Since November global stocks are up around 3 per cent in dollar terms; the US has done even better, gaining roughly 5 per cent. At the same time a broader index of US bonds is off around 2.5 per cent while gold is flat. In other words, gold has beaten bonds but been a drag on equity returns.
Even during equity market sell-offs, gold has been a less reliable hedge. For example, during the May 29 sell-off on the back of turmoil in the Italian bond market stocks got pounded; gold was flat.
Why has gold recently proved a less effective hedge? The change reflects two key, related developments: a stronger, tax-cut fuelled US economy and an accompanying bounce in the dollar. In particular, the stronger dollar has been a headwind for gold. While the dollar declined in December and January, its recent strength has removed one of the key props for the yellow metal.
What to expect going forward? This is still mostly about the dollar. While the twin fiscal and current account deficits suggest a weaker dollar longer-term, fundamentals in the near-term may be more supportive. Although US growth has moderated, Europe has decelerated at a much faster pace. In fact, European economic surprise indexes, i.e. economic data versus expectations, are stuck at the lowest level since 2011.
Beyond slow growth, the other tailwind for the dollar is European political stability, or more precisely, the lack of any in Italy. On Tuesday, growing fears of a populist coalition in Italy pushed 10-year Italian bond yields over 3 per cent, a four-year high. For the first time in years, investors are beginning to question the long-term sustainability of the euro. These fears are probably overblown, but there is no quick cure for the current instability in Italian politics. These concerns are likely to linger, at least through the next Italian election.
In an environment of a stronger US economy and resurgent European political risk, the dollar may, at least temporarily, resume its former role as a safe-haven currency. All else equal a stronger dollar is a headwind for gold. Don’t abandon gold, but own less than you normally would.