Rising oil prices due to Middle East tensions have caused inflation concerns, but gold has not responded as expected. This analysis by portfolio manager CJ Cowan explores why gold’s price has fallen despite typical economic conditions that usually boost it.
Missile strikes in the Middle East and the effective closure of the Strait of Hormuz, through which around a fifth of the worlds oil is transported, has predictably sent the price of oil skyrocketing. Since the beginning of the month, the price of a barrel of Brent crude is up more than 40% and at time of writing sits at $107. What we are seeing is a classic negative supply shock: the supply of oil is falling as no one can get it out of the Persian Gulf, so the price of oil needs to rise to reduce demand and balance it with supply.
The thing with oil is that demand is very inelastic in the short-term, which is to say that the volume of oil people want to buy is not very sensitive to its price. Everyone still needs to drive their cars, transport goods and heat their homes, regardless of how expensive fuel is. That is why the oil price is prone to such violent swings at times of geopolitical stress as demand destruction happens slowly.
The oil price spike has implications for future inflation. Headline inflation measures directly include energy costs, so obviously these are expected to move higher in the coming months. However, even core inflation measures, which strip out food and energy, implicitly include energy as an input into the final consumer price. A pub must now pay more to keep the lights on and the cooker running; this additional cost will likely be passed on to consumers through higher prices.
If higher energy prices push up households’ inflation expectations and workers successfully demand higher wages, those second-round inflation effects that worry the Bank of England come into play, as higher prices beget higher wages which in turn lead to higher prices. With 2022 fresh in the memory, this is something everyone wants to avoid. We must remember this isn’t 2022 though, when there was pent up demand after lockdowns, clogged up supply chains, overzealous fiscal and monetary stimulus, and tight labour markets. These conditions do not exist here in the UK today, although some still do in the US, so the most likely outcome is that higher prices take care of themselves by reducing demand and preventing inflation from spiralling. Here’s hoping.
But I digress. This post was meant to be about gold rather than oil and inflation, although it is all linked. In the macroeconomic backdrop I laid out above, where inflation rises and growth falls, you would normally expect the gold price to rise. This is why we hold it in our portfolios. Instead, the price of gold is down 15% since the beginning of March. What’s going on? To answer this question, we need to go back to how we got to a gold price of over $5,000/oz in the first place.
If we examine the macroeconomic and market conditions during gold’s latest bull run, it is a little strange that the price peaked nearly 160% higher since the start of 2024, and even after its recent fall is still 120% higher. Global growth has been solid, inflation was much lower (although still a little above central bank targets), and equity markets were on a tear. Interest rates were elevated too, so the opportunity cost of holding an asset that doesn’t generate any cashflows was the highest it had been since before the global financial crisis.
My colleague, Ian, wrote a separate post in late January on some of the popular reasons touted for gold’s meteoric rise. He concluded that many of the popular narratives do not fully stack up and gold had become a momentum trade. Both hedge funds and retail investors all jumped on the band wagon, making the gold price vulnerable to a sharp reversal should anything change. This reversal did indeed happen at the end of January but within days the gold price had found a base and resumed its rise, almost touching its highs again.
The froth never got taken out of the market and many holders were still sitting on massive paper profits. In situations like this, an external shock like a war that upsets risk sentiment often sees investors sell whatever has been working. In this regard, gold had become a risk asset, just like equities, rather than a diversifier.
This has left us in a position where at precisely the moment you would want gold to protect your portfolio, it really hasn’t. Of course, equity markets have actually been surprisingly well behaved, with the MSCI All Country World Index (ACWI) only down a little over 5% from its peak. Perhaps if equities fall further then gold will rally back, but the last few weeks would lower anyone’s conviction in that story.
Until the more speculative holders of gold have upped sticks, we need to be careful about expecting normal correlations with growth, inflation and risk assets to hold. How do we know when the froth is gone? We don’t. Some may say that now the gold price is only a few percent higher than at the start of year that we are back to the way we were and the last few weeks were but a minor blip. Others would contend that we are still miles above where the latest bull run began, so gold could have a lot further to fall before it behaves like a safe haven again. Analysing investor positioning surveys and exchange traded funds (ETF) flow data may be the best way to determine when the point of maximum pain has been reached.
Objective analysis of a ‘belief’ asset is by definition very difficult, maybe even impossible. Meanwhile, indirect hedges that rely on historic correlations repeating themselves cannot be expected to work all the time. Just because gold hasn’t worked this time doesn’t mean it is broken forever, but perhaps the real question to ask yourself is: “do you still believe?”. There are several other ways to diversify too – infrastructure, hedge funds and derivatives strategies, to name a few – so whether you’re a gold-bug or not, it’s always a good idea to diversify your diversifiers.
CJ is a portfolio manager of the Quilter Investors Cirilium and Monthly Income Portfolios. CJ joined Quilter Investors in August 2018 from Aberdeen Standard Investments where he worked in the global macro team, managing global government bond and global aggregate portfolios.
CJ is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. CJ has a degree in economics from the University of Bristol and an MPhil in Economic and Social History from Brasenose College, University of Oxford.
