US$ 2,000 Gold is Here! Does it Make Sense to Increase Your Allocation?

The Russia Ukraine war has infused panic and fear across financial markets around the world.

The sanctions imposed on Russia by the US and many other countries, Ukraine applying for membership to the EU the leadership on both sides displaying one-upmanship , and news anchors and social media influencers predicting doomsday (the possibility of a World War III), have made matters worse.

It appears the conflict won't die down anytime soon. On the contrary, it could well be a start of a new cold war.

But the effects of these geopolitical tensions are already reverberating across the globe. Equity markets worldwide have witnessed sharp selloffs. Economic uncertainty has gripped the world.

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But in these uncertain times, one asset class is displaying the trait of being a safe haven, a hedge, and store of value. That assert class is gold.

In dollar terms, gold is up nearly 13% on a year-to-date (YTD) basis. In February 2022 alone it's up 6%.

Graph 1: Gold Prices Inching up since Russia Invaded Ukraine

Along with looming geopolitical tensions, the following factors are working in favour of gold:

1) Spiralling Inflation - Inflation in the U.S. and many other countries, including India, is increasing. It's in fact, making record highs. A variety of factors, such as higher food prices, rising prices of crude oil, supply-chain disruptions, higher input cost, and higher indirect tax levied, among others are pushing inflation up.

And whenever inflation increases, the historical data shows that gold has performed well.

Graph 2: Performance of gold in periods of high inflation

(Source: www.gold.org)

As per the World Gold Council, in years when inflation was higher than 3%, the yellow metal has risen 14% on average. This is also a function of consumer demand for gold and the monetary policy stance adopted by major central banks. Accommodative monetary policy of central banks - Most central banks have kept their monetary policy stance accommodative to support their economies. The US Federal Reserve has, of course, tapered its bond-buying, and has said interest rates may be raised in March 2022.

However, it appears that given the economic uncertainty, the Federal Reserve may not increase rates disproportionately. A small 0.25% hike looks to be on the cards, which perhaps the market has already factored in.

So, to solve the dilemma of higher inflation and looming economic uncertainty, a cautious approach may be followed by major central banks. Not all would vote for aggressive rate hikes that could do more damage to the economy.

The Reserve Bank of India (RBI), has already indicated that it will support growth on a durable basis to mitigate the impact of the pandemic on the economy while ensuring that inflation remains within the target going forward.

While the increase in interest rates may seem to put brakes on gold, the weakening of fiat currencies due to the impact of geopolitical tensions is expected to bode well for gold. The price of gold has already crossed US$ 2,000/oz.

2) Increased Stock Market Volatility - Gold and equity markets, as you may know, usually share an inverse relationship. This is proving to be the case even now, as the equity markets have been very volatile.

Graph 3: Gold tends to perform well in periods of significant market pullbacks

(Source: www.gold.org)

Historical data as seen in the graph above sourced from the World Gold Council, also reveals that gold has done well when stock market volatility has intensified due to a variety of events.

Gold has often rallied in periods of high inflation and high-debt-to-GDP ratios around the world. This is because, unlike financial assets, gold is a real asset. It means, gold does not carry credit or counterparty risk and is usually supported by these factors.

Taking into consideration all these facts and factors, certain central banks aren't taking chances. They are buying gold. India, Russia, Ireland, Kazakhstan, Philippines, and many others buying gold. Others too are holding significant gold reserves.

In his video on gold, Vijay Bhambwani, the editor of Fast Profit Daily, says the US tops the list with 8,130 for tonnes of gold and that gold is basically 79% of its entire reserves.

The next spot goes to Germany, which is holding 3,359 metric tonnes of gold, which is 76% of its entire reserves. The third is Italy at 2,452 tonnes of gold, with that being 71% of its entire reserves, and number four is France with 2,436 metric tonnes, which comprises 66% of its total reserves.

Russia is at the fifth spot and holds about 2,299 metric tonnes of gold but that comprises only 21% of its reserves. Watch Vijay's video here to know his views on gold.

So, central banks surely recognise how important it is to buy and hold gold in such times. It is effectively a part of their reserve management strategy, where gold plays an important part.

Even if you, as a retail or a High Net-Worth Individual (HNI), are under-allocated to gold, maybe you should approach gold strategically now. Increase the allocation to around 5%-10% of your entire investment portfolio to gold. Hold it with a long-term investment horizon (over 5 years) and be ready to assume moderately high risk.

Holding gold strategically in your investment portfolio would serve as a hedge when other asset classes fail to post alluring returns.

Graph 4: Gold has proved to be an effective portfolio diversifier

Just as the way gold turned bold in 2019 and 2020, it may yield appealing returns and prove to be an effective portfolio diversifier in 2022 against the backdrop of escalating geopolitical tensions, and macro-economic uncertainty.

The smart way to allocate funds towards gold for investment is through gold Exchange Traded Funds (ETFs), gold savings funds, or Sovereign Gold Schemes.

Happy Investing!

Disclaimer: This article has been authored by PersonalFN exclusively for Equitymaster.com. PersonalFN is a Mumbai-based Financial Planning and Mutual Fund research firm known for offering unbiased and honest opinions on investing.