthof thedriverschanges
significantlythrough time. For example, inflation has been an“active”driver in the 1970s
and in the aftermathof the subprime crisis in 2007 but not during the“greatmoderation”
in the 1980s and 1990s.
The remainder of this study is structured as follows. In the first section we analyze
the drivers of gold. The analysis includes a thorough theoretical discussion of the drivers
and their origin. The empirical part studies each driver separatelyand conditionalon the
otherdrivers. The time-varying importanceof the driversis also estimated. In thesecond
section, we examine whether the characteristics of gold can be clearly distinguished from
other commodities and whether gold constitutes a separate asset class. The third section
evaluatestheroleofgoldinassetallocation. WhatweightisadequateinaMarkowitz-type
mean-variance optimization framework? The role of gold is also assessed with alterna-
tive assumptions regarding expected returns, standard deviations (risk) and correlations
of stocks, bonds, cash and gold. Finally, section IV summarizes the results and draws
conclusions.
I Drivers of Gold
Gold is associated with many properties and drivers that potentially influence its value.
This section first analyzes the key drivers theoretically, presents and discusses the evolu-
tion of the drivers graphically and then estimates the exposure of gold to these drivers
econometrically.
A Theoretical Analysis
One important part of this section is the focus on the interaction among the drivers. We
illustrate that several of the major drivers are related to each other and may compensate
each other. Since the importance of the drivers may change through time it is crucial to
complement an empirical analysis with a theoretical analysis to have intellectual tools to
predict future changes of the price of gold.
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There are “traditional”drivers related to the store of value and currency properties
including (i) (consumerprice) inflationrates, (ii) currencychanges,(iii) interestratesand
(iv) mining supplyfactorsrelatedto the priceregime of gold. Other drivershave emerged
only recently and can thus be labeled “new”drivers. These include (i) commodity and
stock prices1 related to investment diversification and portfolio protection demand, (ii)
safe haven demand2, (iii) emerging market central bank demand and (iv) momentum or
speculative demand. We first discuss the traditional drivers followed by a discussion of
the new drivers.
Gold has been used as a store of value and a means of exchange for centuries (see Jas-
tram, 2009). In the more recent past, i.e. during the Gold Standard, gold was explicitly
and directly linked to currencies and thus money. In fact, gold has desirable properties
of money. It is durable, easily recognizable, storable, portable, divisible and easily stan-
dardized. Furthermore, changes in its stock are limited, at least in the short run, due
to high costs of production. Because of these physical attributes it has emerged as one
of the earliest forms of money (see Bordo, 1981). The store of value property is directly
linked to two key drivers of gold, i.e. inflation and currencychanges.3 If gold is positively
influenced by inflation and thus an inflation hedge (in the sense that it fully compensates
investors for higher inflation), the price of gold co-moves with the rate of inflation. In
other words, a 2% inflation rate leads to a 2% increase of the value of gold. The under-
lying economic mechanism can be easily explained with an example. If the price index
consisting of goods and services increases by, say 2% per year, gold becomes relatively
cheap compared to this index. As a consequence, the demand for gold will increase until
the change of the price of gold equals the change in the price index.
This example can also be used to explain that gold is influenced by currency changes.
1Commodity and stock prices are also used as a proxyfor economic growth and thebusinesscycle.
2Thetimingofthesafehavendemandcanbeclearlydistinguishedfromthe“investmentdiversification”
or“portfolio protection”. Thesafe havendemand occursduringorshortly after a crisis or crash while the
other two demandtypesoccur before theoccurrence of a crisis or crash.
3Note that the store of value characteristic of gold holds in a Gold Standard system in which gold is
directlylinkedtoacertainamountofcurrencyunitsundercertainconditions. Ifthereisnoinflation,gold
acts as a store of valuein such a system. In a fiat money system gold is a store of value if its price in the
fiat currency increases with thegeneral price levelor theitems it is considered to bea store of valuefor.
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If the value of gold in country A increased by 2%, gold has become more expensive in
countryAthanincountryBundertheassumptionthattheexchangeratehasnotchanged.
