Gold: mild upside and a powerful diversifier

We foresee mild further upside for gold prices but consider its diversification qualities in portfolios its main attraction. We look at gold’s historical trading behaviour and conclude that it remains a good tail risk hedge, in spite of its temporary fall in March. With Treasury yields already very low, investors need to look at other areas, such as gold, for diversification. Gold is a good complement to Treasuries as a diversifier of stock portfolios, as it has different fundamental drivers.

Gold: mild upside and a powerful diversifier

Gold price outlook: mild further upside

Our average gold price forecast for 2021 is USD1965/oz, and in the short term, we foresee a USD1850-2150 trading range. As we have discussed in other publications, this price path is due the following factors:

  • Main positives: continuation of low interest rate policy and substantial search for diversification in portfolios. Uncertainty related to COVID-19 and geo-politics remains high, supporting gold. Some investors see attraction in gold because they are worried about debt sustainability or inflation, but we do not see these as major concerns.
  • Main negatives: equity risk appetite is healthy, and could weigh on gold as the economy improves (though the recovery is volatile). Mining supply was low due to strikes, but could pick up again. Scrap supply could pick up too, while jewellery demand could fall at current high prices. ETF and speculative positions remain high.
  • Causes of volatility: US elections could create USD volatility, spilling over into gold volatility.

Gold has been boosted by the fall in real yields and USD weakness, but both trends are running out of steam

Gold: mild upside and a powerful diversifier

Source: Bloomberg, HSBC Private Banking as at 10 October 2020. Past performance is not a reliable indicator of future performance.

Gold is still a good diversifier, in our view

Although we see mild further upside to prices, the case for gold in 2021 is principally based on its diversification potential in multi-asset portfolios.

Some investors worry that gold has become more correlated to equities in recent months. As the graph on the bottom of this page shows, the correlation between monthly returns of gold and the S&P 500 move up and down, but it has picked up since the start of this year. Does this mean that gold has lost its diversification potential? We don't think so, for two reasons.

1. Asset price inflation has caused most assets to trend up together

Central bank liquidity and falling rates have benefited equities, credit, Treasuries and gold, causing correlations to pick up. It is no surprise that in our graph at the bottom of this page, correlations picked up in 2008, 2013 and 2020, which are exactly the times when the Fed boosted the size of its balance sheet.

Size of the US Federal Reserve's balance sheet

Gold: mild upside and a powerful diversifier

Source: Bloomberg, HSBC Private Banking as at 10 October 2020.

So, what lies ahead? As our graph above shows, the Fed's balance sheet size is flattening out and hence, this should become a less powerful driver of asset class performance, allowing gold to decouple from equities.

Moreover, investors probably don't mind if correlations are high due to equities and gold moving up together. It would be worse if they fall together; but the good news is that a rapid reduction in the Fed's balance sheet, which could hurt gold and equities, is a very unlikely scenario.

Gold's correlation with equities moves up and down. At 0.6, it is currently above average, but this is probably temporary

Gold: mild upside and a powerful diversifier

Source: Bloomberg, HSBC Private Banking as at 10 October 2020. Past performance is not a reliable indicator of future performance.

2. What happened in March…

Perhaps more concerning to some investors, was gold's temporary drop between 9 March and 19 March 2020, when equities corrected, and investors arguably needed diversification the most. But we would point out that during that very brief episode, even US Treasuries sold off.

What happened?

During the COVID-19 equity bear market, gold initially rallied, as we would expect, due to it safe haven qualities (see graph below). As the equity sell-off intensified, there was wide-spread liquidation in equities and other risk assets, causing investors to scramble for USD liquidity. This also caused people to liquidate gold positions to generate cash. Moreover, USD appreciation typically hurts gold and probably contributed to its sell-off. We would note, however, that this episode was short-lived, and that gold's correction (-6 per cent month-over-month at its lowest level) was relatively mild. Equities and gold both recovered once central banks managed to reduce the search for liquidity and re-started the asset price inflation trend. We note that the same pattern (gold rally, followed by liquidation and recovery) also unfolded from September to December 2008.

During the COVID-19 equity bear market, gold initially rallied, then suffered from liquidation, before recovering quickly

Gold: mild upside and a powerful diversifier

Source: Bloomberg, HSBC Private Banking as at 10 October 2020. Past performance is not a reliable indicator of future performance.,

Gold has been a good tail risk hedge through history and we don't see any major reason why this would change.

