• The London Financial

Financial Uncertainty and the ‘Golden Boom’

Abstract


Uncertainty dictates the current economic climate. Whilst expansionary monetary and fiscal stimuli forced a financial asset rally, a balance sheet crisis began, and the financial markets remain uncertain for the future. A debt crisis could be imminent, but a steady recovery could occur. How should investors adapt their portfolios to incorporate the risks of a second wave or W-shaped recovery curve? Why gold? Why now?



The Current Climate Uncertainty dictates the current financial environment. The 2020 world recession is unlike no other, and whilst some attempt to predict the future, there must be general acceptance that questions cannot currently be answered. However, preparing for possible scenarios is vital for governments to ensure that a broken economy does not receive further fractures. The current liquid asset markets are experiencing high volatility, but most of which is just general ‘noise’. This ‘noise’ is the consistent speculation occurring from unimportant and meaningless news events. Whilst it is vital for long term investors to pay full attention to short term changes in such a volatile period, the rapidly swinging daily markets should not be of concern. Asset prices will slowly converge towards their actual value as the recession begins to end, whilst the relevant dividends, rent or interests are key determinants in valuing these assets. However, as uncertainty continues, and as central banks begin to prepare for an ongoing financial crisis, investors turn to gold as a safety haven and a hedge.

Historically, long term macroeconomic behaviour tends to be negatively correlated with the gold market. Uncertainty generates a lack of confidence in most financial asset markets, and it leads to investors searching for a hedge to reduce their investment risks. As a safe and stable asset, gold has no credit risk like most financial assets, and will inevitably retain its value. Contrary to these general long term trends, when looking short term at the market, gold tends to positively correlate with global market behaviour in periods of high confidence or fear. The graph below illustrates the current impact of the financial crisis on both the S&P500 and the gold market. This evidently indicates that treating gold as a safe haven must be viewed as long-term, and as a hedge tactic used by investors to insure their investments. Whilst the global markets saw a heavy retreat of investments in March, the return of confidence has led to higher risks, and thus growing demand for gold as a hedge. With gold prices growing to prices over 1,800 USD this week, they have reached similar prices that were hit after the 2008 recession. So, what does the future of the gold market entail? The changes in the value of gold over the coming year will rely on the level of uncertainty that are generated by the current financial crisis.



The Impact of COVID-19 on Gold As a safe haven asset, the uncertainty that has been brought about by the first world pandemic since the Spanish Flu has led to strength in the gold market. The above graph on the left highlights the impact of COVID-19 on GDP of G20 countries, with the red bar indicating the possible extended damage from a second wave. The halt in consumer demand has led to a microeconomic catastrophe, with most industries receiving large damages to their balance sheets. The fixed payments and costs that are included in rent and other contracts, without the continued revenue from consumer demand, have left huge losses for industries and will no doubt take many years for recovery. The value of financial assets has dropped as a result, and whilst investors are uncertain for the future, so they have wanted to hedge their investments with risk. The tail risk, (risk of assets moving more than three standard deviations) has dropped since the March fall, but as investors regain confidence, it is important to analyse how other phases of the COVID-19 could impact the economy.

Phase 1 - Uncertainty Retreat (Gold: -200) In March 2020, the fear of COVID-19 and its shutdown of the economy hit the financial markets. Asset managers pulled out of their investments with fear of a financial crisis, which had a huge blow on the financial markets.This retreat in investor confidence in conjunction with a boom in the USD market led the XAUUSD (gold) market to plummet. Contrary to long term negative trends of macroeconomic performance and the gold market, the retreat of investments accompanied the reduced demand for hedges like gold, as asset managers pulled out of their portfolios.

Phase 2 - Optimism Rally (Gold: +250) As fear and uncertainty took control of financial asset markets, investors began to regain confidence and joined on with one of the largest and longest rallies that markets have ever seen. The monetary and fiscal stimulus of governments forced financial assets to grow in value. The rise in investments was accompanied by huge uncertainty as to whether markets could potentially collapse, so gold played a huge importance in portfolios for risk management, as a safe-haven asset which is not vulnerable to credit risk.

Phase 3 - Balance Sheet Crisis (Gold: +10) This was the real microeconomic crisis, which began with the retail and production sectors. The lockdown had halted revenue and the survival of firms with tight balance sheets became of significant fear. With fixed payments continuing, firms such as airlines and other industries were relying on bail outs from the government or faced potential liquidation. The result led to further uncertainty and the rise of gold as a safe hedge.

Phase 4 - Neutrality (Gold: +100) The neutral phase of the economy continues in the current period. High daily fluctuations can be considered as pure ‘noise’, whilst news headlines cover both optimistic and pessimistic outlooks on the future economic status of the world. There is one aspect that is agreed by all parties though: there can be no certainty as to the future of COVID-19 and its economic impact. This has led gold to rise from 1700 to over 1800, and this phase is likely to continue until the suspected second outbreak around Autumn. This is the final stage in which financial assets of the entire globe move homogeneously, and until single country outbreaks begin to occur.


Whilst the future of the economy and financial markets are hard to predict, in a period that the world has never experienced something similar before, investors must be aware of the different outcomes that could possibly occur. The spectrum of future risk stems from the ability of governmental policy to prevent a damaging second outbreak and to create a ‘U’ shaped recovery instead of a ‘W’ shaped recovery. The following phases cover around 90% of potential risk, incorporating the potential secondary economic impacts as well as the likelihood of another outbreak.

Phase 5a - Controlled Second Wave (Gold: -50 to +100) The optimistic view on the financial recovery suggests that this is the end of the financial crisis, and that world-wide fiscal and monetary stimuli, especially quantitative easing and payment schemes for businesses, will raise consumer demand and recover the economy. It also will involve successful area lockdowns where the virus can be contained in specific areas and prevented before the outbreak. With this in place, investors will still remain uncertain, but will also have confidence to fully reinvest into financial assets and grow their portfolios. This is likely to lead to lead gold (XAUUSD) to a value of around 1850, as investors will continue to use gold as a hedge as they increase their portfolio sizes and risks.

Phase 5b - Uncontrolled Second Wave (Gold: +200 to +500) The pessimistic view can be seen as a more fractured economy and vulnerable financial market. This would suggest that the bankruptcies and unemployment will soon filter through the economy and lead to a second fall, which may be accompanied by a second wave of the virus. This would leave the government huge levels of debt, create credit risk, and ultimately create a financial crisis. Whilst gold is likely to fall sharply in short term investor fear, the long term will see gold reach prices potentially higher than it did in 2011 after the great recession.

The above phases should not suggest simplicity towards the future of financial assets, but they must indeed be used as a spectrum of risk for investors who are contemplating when and how they should adapt their portfolios. The value of gold has boomed in recent months, and whilst its long term future remains uncertain, investors must ensure they use the precious metal as a hedge against financial assets and overweigh it within their portfolios.



By James C.E. Silk - BA Economics Student at Durham University


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