When asked why we invest in gold the standard answer often involves, ‘because it is a safe haven,’ or, ‘because it is a hedge against financial collapse.’ Often people base these statement on historical examples many hundreds of years old, but what about in recent history? Has gold proved itself in recent years? And when we talk about a safe haven, do we realise that it is not the same as a hedge?
I look at a paper that answers these very questions. As is so often the case in gold investment, the answers to above questions are not clear cut but the overall message remains the same: gold is both a hedge and safe haven.
Is gold a safe haven everywhere?
Baur and McDermott (2009) examined the role of gold in the global financial system and asked ‘Does gold act as a safe haven against stocks of major emerging and developing countries?’
Looking at data between 1979 and 2009 the study finds that gold is both a hedge and a safe haven for both the US and major European stock markets. However it is not shown to be so for Australia, Canada, Japan and the BRIC stock markets.
They find that ‘gold was a strong safe haven for most developed markets during the peak of the recent financial crisis.’ The authors argue that ‘gold may act as a stabilizing force for the financial system by reducing losses in the face of extreme negative market shocks.’
Interestingly, looking at daily data the authors ‘find evidence of the strong-form safe haven’ for Canada, France, Germany, Italy, Switzerland, the UK and the US.’ This finding, they believe, ‘suggests the potential for gold to act as a stabilizing force for financial markets by reducing losses when it is most needed.’
When and why we invest in gold
Traditionally we refer to gold priced in dollars, many investors (particularly at the moment) choose to invest in gold as a hedge against inflation and a falling dollar. Should the dollar lose value then the price of gold (as priced in dollars) will rise. This theory, of using gold as a hedge against exchange rate risk, has been shown in previous academic work.
The authors believe that investment demand is ‘counter-cyclical’, i.e. demand rises as the global economy ‘enters a recession.’ In contrast, jewellery and industrial demand both follow the business cycle.
Since the financial crisis gold investment, according to the World Gold Council, has continued to reach new highs. Demand in bar, coin and ETFs appears to outstrip jewellery demand on an annual basis. This phenomenon had not been seen prior to the financial crisis.
Frequently the mainstream financial media use the phrases ‘hedge’ and ‘safe-haven’ to mean the same thing. This is not the case and the authors offer up definitions:
Hedge: A weak (strong) hedge is defined as an asset that is negatively correlated (uncorrelated) with another asset or portfolio on average.
Safe haven: A strong (weak) safe haven is defined as an asset that is negatively correlated (uncorrelated) with another asset or portfolio on average.
The authors believe that the key difference between the two is the ‘length of the effect’. ‘The important property of the hedge is that it holds on average whilst the key property of the safe haven is that it is only required to hold in certain periods.’
Gold and stock markets
When it comes to North American stocks, gold acts as a hedge. Looking at daily data, the authors find that gold provides the compensating property of a strong hedge. It acts as a safe haven (short term phenomenon) when there are extreme negative market shock at a daily frequency.
Key findings for those investing in stock markets in France, Germany, Italy, Switzerland, the UK and the US is that gold acts a safe haven when looking at the daily data. The authors also find similar results for weekly and monthly data.
They find that gold provides ‘a safe haven for developed markets in times of extreme market conditions.’ This occurs when investors sell stocks in order to buy gold when they are faced with heavy losses or high levels of uncertainty.
This is not the case in emerging markets where the authors observe that investors react differently to shocks. Here they are more likely to sell shares in response to a negative market shock but rather than turn to a ‘safe haven’ they may well shift their portfolios to markets in the developed world. I wonder if this is because many already invest in gold automatically, particularly in Asia and therefore do not see it as an alternative investment.
Overall the authors find that in European and US markets gold acts as both a strong hedge and a safe haven. In these areas, gold is ‘generally’ a strong safe haven when there are very extreme market conditions, in both daily and weekly returns.
Interestingly gold is not a safe haven nor a hedge for BRIC countries, Australia, Canada and Japan.
Gold and uncertainty
During periods of increased volatility gold acts as a hedge in Euro countries, Switzerland and the US. This does not stand however when there are periods of extreme volatility or uncertainty unless one is looking at markets in China and the US.
‘The results imply that in times of increased uncertainty, gold is a safe haven but loses this property for most markets in times of extreme uncertainty proxied by a global volatility estimate.’ i.e. if there are extreme levels of volatility and uncertainty then both stocks and gold ‘co-move thereby eliminating the safe haven property.’
Gold and crisis periods
The authors look at three separate crisis periods:
- The stock market crash in October 1987
The key finding from this crisis is that gold was a weak safe haven in all markets and a strong safe haven in Canada and the US.
- The Asia crisis in October 1997
During this crisis the authors find that the ‘results are more heterogeneous and exhibit larger absolute total effect estimates’. Gold was not a safe haven in Canada and the US.
- The global financial crisis which originated as a sub-prime crisis in 2007 and peaked in September 2008.
This is the crisis where we see the most interesting results reported. For the European countries and the US, a strong safe haven effect is seen. Brazil, Canada and India also see a safe haven effect. In contrast the authors find a strong positive co-movement of gold and stocks, ‘most notably Australia.’
Interestingly the authors find that there is a difference in the safe haven effects of high volatility and financial crisis periods. This is because ‘financial crisis episodes are relatively short (20 trading days) compared to the high volatility spells…the results imply that the safe haven effects holds only for a certain number of days.’
Conclusions
The study finds that it is the most developed country stock markets against which the safe haven effect is found. But these findings are at their strongest in daily data, especially when exceptionally rare and extreme shocks take place.
‘These results suggest that investors react to short-lived and extreme shocks by seeking out the safe haven of gold. In this context, gold can be seen as a panic buy in the immediate aftermath of an extreme negative market shock.’
As the authors originally hypothesised, they find that ‘gold is, at best, a weak safe haven for some emerging markets.’ In regard to gold’s role as a safe haven during crises, it performs well during those involving Western markets, but it did not act as one during the 1997 Asia crisis.
As we currently find in the behaviour of the gold futures price, rising uncertainty ‘causes investors to seek out the safe haven, but under extreme uncertainty gold moves with stock markets.’ Presently market participants appear to feel reassured by the occasional forward guidance offered by the Fed, one could therefore argue that we are just in a period of relatively low uncertainty. But as markets begin to realise that tapering or other elements of monetary policy are merely treatments rather than cures, I suspect that uncertainty will begin to rise and will take the gold price with it.
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