A look at the worst months for the S&P 500 US equity index since 1980 (see graph below) shows that in 10 out of 12 cases, gold prices were up, showing a negative correlation with equities. Even in the two episodes (March 1980 and August 1998) where gold was down, it as down considerably less than equities, offering diversification benefits.

We also show the 2008 and 2020 episodes, as discussed on the previous page, where gold was up early in the month, and then down temporarily later in the month. The fact that gold fell much less dramatically in 2020 than in 2008 may be because investors quickly more quickly factored in central bank action, which halted the gold liquidation.

Gold remains a good tail risk hedge: examining the performance of gold during the worst equity market periods

Gold: mild upside and a powerful diversifier

Source: Bloomberg, HSBC Private Banking as at 10 October 2020. Past performance is not a reliable indicator of future performance.

Gold and Treasuries: not an either / or

US Treasuries performed strongly during the COVID-19 equity bear market (apart from the very short liquidation episode discussed above). But with US Treasury, German Bund and UK gilt yields near historical lows, safe haven bonds are unattractive to many investors. In addition, the question is how much lower yields can fall from here, if equity markets were to correct again. Although there is no floor for yields, the jury is out whether safe haven bonds will remain as powerful diversifiers as they were in the past.

As a result, we think investors need to get diversification wherever they can get it, and gold (as well as alternative assets) continues to play an important role in that mix, in our view.

Historically, gold has added to the diversification of portfolios composed of equities and safe haven bonds, as we show in the table below. In part, this is because gold is driven by other factors than Treasuries. Both tend to benefit when interest rates fall or risk appetite deteriorates. But gold can do well when there are inflation concerns or when investors worry about debt sustainability, which could hurt government bonds (neither are major concerns for us currently, though). Gold's supply is finite, which is a positive when there are concerns about currency debasement. Even for relatively small changes to FX rates, gold tends to benefit if USD is weak, while the relationship between USD and government bond yields is often less pronounced. Finally, gold's supply and demand characteristics are largely acyclical, reducing its correlation to other assets.

Adding gold to an equity / Treasury portfolio further reduces its volatility.

Gold: mild upside and a powerful diversifier

Source: Bloomberg, HSBC Private Banking as at 10 October 2020. Past performance is not a reliable indicator of future performance. Note: a 70/20/10 portfolio would have experienced 12 per cent volatility over the 1980-2020 period, and 10 per cent in the past 10 years, in line with the 70/30 portfolio.

Imperfect but still useful

In summary, we think that gold continues to play an important role in portfolios, as a portfolio diversifier. We see valid explanations for its recent positive correlation with equities, but believe this correlation should fall back to a more normal level going forward. We also believe it remains a good tail risk hedge, but we use gold as a complement to high rated bonds and alternative assets to build a truly diversified portfolio.

Risk Disclosures

Risks of investment in fixed income

There are several key issues that one should consider before making an investment into fixed income. The risk specific to this type of investment may include, but are not limited to:

Credit risk

Investor is subject to the credit risk of the issuer. Investor is also subject to the credit risk of the government and/or the appointed trustee for debts that are guaranteed by the government.

Risks associated with high yield fixed income instruments

High yield fixed income instruments are typically rated below investment grade or are unrated and as such are often subject to a higher risk of issuer default. The net asset value of a high-yield bond fund may decline or be negatively affected if there is a default of any of the high yield bonds that it invests in or if interest rates change. The special features and risks of high-yield bond funds may also include the following:

  • Capital growth risk - some high-yield bond funds may have fees and/ or dividends paid out of capital. As a result, the capital that the fund has available for investment in the future and capital growth may be reduced; and
  • Dividend distributions - some high-yield bond funds may not distribute dividends, but instead reinvest the dividends into the fund or alternatively, the investment manager may have discretion on whether or not to make any distribution out of income and/ or capital of the fund. Also, a high distribution yield does not imply a positive or high return on the total investment.
  • Vulnerability to economic cycles - during economic downturns such instruments may typically fall more in value than investment grade bonds as (i) investors become more risk averse and (ii) default risk rises.

