Gold: safe-haven role firmly established

Key takeaways

• Historically, government bonds have been the safe-haven or risk-free asset of choice to diversify the risk in a portfolio.
• However, negative government bond yields in Europe and Japan have fundamentally changed the relative merit of government bonds versus gold as safe havens, for two reasons: 1/ in these economies, government bonds no longer have an income advantage over gold; 2/ there is a limit to how low negative bond yields can go and still attract investors.
• We believe the negative yield environment will remain in place for euro and Swiss franc government bonds for the near future. This has profound implications for long-term portfolio construction: the expected returns of government bonds in case of a stress scenario are capped and gold becomes a necessity rather than an optional allocation.

Gold has traditionally been considered as a safe-haven asset, together with government bonds, in an investment portfolio. In other words, when financial markets experience stress or investors become more cautious, both the gold price and government bonds have tended to appreciate. However, the safe-haven or risk-free asset of choice to diversify the risk in a portfolio has always been government bonds. Why?

The answer is that government bonds have three attractive characteristics. First, they exhibit a persistently negative correlation with equities, i.e. government bonds appreciate when equities depreciate. Second, government bonds present lower risk metrics than equities, which means replacing equities with government bonds will systematically reduce portfolio risk. Finally, government bonds offer a recurring income component in the form of bond coupons.

Gold, on the other hand, has:

1. an unstable correlation with equities – although it tends to be negative in severe periods of stress (chart 1)
2. comparable volatility to equities, which means replacing equities with gold does not automatically reduce portfolio risk (chart 2)
3. no cash flow generation – and even instead a cost when it comes to physically holding gold, which requires storage in a safe.

In addition, there have been striking moments where gold did not protect portfolios against equity drawdowns, notably in the financial crisis of October 2008 where both gold and US equities dropped by around 20% due to global portfolio de-risking and forced sales by funds stuck with their illiquid credit positions. Nevertheless, gold quickly attracted flows again shortly afterwards, recovering its losses and gaining almost 35% when equity markets fell another 30% in Q1 2009.

The comparison illustrates why we have been reluctant for some time to consider gold as a strategic safe-haven asset, preferring instead to use government bonds or the Japanese yen as hedges to dampen losses during volatility episodes.

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