Why oil and gold look like an expensive insurance policy right now despite market risks
Kerry Craig says while there has been plenty of turbulence to spook investors, a flight to the traditional safe investment havens might be premature
As the twilight of the middle of the business cycle – which charts the rise and fall in world gross domestic product – fades, investors are grappling with how to best position portfolios. Commodities, namely oil and gold, have been classic late cycle plays. While some investors dismiss the use of historical comparisons, given the structural changes in markets and economies this time, history can still prove a useful guide on how these two asset types may perform heading into the next economic downturn.
This year has been a mixed bag for commodities performance. The broad Bloomberg Commodities Index ended the first half of the year pretty much flat, as rising oil prices were offset by declining metal prices.
The steady fall in the price of gold since April may come as a surprise, given its “safe haven” status at a time when tail risks (unexpected events that could negatively impact portfolios) have been rising and investors’ nerves are increasingly frayed. However, many of the bastions of safety for investors are yet to signal impending doom.
Although US government bond yields have struggled to break through the 3 per cent barrier, they are well off historical lows. Meanwhile, the yen and Swiss franc, traditional safe havens in periods of stress, are yet to be the recipients of significant inflows.
Why is the gold price falling when the list of risks has never been longer? Gold is often viewed as the ultimate insurance policy against a market catastrophe, and an allocation to gold has been a fairly consistent late cycle trade, living up to its name as the king of metals.
The value of gold should rise as the economic outlook deteriorates and real interest rates fall as monetary policy is loosened. However, in the run-up to a recession, the yellow metal can struggle. Despite risks to the growth outlook from trade and geopolitics, the US Federal Reserve has persisted in hiking rates, lifting real rate interest rates, which in turn has created bursts of US dollar strength, resulting in dual headwinds for gold.
It is likely that gold will once again perform well once the wheels start to come off the global economy. But the US is a decade into its expansion and there are no guarantees about when it will end. There is certainly little sign of a recession in the coming year. Until then, gold looks like an expensive insurance policy in terms of the opportunity cost of holding an asset that could offer greater return potential against a relatively robust growth outlook.
Investing in the oil market can lift return potential during the latter stages of the business cycle, when demand is usually running above supply and there may be looming capacity constraints limiting future supply. Geopolitical risk, an all too familiar influence in today’s markets, can add to the upside as sharply rising prices reflect anxieties over supply, as was the case in the 1970s. However, this is a double-edged sword as rising oil prices can artificially end the cycle as central banks react to higher inflation and consumption is dampened.
Commodities is one of these broad groupings which belies the traits of the underlying components. Not every commodity will perform at the same time. While gold needs clear evidence of an imminent recession, the oil market will have already retrenched, given the anticipated decline in demand.
The upside to the oil market may not be as great this time around. The increased cooperation between Organisation of the Petroleum Exporting Countries and non-Opec members on production targets suggests that supply outages can be covered by Opec members. Meanwhile, an increasing share of global production is coming from US shale, which has proven very responsive to price changes.
The deterioration in relations between Iran and the US mean a spike in oil prices can’t be ruled out. But capacity constraints are not as evident now as in past cycles.
There is plenty to keep investors on their toes and many of the mini-shocks experienced this year may feel amplified against the late cycle dynamic. Economic growth globally looks robust, if less synchronised, and the corporate backdrop is supportive of growth assets, such as stock. Additional caution may be warranted, but it’s too early for all-out defensive positioning in portfolios. Commodities will have a role to play when the time comes, but that time is not now.
Kerry Craig is a global market strategist at J.P. Morgan Asset Management