Macroeconomics guides gold

One of the critical features of this decade is the recurrence of two deeply impactful bear markets over a very short period of time. Both were led by easy credit, over valuation and subsequent collapse.

This has come about as two features have emerged. One, telecommunications revolutionised business processes and two, global capital flows have increased volatilities across asset classes.

The result of the financial ups and downs concomitant with telecommunications-capital flow has led to substantive amount of wealth created and lost and more importantly, the quest for an asset that is a store of value has increased.

The premia for such a quest has increased manifold as the "rich" working populations of the North Atlantic and Japan head over into retirement. In a strange twist of historical irony — just as our financial systems have become more "rational", the flow of funds and taxes increasingly harmonised — the global investor has gradually upped her faith in the oldest of stores of value: Gold.

From a portfolio manager's perspective the advent of financial engineering, securitisation and new capital markets have theoretically led to greater opportunities for diversification of risk in portfolios have increased. The principle of diversification, however, only works if the correlation between factors of risk is low, i.e., it only makes sense to diversify across asset classes if the returns on one asset decline, the other's returns remain constant or increases.

In essence, diversification relies solely on the, almost metaphysical, correlation. During the credit crises of the 2008, dramatic declines in highly sophisticated hedge fund strategies of hedge funds like Global Alpha at Goldman Sachs revealed that correlation across asset classes aren't as well understood as previously thought. The deep, or fundamental, reason is that neither does mainstream finance-economics have a model of what correlation really is. As we presently understand, correlation is an emergent phenomena - a statistical property that attempts to measure a highly technical and restrictive relationship between variables.

In the past crises correlation estimates between two assets — say returns on corporate bonds and corporate equities of AA rating — were stable when the market's supply and demand roles functioned well. However, in times of crises induced by liquidity constraints - the underlying supply and demand mechanism breaks down and resultantly the correlation numbers spike and swirl. Typically, fund managers have used gold as back up in their portfolio. The reasoning has been that gold is generally assumed to move in an opposite direction to prevailing market sentiment. Since early 2000s, gold prices have quadrupled and have withstood the two bearish markets. To make matters more stark, a recent bit of research by the World Gold Council makes this clear. They argue that a fund manager who didn't allocate 8.5 per cent of his $10 million (Dh36.7 million) portfolio to gold would have incurred nearly $500,000 loss.

Tail risk

In recent weeks, news agencies have been rife with news of "super-rich" individuals purchasing physical gold. The conventional story about diversification that we laid out above might indeed be true. But, there is also increasing evidence that gold is viewed as a possible hedge against tail-risk. Tail risk refers to the risk to the portfolio due to events that cause extreme losses on returns.

Naturally, the question has increasingly turned to what sort of extreme events are markets pricing in. Crash in the US dollar, a failed auction at the US Treasury and so on. The most visible of such graduated panic-state is visible in the US dollar market. As previously mentioned, the potential consequences of a large scale quantitative easing (QE) programme are much feared. In Aug-ust-September, the dollar index has been unable to pierce through the 50 day moving average and more recently has dropped below the 200 day moving average. The dollar has slowly begun to cave into market prejudices against loose monetary policy. If the dollar is seen as a store of value, it is because the alternatives are worse.

 The columnist works for a major European investment bank in New York City. You can follow his tweets at http://twitter.com/ks1729