Your Money: Gold remains an effective portfolio diversifier

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March 9, 2021 2:30 AM

Market sentiment was mixed. Improving earnings, plummeting virus numbers, impending stimulus and indicators suggest an economic recovery on the one hand and rising bond yields, expectations of higher inflation, concerns about rich equity valuations and sluggish vaccinations on the other.

The longer and bumpier the road from vaccine to vaccination, the slower restrictions and social distancing measures will be lifted, and the later we come back to normalcy.

The first month of 2021 was marked by rising yields, choppy equity markets, strengthening dollar and weakening gold. These trends continued in February, with gold trading at multi-month lows and ending the month 7% lower in USD terms.

Market sentiment was mixed. Improving earnings, plummeting virus numbers, impending stimulus and indicators suggest an economic recovery on the one hand and rising bond yields, expectations of higher inflation, concerns about rich equity valuations and sluggish vaccinations on the other.

Vaccine rollout
The longer and bumpier the road from vaccine to vaccination, the slower restrictions and social distancing measures will be lifted, and the later we come back to normalcy. The longer the pandemic’s economic shadow, the easier fiscal and monetary policies will be. This bodes well for gold.

Optimism about vaccination progress, upcoming US stimulus and global economic recovery has driven up expectations of inflation and instigated a selloff in bonds around the world. A gain in yields is weighing on demand for non-interest-bearing gold. Yields have risen faster than inflation expectations pushing up real rates by 30 basis points. This is leading to selling in gold. In addition, the US dollar is reaping the benefits of rising yields as they attract massive demand, further hurting its counterweight gold.

Equity markets have reacted negatively to higher yields as they are generally considered as an alternative to the dividend yield. The accommodative stance of global policymakers is unlikely to change until the vaccines restore some normalcy. However, bond markets seem to think that central bankers will soon cut back on their bond purchases or start increasing rates to accommodate higher inflation. There is thus a risk of a taper tantrum in markets similar to the one we witnessed in 2013 which could derail the stock market rally.

Dollar sell-off
The US dollar has been strengthening amid the recovery in US bond yields. But with a host of factors in place to put downward pressure, dollar strength will be short lived. By committing to keep interest rates where they are now for the next couple of years, Powell has endorsed a decline in the dollar. Combine that with more spending with Biden’s $1.9 trillion fiscal stimulus and expected infra splurge and you have ballooning deficits and further increase in debt which will keep the dollar under pressure. With more money trickling down to the real economy, the market is expecting robust inflation going forward.

The Indian rupee has been appreciating, hurting INR gold prices. The appreciation in the rupee is primarily due to a positive economic outlook and robust fund flows in Indian equities by FIIs. If investment flows are sustained then the rupee could appreciate. If the flows slowdown or reverse, the currency could be back to its gradual depreciating trend, giving a push to gold.

Gold prices in India have fallen relatively more due to a combination of falling International gold prices, appreciating rupee and reduction in customs duty. The macro economic uncertainties like rising deficits and debt, lower rates for longer, threat of high inflation, lower real rates and bursting of asset bubbles, all seem plausible and therefore warrant an allocation to gold which remains an effective portfolio diversifier and counterweight to paper money which is losing credibility as a store of value.

The writer is senior fund manager, Alternative Investments, Quantum AMC

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