Gold Update

This piece was originally written on April 19th, 2012 for IPI

The first quarter of 2012 has proven challenging for many investors in different asset classes. While volatility unexpectedly collapsed in the US equity market wrong-footing many underexposed investors, it picked up significantly in most commodities – including gold – and it produced varied responses in currencies.

This mixed bag is the result of many and often conflicting dynamics.  Europe was forced into large liquidity injections in order to buy time and attempt to heal its sovereign debt crisis. Such liquidity injections in the form of the LTRO program (Long Term Refinancing Operation) helped the short term performance of risky assets but more cautious or at least less dogmatic comments from the Federal Reserve provided headwinds to these rallies. Other interesting events include the first Japanese trade deficit in decades and a much forecast Chinese economic slowdown.

Gold ended up higher for the quarter but with a level of volatility much higher than its historical average; the yellow metal’s annualized volatility measured 20.4% versus its historical average of 16% (source: World Gold Council).  While much of this volatility manifested itself on the upside, it is important to note significant price drops such as February 29^th when the metal dropped almost $80.  Increased volatility seems to be here to stay as the second quarter already registered a more than $50 drop in the first couple of days.

On a short term basis correlations between gold and US equities have also increased as the risk on/risk off dynamic continues to play out.  Long term correlations, however, continue to remain insignificant.

The long term macro picture does not seem to be changing; excess global liquidity remains the recipe du jour to stabilize a financial system still afflicted by enormous global imbalances.  As a result real interest rates continue to remain negative providing support to the metal. From this perspective, the current volatility and the upcoming negative seasonality bias may provide opportunities.

On the subject of correlations, I would like to quote a recent study by Credit Suisse: “Commodities as an Asset Class: Correlations Have Peaked.”  There has been much controversy on the increase in correlations between commodities and traditional asset classes after the 2008 crack.  One widely held opinion stressed the “financialization” of commodities as the major culprit, or in other words, the securitization of commodities and the proliferation of long biased, retail oriented products crucially correlated to other assets.  Credit Suisse argues for a different approach and it has looked at correlations in other historical periods when massive macro shocks occurred and it found similar increases in correlations in terms of magnitude and time horizon.  Looking forward, their strategic call is for a de-linking between the performances of commodities in general and traditional asset classes.

I tend to believe that securitization and the inevitable ramifications of macro global shocks have both played a part in the new correlation dynamic.  But I do concur with Credit Suisse and I expect a more independent performance going forward between commodities and traditional assets.

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