Why you need to add the yellow metal to your investment portfolio

Gold is a multi-faceted asset class with various price drivers. Many of these drivers are concurrently at play right now, highlighting the complexities of the current investment environment and the relevance of gold in investment portfolios.

The precious metal has been on the back foot since July amid a growing hawkish narrative by the US central bank to keep interest rates higher for longer with the backdrop of still above-target US inflation and a resilient US economy. US treasury yields have moved up to levels last seen in 2007 and the dollar too has been strengthening, increasing the opportunity cost of holding non-yielding gold and weighing on its prices.

But these dynamics have taken a back seat since the Israel-Hamas conflict broke out earlier this month driving up gold prices. Investors have rushed to the relative safety of gold, as they have time and again in the past, as uncertainty prevails on the geopolitical front and risk assets see drawdowns.

An uptick in crude prices to above $90 per barrel levels as a result of the situation in the Middle East too is supporting interest in gold as concerns about higher inflation come back.

Some more gains for gold in the short term will not be surprising if the Israel conflict escalates to include more countries. However, if the conflict stays contained and market sentiment improves, we can see gold lose some of the risk premium and move lower as fundamentals of higher US treasury yields and stronger dollar come to the front.

Investors can use any such pullbacks in prices to build their gold allocation as the medium-term prospects for gold have improved.

Barring one or two tactical rate hikes that may come this year, we are close to the end of the Federal Reserve’s monetary tightening, which has been pressuring gold prices over the last year or so. Also, a US economic slowdown is likely in the coming quarters as pandemic-era savings and loan moratoriums supporting the US economy are now no longer tailwinds and the lagged effect of the aggressive policy tightening are expected to show up as credit offtake slows and loans get repriced at higher interest rates.

A growth setback and resulting financial market volatility could trigger some policy easing by the Fed, as it has in the past. Though markets are currently expecting the first rate cut to come in mid-2024, the Fed’s hawkishness could get tested sooner. If the Fed is forced to cut rates while inflation remains above its target, which is likely given that the favourable base effects have moved out and energy markets are heating up again, that will be bullish for gold prices as interest rates and the US dollar retreat.

Gold is also finding support in sustained central bank gold buying as they diversify their reserves away from the dollar, and the concerns regarding ballooning US government debt levels which have crossed $33 trillion.

While the domestic economy continues to look well placed, it is vulnerable to external shocks. As such, gold can be a good portfolio diversifier and cushion investors from volatility in risk assets like it did in the equity market disruptions of 2008, 2011, 2016 or 2020. A steady depreciation of the Indian rupee vis-à-vis the dollar is another reason to hold gold. Studies suggest that a portfolio allocation of 10-15% to gold can play a risk-reducing role without compromising on returns potential.

While most investors understand the relevance of gold, they underestimate the importance of the instrument they choose to take that exposure. Physical gold, which is the preferred investment route, comes with concerns of purity. High retailer markups, making charges, storage costs as well as lower resale value eat into investor returns.

The growing digital economy and awareness about financial products is leading to increased interest in financial gold avenues like gold exchange traded funds (ETFs) and gold index funds. Gold ETF units which are backed by gold of the highest purity are traded on the exchange just like equities, offering investors the potential of gold investments without the hassles of holding bulky physical gold, and the flexibility and liquidity to buy and sell at close-to market prices as and when they want during market hours.

Ghazal Jain is associate fund manager (alternative investments) at Quantum AMC.

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Updated: 26 Oct 2023, 11:51 PM IST