Gold has long been regarded as a symbol of wealth and a safe haven for investors, particularly in Asia where it has been cherished since ancient times. For investors, gold not only represents a scarce and precious asset, but also plays an important role in hedging equity market risks within investment portfolios. Historical data demonstrates that during periods of stock market downturns, especially during financial crises characterized by extreme market volatility, gold’s unique characteristic as a safe haven asset attracts a significant influx of investors, subsequently driving up its price.

Recently, however, a noteworthy trend has emerged in the market: while the U.S. stock market continues its upward trajectory, hitting new highs, gold prices have also been rising in tandem, reaching historic levels. This phenomenon has prompted many investors to question: is the long-standing low correlation between gold and stocks undergoing a shift? Are gold's hedging properties against equity market risks waning? Besides gold, what other financial instruments can investors consider to effectively hedge these risks? In this edition of Poseidon’s Market Foresight, we will delve into the role of gold in investment portfolios, analyze historical data to understand how gold has historically hedged risks for investors, and compare it with other hedging instruments.

Why Did Gold Prices Hit All-time Highs?

Since the end of February, there has been a notable surge in gold prices. On March 20th, spurred by the dovish signals from the Federal Reserve, gold prices rose further, reaching an intraday high of $2,225. This marks the fourth time within a month where gold prices have set a fresh record high. To better comprehend the factors driving this gold rally, we will analyze its recent trend from the perspectives of gold's monetary, commodity, and financial attributes.

In our previous Poseidon’s Market Foresight, we delved into the evolution of gold, tracing its historical role as a circulating currency to its current function as a reserve currency and hedging instrument following the abandonment of the gold standard. Central banks worldwide have emerged as significant buyers of gold, holding substantial amounts as reserve assets to maintain the stability of national currencies and establish trust in international trade. In recent years, heightened geopolitical risks, such as the Russia-Ukraine conflict and the Israel-Hamas war, have prompted central banks to ramp up their purchases of gold. Their objective is to diversify their foreign exchange reserves, reduce dependence on a single currency like the US dollar.

According to the World Gold Council, central banks purchased 1081 tons and 1037 tons of gold in 2022 and 2023, respectively, surpassing the 450 tons purchased in 2021. This accounts for nearly a quarter of the global gold demand. Since June 2023, central banks have achieved net purchases of gold for eight consecutive months. Notably, the People's Bank of China (PBoC) has continuously increased its gold reserves for the 16th consecutive month, reaching a total holding of 2245 tons. Nevertheless, the proportion of gold in China's foreign exchange reserves remains relatively low, accounting for only 4.3% of official reserve assets, far below the global average of approximately 14%. Considering factors such as financial security and reserve asset diversification, the PBoC is likely to continue increasing its gold holdings in the future. At the same time, other emerging countries like Poland and Turkey have also been actively purchasing gold in 2023. According to the World Gold Council's forecast, central banks will continue to be strong buyers in the gold market in 2024, further driving up gold demand.

In addition to the heightened gold acquisition by central banks, the recent surge in gold prices can be attributed to robust retail purchases of jewelry, gold bars, and coins. In China, the sluggish performance of the stock and real estate markets has prompted investors to turn to gold investments as a means of diversifying their asset portfolios. According to data from the World Gold Council, China surpassed India in 2023 to become the world's largest buyer of gold jewelry. The Council further predicts that Chinese retail demand for gold jewelry, bars, and coins will remain robust in 2024, exceeding the long-term average.

In other emerging markets such as India and Turkey, consumers' interest for gold remains strong. In India, gold has always been considered the most precious gift. Especially during the wedding season, the demand for bridal jewelry accounts for one-third of the country's total gold demand. In Turkey, as the fifth largest gold market globally, its high inflation, limited investment options, and a depreciating lira have all made gold a more attractive investment and value preservation tool for Turkish consumers. Gold demand in Turkey surged in 2023, nearly doubling that of 2022. With the increasing purchasing power and steady income growth of consumers in developing countries, the corresponding wealth effect will further bolster the demand for gold.

Gold, as a physical asset, differs from stocks or bonds as it does not offer stock dividend or coupon payment. During periods of high bond yields, investors who choose to hold physical gold forego the potential for higher interest income, thus incurring significant opportunity costs. However, when the market perceives dovish signals from the Federal Reserve, resulting in declines in bond yields and US dollar, this reduces the opportunity cost of holding gold and makes gold investment more attractive to investors holding non-US dollar currencies. Moreover, the decline in real interest rates, ongoing geopolitical risks, and the US elections have heightened risk aversion sentiment in the market. Against this backdrop, the status of gold as a safe haven asset has become increasingly prominent.

