KEY TAKEAWAYS
- Gold’s volatility amid the ample challenges of 2022 prompted many to question its reputa-tion as a safe haven.
- While multiple factors can affect the price of gold, we believe changes in real interest rates—i.e., the difference between nominal interest rates and inflation—are the most important driver over the medium and long terms.
- With only a very slight decline in price for full-year 2022, gold handily outperformed equity and fixed income markets alike and underscored why a number of First Eagle’s portfolios maintain a strategic allocation to gold.
- We expect uncertainty—monetary, economic, policy, geopolitical, etc.—to persist in 2023, and we continue to think that gold’s reputation as a potential hedging tool for capital preser-vation is unparalleled.
Financial markets were rattled by a litany of interlocked challenges during 2022, including war, high inflation, rising interest rates and fears of recession.
While gold rallied in the weeks leading up to and immediately following Russia’s late-February invasion of Ukraine, its price softened as financial markets shifted their focus to the Federal Reserve’s efforts to combat persistently high inflation. This volatility in the face of uncertain conditions prompted many to question its reputation as a safe haven and had some commentators asking, “Why bother?”
Ultimately, we believe that 2022 highlighted why a number of First Eagle’s portfolios “bother” with a strategic allocation to gold; namely, because its reputation as a potential hedging tool for capital preservation is unparalleled, if perhaps misunderstood. Gold behaved as expected—if not better—in 2022 given the year’s conflicting dynamics; though the intra-period movement in price was significant, gold’s return of -0.3% in 2022 handily outperformed equity and fixed income markets alike.1
We expect uncertainty—monetary, economic, policy, geopolitical, etc.— to persist in 2023, and we are inclined to prepare for range of potential outcomes. Our view is that of all the available potential hedging options, both real and financial, gold’s differentiated risk-return characteristics could promote long-duration resilience across the widest variety of adverse circumstances.
Living in the Real World
In 2022, no-longer-transitory inflation become a meaningful concern in developed market economies for the first time in many decades. Since gold is widely viewed as a potential hedge against inflation, its price should benefit from multi-decade-high inflation levels, right? Well, it’s not quite as simple as that. While inflation can help influence movements in the price of gold, it’s not the primary catalyst.
Consider gold in 2022. Gold rallied early in the year as investors flocked to perceived safe havens in the weeks leading up to and immediately following Russia’s invasion of Ukraine in late February. However, it wasn’t long before markets turned their attention to the likelihood that the Fed would soon act to combat unflagging inflation, and gold’s 2022 peak was established only days before the central bank launched one of its most aggressive rate-hike cycles in decades. Signs that the Fed may be prepared to slow its pace of tightening prompted a November rebound in gold, and the metal finished the year down only 0.3% despite significant intra-period swings in both directions.2
While multiple factors can affect the price of gold, we believe changes in real interest rates—i.e., the difference between nominal interest rates and inflation—are the most important driver over the medium and long terms. Real interest rates represent the opportunity cost of owning gold; since it pays neither dividends nor interest, gold is relatively expensive to hold when real interest rates are high and relatively inexpensive to hold when they are low. Thus, real interest rates and the price of gold historically have been negatively correlated; as shown in Exhibit 1, when real interest rates have moved lower, the gold price, despite some lead/lag effects, has generally moved higher and vice versa.
Looking specifically at 2022, stubbornly high inflation prints prompted the Fed to raise its federal funds target rate by 425 basis points between March and December while maintaining steadily hawkish rhetoric.3 The real interest rate—as represented by the yield on 10-year Treasury inflation-protected securities (TIPS)—trended decidedly upward in response, climbing from around -1% in March to an early-November peak above 1.7%, the largest spike in real rates since the global financial crisis.4 That the price of gold fell about 18% during the trough-to-peak period in real rates during 2022 doesn’t come as a surprise. It’s worth noting, however, that the gold price’s decline of 0.3% for full-year 2022 handily outpaced most risk assets—including equities (S&P 500 Index: -18.1%) and long-term bonds (Bloomberg US Long Treasury Index: -29.3%)—and provided the portfolio ballast we seek.5
Despite the market, macro and geopolitical trends pointing to the contrary, the behavior of real and nominal interest rates in 2022 suggests the Fed has convinced investors that it will be successful in its efforts to get prices under control without tipping the economy into a protracted decline. The yield on 10-year TIPS, our proxy for real interest rates, is composed of the current nominal 10-year Treasury rate plus market expectations for average inflation over the security’s tenor (termed the “breakeven inflation rate”). As shown in Exhibit 2, the breakeven inflation rate peaked in March and has been biased lower since, implying that inflation expectations remain anchored. It also implies that the increase in real interest rates during 2022 was fueled primarily by higher nominal rates, whose path to levels not seen since 2008 indicates confidence that significant rate cuts will not be needed to stimulate a flagging economy.
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