Risks associated with subordinated debentures, perpetual debentures, and contingent convertible or bail-in debentures

  • Subordinated debentures - subordinated debentures will bear higher risks than holders of senior debentures of the issuer due to a lower priority of claim in the event of the issuer's liquidation.
  • Perpetual debentures - perpetual debentures often are callable, do not have maturity dates and are subordinated. Investors may incur reinvestment and subordination risks. Investors may lose all their invested principal in certain circumstances. Interest payments may be variable, deferred or canceled. Investors may face uncertainties over when and how much they can receive such payments.
  • Contingent convertible or bail-in debentures - Contingent convertible and bail-in debentures are hybrid debt-equity instruments that may be written off or converted to common stock on the occurrence of a trigger event. Contingent convertible debentures refer to debentures that contain a clause requiring them to be written off or converted to common stock on the occurrence of a trigger event. These debentures generally absorb losses while the issuer remains a going concern (i.e. in advance of the point of non-viability). "Bail-in" generally refers to (a) contractual mechanisms (i.e. contractual bail-in) under which debentures contain a clause requiring them to be written off or converted to common stock on the occurrence of a trigger event, or (b) statutory mechanisms (i.e. statutory bail-in) whereby a national resolution authority writes down or converts debentures under specified conditions to common stock. Bail-in debentures generally absorb losses at the point of non-viability. These features can introduce notable risks to investors who may lose all their invested principal.

Changes in legislation and/or regulation

Changes in legislation and/or regulation could affect the performance, prices and mark-to-market valuation on the investment.

Nationalization risk

The uncertainty as to the coupons and principal will be paid on schedule and/or that the risk on the ranking of the bond seniority would be compromised following nationalization.

Reinvestment risk

A decline in interest rate would affect investors as coupons received and any return of principal may be reinvested at a lower rate.
Changes in interest rate, volatility, credit spread, rating agencies actions, liquidity and market conditions may significantly affect the prices and mark-to-market valuation.

Risk disclosure on Dim Sum Bonds

Although sovereign bonds may be guaranteed by the China Central Government, investors should note that unless otherwise specified, other renminbi bonds will not be guaranteed by the China Central Government.

Renminbi bonds are settled in renminbi, changes in exchange rates may have an adverse effect on the value of that investment. You may not get back the same amount of Hong Kong Dollars upon maturity of the bond.

There may not be active secondary market available even if a renminbi bond is listed. Therefore, you need to face a certain degree of liquidity risk.

Renminbi is subject to foreign exchange control. Renminbi is not freely convertible in Hong Kong. Should the China Central Government tighten the control, the liquidity of renminbi or even renminbi bonds in Hong Kong will be affected and you may be exposed to higher liquidity risks. Investors should be prepared that you may need to hold a renminbi bond until maturity.

Risk disclosure on Emerging Markets

Investment in emerging markets may involve certain, additional risks which may not be typically associated with investing in more established economies and/or securities markets. Such risks include (a) the risk of nationalization or expropriation of assets; (b) economic and political uncertainty; (c) less liquidity in so far of securities markets; (d) fluctuations in currency exchange rate; (c) higher rates of inflation; (f) less oversight by a regulator of local securities market; (g) longer settlement periods in so far as securities transactions and (h) less stringent laws in so far the duties of company officers and protection of Investors.

Risk disclosure on FX Margin

The price fluctuation of FX could be substantial under certain market conditions and/or occurrence of certain events, news or developments and this could pose significant risk to the Customer. Leveraged FX trading carry a high degree of risk and the Customer may suffer losses exceeding their initial margin funds. Market conditions may make it impossible to square/close-out FX contracts/options. Customers could face substantial margin calls and therefore liquidity problems if the relevant price of the currency goes against them.

Currency risk – where product relates to other currencies

When an investment is denominated in a currency other than your local or reporting currency, changes in exchange rates may have a negative effect on your investment.

Chinese Yuan ("CNY") risks

There is a liquidity risk associated with CNY products, especially if such investments do not have an active secondary market and their prices have large bid/offer spreads.

CNY is currently not freely convertible and conversion of CNY through banks in Hong Kong and Singapore is subject to certain restrictions. CNY products are denominated and settled in CNY deliverable in Hong Kong and Singapore, which represents a market which is different from that of CNY deliverable in Mainland China.
There is a possibility of not receiving the full amount in CNY upon settlement, if the Bank is not able to obtain sufficient amount of CNY in a timely manner due to the exchange controls and restrictions applicable to the currency.

Illiquid markets/products

In the case of investments for which there is no recognised market, it may be difficult for investors to sell their investments or to obtain reliable information about their value or the extent of the risk to which they are exposed.

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