Effectiveness of Gold as a Hedge Against the Stock Market

By examining the historical bull markets of gold, we can observe a phenomenon: whenever the gold market experiences a significant surge in prices, the stock market often undergoes a significant downturn during the same period. Take the global financial crisis in 2008 as an example. The S&P 500 index suffered a heavy blow from August 2008 to March 2009, witnessing a substantial decline of 47%. However, during the same timeframe, the price of gold exhibited a completely different trend, achieving a 12% increase. In fact, due to the low correlation between gold and the stock market, many investors regard it as an effective hedging tool. They strategically allocate gold in their portfolios to mitigate potential risks that may arise during periods of increased market volatility. To further classify the role of gold in hedging portfolio risks, we can identify three categories: tail risk, inflation risk, and geopolitical risk.

Looking back at the black swan events that occurred in the US stock market in the past, gold has yielded positive returns to investors in most cases. As depicted in the chart below, when the S&P 500 index undergoes a decline of over 15%, the return of gold consistently surpasses that of the stock market during the same period, offering investors an effective means to mitigate market volatility and minimize portfolio drawdowns. The main reason behind this phenomenon can be attributed to the "Flight to Safety" phenomenon, wherein investors shift towards safer investments amid heightened market uncertainty.

The concept of "Flight to Safety" refers to the phenomenon where investors redirect their funds from high-risk assets to safer assets during times of financial crisis, in order to mitigate portfolio risks. When faced with plunging asset values, tightening credit conditions, and economic recessions, investors tend to reallocate their funds to more stable assets in order to safeguard their investments. As an important tool for hedging market risks, gold often becomes the preferred choice for investors, and its price also rises accordingly. Under such circumstances, if investors have already allocated an appropriate amount of gold in their portfolio prior to the crisis, it will effectively counterbalance some of the impact caused by a decline in the stock market, thereby reducing the overall risk of their investment portfolios.

Compared to ordinary currencies, gold has been an effective store of value, which ensures the stability of its worth. By comparing gold prices with US inflation data, we can observe that gold can effectively maintain its purchasing power in most inflationary environments. For example, in the 1970s, when US inflation rates surged to 14%, gold prices increased by over 100%, helping investors effectively hedge against inflation. Additionally, when geopolitical risks intensify, gold is widely sought after by investors due to its hedging properties. For instance, after the outbreak of the Russia-Ukraine conflict, investors sought safe-haven assets, and gold prices rose by 4% within the subsequent month.

However, it is worth noting that the correlation between gold and the stock market, which has historically been low, can potentially change with shifts in economic conditions. Recently, gold price and the US stock market have been rising in tandem, primarily attributed to a common factor - Federal Reserve policy. When market expectations for interest rate cuts rise, it often creates favorable conditions for the ascent of the US stock market. Interest rate cuts can reduce financing costs for businesses, enhance market liquidity, and alleviate the debt burden on companies and consumers. At the same time, increased expectations for interest rate cuts can also put downward pressure on bond yields. As bond yields gradually decline, investors may redirect their investments toward alternative asset classes, including gold. Therefore, when considering the use of gold as a hedge against stock market risks, it is crucial for investors to take into account the current economic environment and monetary policy to determine whether there is a low correlation between gold and stock market.

Comparison of Gold and Other Hedging Instruments

Portfolio hedging is a strategy employed in portfolio management to safeguard investors against market fluctuations and specific risks. When investors anticipate potential declines in certain assets within their portfolios, they adopt hedging strategies to mitigate portfolio risks. These strategies are typically executed by taking positions that are inversely correlated to the original investment assets or by entering derivative contracts like options or futures.

There are various approaches to portfolio hedging, and the selection of an appropriate strategy depends on the specific goals and risk preferences of investors. For instance, when hedging against downside risks in the US stock market, gold is often considered a valuable hedging asset. Investors tend to turn to gold when the stock market experiences declines or significant volatility. Similarly, bonds are widely used as hedging instruments for US stocks due to their negative correlation with the stock market. In recent years, cryptocurrencies have gained attention, attracting significant funds and prompting investors to explore their hedging effects on US stocks. In addition to directly purchasing assets with negative correlation, some investors opt for hedging through the purchase of nonlinear derivatives such as options. Common strategies include buying put options and put spreads.

Bonds possess characteristics of low risk and stable cashflow, making them effective in hedging against stock market fluctuations. In the past, a portfolio allocation combining stocks and bonds was a popular choice as inflation in the US market remained relatively low, and the overall correlation between stocks and bonds was negative. Holding both assets allowed for risk mitigation. However, the correlation between stocks and bonds is not static. Recently, the relationship between stocks and bonds has turned positive, limiting the hedging effectiveness of bonds. In contrast to bonds, gold is a physical asset with intrinsic value. Its performance in high inflation environments has contributed to its popularity as a hedging instrument.

Conclusion

Gold serves not only as a durable store of value but also as a powerful tool for portfolio risk hedging. In 2024, the international geopolitical landscape remains volatile, coupled with the approaching elections in various countries including the U.S. In this dynamic environment, the distinct value of gold as a safe-haven asset becomes even more pronounced. Against this backdrop, gold can provide investors with effective risk hedging protection and meet their needs for wealth preservation in times of uncertainty.