Arbitrageurs will buy gold in country B and sell in country A changing the price of gold
in at least one of the countries. This process will stop once the price of gold in both
countriesdenominatedin a common currencyis equal. The price of gold can eitheradjust
in local currency or through changes in the relative values of the currencies represented
by changes in the exchange rate.4
Hence, the two properties of gold as an inflation hedge and a currency hedge are
fundamentally similar.5 The value of a currency either decreases through inflation or
through a depreciation. In gold price terms, both inflation and currency depreciation
increase the price of gold in local currency.6
The relationship between inflation and currency changes can also reveal two other
properties of gold. Gold is a homogeneous and a global asset. If two countries have a
fixed exchangerate, the prices can only adjust in local currency and not via the exchange
rate. Hence, if the inflation rates differ in the countries with a fixed exchange rate, gold
cannot be an effective (full) inflation hedge in both countries but only in one country.7
It is important to note that the inflation and currency relationship of gold is not
exclusive to the US dollar. An inverse relationship between the value of the US dollar
and the price of gold in US dollars does also exist for other currencies. For example,
a depreciation of the euro will tend to increase the price of gold in euro. Hence, the
4Assume that at t = 0: 1,000 USD = 1oz gold, 1 USD = 1 AUD and 1000 AUD = 1oz gold. If the
inflationrateintheUSis5%,thepriceofgoldinUSDrisesto1,050USDatt=1. Ataconstantexchange
rate,gold isnowmoreexpensiveinUSDthaninAUD.Hence,arbitrageurswillbuygold inAustraliaand
sellgoldintheUS.Ifthereisnoexchangeratechange,thistradewillstoponcethepriceofgoldinUSDis
equaltothepriceofgoldinAUD,i.e. 1,050AUD=1ozgold. Alternatively,thearbitrageopportunitywill
vanishiftheUSDdepreciates. ThishappensifUSDisexchangedforAUDtopurchasegoldinAustraliato
besoldintheUS.Moreformally,thepriceofgoldisequalinbothcountriesiftheexchangeratechangesto
1.05USD=1AUD.GoldinAustraliaisvaluedat1,000AUDwhichisequalto1,050USD.Thisexample
demonstrates that theproperties of gold as an inflation hedge and currencyhedge are linked.
5Interestingly, the literature has focused on these drivers separately but not analyzed these drivers
jointly. Forexample,theinflationhedgepropertyisanalyzedbyBlose(2010)andGhosh,Levin,MacMillan
and Wright (2002) and the currency hedge property is studied by Capie, Mills and Wood (2005) and
Sjaastad (2008).
6The“parity conditions”such as Purchasing Power Parity and the International Fisher Effect imply
that a currency with a higher inflation relative to anothercurrency will depreciate.
7Sinceinflationratesdiffered(andcontinuetodiffer)widelywithintheEurozoneinthepast,goldwas,
by definition,not an inflation hedgein all Eurozone memberstates at all times.
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main reason for this negative relationship is not that gold is priced in US dollars but that
arbitrage implies an equal price of gold across countries. Hence, if the euro depreciates
relative to the US dollar, gold becomes relatively cheap. Arbitrage will increase the price
of gold in euro to eliminate the price difference.
Interestratesdoalsopotentiallyinfluencethepriceofgold. Highinterestratesincrease
the opportunity cost of holding gold, also known as the“cost of carry”(e.g. Blose, 2010),
and will thereforetend to reduce the price of gold. However,since interestrates generally
co-move with inflation rates, high interest rates imply high inflation rates and the latter
tend to increase the price of gold. These two effects are combined in the real interest
rate, i.e. the difference between nominal interest rates and the inflation rate. The real
interest rate therefore represents the net effect of the two drivers. It is obvious that a
macroeconomic regime in which the nominal interest rate is below the inflation rate, i.e.
negative real interest rates, can be expected to exert a particularly strong influence on
the price of gold.
The drivers described and discussed above can be considered“traditional”drivers.
New drivers are mainly related to an increased role of gold in portfolio allocation
especially as a“diversifier”due to its low correlation. Gold has emerged as an asset used
for portfolio diversificationand portfolioprotectionin recentyearspossibly due to studies
thatemphasizedthesecharacteristicsforcommoditiesingeneral(e.g. seeErbandHarvey,
2005 and Gorton and Rouwenhorst, 2006) and for precious metals in particular (Hillier,
Draper and Faff, 2006). Gold has been a store of value and thus a safe haven for a long
time. However, more recently the safe haven property is defined in a narrower sense and
associatedwithadversefinancialmarketconditions(e.g. seeBaurandMcDermott,2010).
Emerging markets, in particularChina, haveaccumulatedlarge FX reserveswith very
low but increasing gold holdings relative to industrial countries like the US and major
European countries. Central bank diversification demand of these emerging markets may
have driven the price of gold in recent times.
Emerging market investment (or consumption) demand, especially in countries in
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which gold plays a large cultural role like in India, can also influence the price of gold.8
These new drivers, like the“traditional”drivers, are interconnectedwhich implies that
anisolatedanalysismaybemisleading. Forexample,if thesafehavendemandisanalyzed
from a US investor or US dollar perspective, the safe haven effect may be underestimated
in times in which both the US dollar and gold both act as safe haven assets. The US
dollar has been a safe haven asset in the past and also acted as such during the global
financial crisis (see Mundell, 1999 and Fratzscher, 2009). If both gold and the US dollar
increase in value, the price increase of gold in US dollar is partially compensated by the
appreciatingUS dollar. This effect is related to the inverse relationship between the price
of gold and the currency in which gold is denominated.
Large swings in the US dollar or exchange rate volatility may increase the desire of
emergingmarketcentralbankstodiversifytheirUSdollar reservestoreducetheexposure
to one currency. Hence, currency movements and central bank demand for gold may
be related. Again, focussing on only one component can lead to incorrect conclusions.
Feedback effects may also play an important role. There may be a significant feedback
effect from past price changes on the price of gold and changes in the correlation of
gold with equities. If, for example, the gold-equity correlation increases due to increased
investment demand for gold, the higher correlation diminishes the positive diversification
effect and may lead to lower future demand for gold as a diversifier. Similarly, if market
participantsusegoldasanindicatorofvolatilityanduncertainty,positivepricemovements
may be self-enforcing.9
8Consumptionorjewelerydemandisnotavailableonamonthlybasiswhichisusedbelow. Wethususe
emergingmarketstockindicesasaproxyfortheincreasingprosperityofaregionorcountryandassociated
demandforgold. TheWorldGoldCouncilprovidesdataongolddemandincludingjewelery. Specialdata
on Indiaand Chinaare includedin World Gold Council (2013) for example.
9Tkacz (2007) analyzes the role of gold as an indicator of inflation. Theories about the manipulation
of the gold price are related to a feedback effect and justified with the argument that central banks do
not havean interest in high gold prices since they may signal futureinflation or a decreasing valueof the
currency or money therebythreateningtherole of thecentral bankand the government.
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B Descriptive Analysis
This section analyzes the drivers empirically by describing their properties and their re-
lationship with gold through time. The data is mainly obtained from Thompson Reuters
Datastream and supplemented with data from the International Monetary Fund’s In-
ternational Financial Statistics and Bloomberg. We obtained more than 500 different
time-series that were considered as potential drivers. The sample period starts in 1968
and endsin January2013. Monthlydatawasused sincetime-seriesdataof a major driver
represented by consumer price indices is only available on a monthly basis. Since this
study is concerned with a long-term perspective of gold and its drivers, a monthly fre-
quencyappearsto be a perfectmix betweenannualor quarterlydata with lowervolatility
but a lower number of observations and a daily frequency with a relatively large number
of observations and increased statistical power but with a higher volatility.
Figure 1 presents the price of gold and the US consumer price index from 1968 to
2013. The graph shows thatthe price of gold increasedfrom a value around 40 US dollars
in 1968 to more than 1,800 US dollars in 2011 and was worth around 1,600 US dollar in
January 2013. The price of gold fluctuated significantly in this 40-year time period. It
reachedvalues around 700 US dollar in 1980 but fell significantlyafter that and remained
around 400 US dollars or below for the rest of the 1980s, in the 1990s and the beginning
of the 2000s. Gold started to increase significantly around 2004 from 400 US dollars to
more than 1,800 US dollars in 2011. Since the graphical presentation of the two time-
series, gold and the US consumer price index, exhibit similar relative values in 2013 but
a higher relative starting point of the US CPI, it can be derived that the price of gold
has increased by more than the US CPI. Hence, gold has acted as an inflation hedge for
this 40-year time-period.10 However, the fluctuations of the price of gold show that gold
has not been an inflation hedge at each point in time. Since gold did not yield positive
returnsin the1980sandthe1990sit did notfully compensatefor a constantlyrising price
level in this period. So where does the variation come fromor why is gold not an inflation
10Gold has also acted as a hedge for a muchlonger time period as shown in Jastram (2009).
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hedgeatalltimes? Oneexplanationisthatgoldreactsorperhapsoverreactstosignificant
changes in inflation and the risk of prolonged high inflation rates. Since the 1970s can
be characterized by such an inflation regime a higher price of gold is justified. The lower
value of gold in the 1980s and 1990s is consistent with this explanation since this period
is represented by relatively low inflation rates and the perception that inflation does not
poseaseriousrisktofinancialandeconomicstability. Theperiodisalsolabeledthe“great
moderation”andreflectsafundamentalchangeininflationexpectations. Figure2presents
thedynamicrelationshipofthepriceofgoldandaglobalconsumerpriceindex. Thegraph
shows that gold (denominated in US dollars) provided a lower level of protection against
global consumer price changes than against the US consumer price index.
*** Insert Figure 1 about here ***
*** Insert Figure 2 about here ***
Figure3presentstheratioofthepriceofgoldinUSdollarrelativetotheUS consumer
price index. This ratio analysis provides the real price of gold and shows that the real
pricereacheditshighestlevelintheyear1980andwasnothigherattheendofthesample
despitetheconsiderableprice increasebetween2004and 2013. Thetime-series plot of the
ratio also suggests that the real price of gold fluctuates around a constant.
*** Insert Figure 3 about here ***
Figure 4 presents the evolution of the price of gold and the trade-weighted value of
the US dollar through time and the dynamic relationship between the two series. The
time-series plot of the US dollar value shows a slightly decreasing value of the US dollar
over the sample period relative to an increasing price of gold over the same period. This
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