The relevance of gold as a strategic asset 2020 - Japan edition

New decade, renewed challenges

As the new decade begins, Japan faces an expanding list of macroeconomic challenges that are both old and new. Among these:

• An exceptionally high level of public debt at 238% of GDP, will limit future economic growth and reduce the potential for savings and investments
• Unfavourable demographics also hinder the government’s ability to finance increasing social security expenditures
• Ultralow and negative interest rates have pushed investors to seek risk assets at elevated valuation levels
• Continued financial market uncertainty, ranging from geopolitical tensions to expectations of diverging global economic growth and an increase in asset volatility.

Given the macroeconomic challenges confronting the Japanese economy and the aggressive monetary easing that has taken place under the Abe administration, the Japanese Yen has fallen 23% against the US dollar since the start of 2013. For Japanese investors, we believe that gold is not only a useful long-term strategic component for portfolios, but one that is increasingly relevant in the current environment (see 2020 Gold Outlook).

The increased relevance of gold

Institutional investors have embraced alternatives to traditional stocks and bonds in pursuit of diversification and higher risk-adjusted returns. The share of non-traditional assets among global pension funds increased from 7% in 1998 to 23% in 2019 ² (Chart 1). This number increased to 11% in Japan from 7% a decade earlier. 

Gold allocations have been recipients of this shift. Gold is increasingly recognised as a mainstream investment, evidenced by the growth in global investment demand – an average of 14% per year since 2001 – and by an almost four-fold increase in the gold price over the same period.³

The principal factors behind this growth include:

• Emerging market growth: economic expansion –notably in China and India – increased and diversified gold’s consumer and investor base (see Chart 13, and Chart 24 in the full report)
• Central bank demand: a surge of interest in gold among central banks across the world, commonly used in foreign reserves for safety and diversification, has encouraged other investors to consider gold’s positive investment attributes (see Chart 15 in the full report).
• Market access: the launch of gold-backed ETFs in 2003, along with the launch of Gold Accumulation Plans (GAPs) since the 1980s and the cross-listing of SPDR® Gold Trust on the Tokyo Stock Exchange since June 2008 have facilitated access to the gold market and materially bolstered interest in gold as a strategic investment, reduced total cost of ownership and increased efficiencies (see Chart 14 in the full report)
• Market risk: the global financial crisis prompted a renewed focus on effective risk management and an appreciation of uncorrelated, highly liquid assets such as gold (see Chart 16 in the full report). Today, trade tensions, the growth of populist politics and concerns about the economic and political outlook have encouraged investors to reexamine gold as a traditional hedge in times of turmoil (see Chart 25, and Chart 26 in the full report)
• Monetary policy: persistently low interest rates reduce the opportunity cost of holding gold and highlight its attributes as a source of genuine, long-term returns, particularly when compared to historically high levels of global negative-yielding debt (see Chart 23 in the full report). In Japan, government bonds, up to and including the 10-year tenor, are currently trading with negative yields.

Gold’s strategic role

Gold is a clear complement to stocks, bonds and broad-based portfolios. A store of wealth and a hedge against systemic risk, currency depreciation and inflation, gold has historically improved portfolios’ risk-adjusted returns, delivered positive returns, and provided liquidity to meet liabilities in times of market stress. 

In Japan, years of aggressive monetary easing and a less than ideal fiscal situation, exacerbated by deteriorating demographics and slowing growth, have reduced both domestic and overseas asset returns as well as increased the headwinds against the Japanese Yen and sovereign debts. In this environment, gold will have a greater role to play as a superior store of wealth and source of returns in years to come.

1. A source of returns

Gold is long considered a beneficial asset during periods of uncertainty. Historically, it generated long-term positive returns in both good times and bad. Looking back almost half a century the price of gold has increased by an average of 8.4% per year in yen since 1971 after Bretton Woods collapsed.⁴ Over this period, gold’s long-term return was comparable to Japanese stocks and higher than Japanese bonds.⁵ Gold has also outperformed  other major asset classes over the past two decades (Chart 2 and Chart 17 in the full report).

Gold is used to protect and enhance wealth over the long-term and it operates as a means of exchange, because it has global recognition and is no one’s liability. Gold is also in demand as a luxury good, valued by consumers across the world. And it is a key component in electronics.⁷ These diverse sources of demand give gold a particular resilience: the potential to deliver solid returns in good times and in bad (Focus 1).

For compounded annual growth rates see Chart 17, in the full report.

Beating inflation, combating deflation

Gold is long considered a hedge against inflation and the data confirms this. The average compounded return of gold in yen during the seven years of Abenomics from 2013 to 2019 at 1.9% has outpaced the average annual inflation at 1.06% over the same period. Looking further back, the average annual return of 8.4% in yen since 1971 has also outpaced the Japanese consumer price index (CPI). 

Gold also protects investors against extreme inflation. In years when inflation was higher than 3% gold’s price increased 28% on average  (Chart 3). Over the long-term, therefore, gold has not just preserved capital but helped it grow. 

Notably too, research by Oxford Economics shows that  gold should do well in periods of deflation.⁸ Such periods  are characterised by low interest rates, reduced consumption  and investment, and financial stress, all of which tend to foster demand for gold. 

Outperforming fiat currencies

Investor demand has been boosted by persistently low interest rates and concerns about the outlook for the dollar, as these factors affect the perceived opportunity cost of holding gold.

Historically, major currencies were pegged to gold. That changed with the collapse of Bretton Woods in 1971. Since then, gold has significantly outperformed all major currencies as a means of exchange  (Chart 4).

This outperformance was particularly marked immediately after the end of the Gold Standard and, subsequently, when major economies defaulted. A key factor behind this robust performance is that the supply growth of gold has changed little over time – increasing by approximately 1.6% per year over the past 20 years.⁹ By contrast, fiat money can be printed in unlimited quantities to support monetary policy, as exemplified by the Quantitative Easing (QE) measures in the aftermath of the global financial crisis. For example, the Bank of Japan (BoJ) currently holds approximately 50% Japanese government bonds and is one of the first central banks globally to own more assets than the size of the economy it is trying to stimulate. Its balance sheet has risen from 32% of GDP in December 2012 to 103% of GDP in December 2019 after seven years of Abenomics. 

2. Diversification that works

The benefits of diversification are widely acknowledged – but effective diversifiers are hard to find. Many assets are increasingly correlated as market uncertainty rises and volatility is more pronounced, driven in part by risk-on/risk-off investment decisions. As a result, many so-called diversifiers fail to protect portfolios when investors need them most.

Gold is different, in that its negative correlation to stocks and other risk assets increases as these assets sell off (download the full report to see Chart 26). The 2008-2009 financial crisis is a case in point. Stocks and other risk assets tumbled in value, as did hedge funds, real estate and most commodities that were long deemed portfolio diversifiers. For example, the TOPIX fell by 28% from December 2007 to February 2009. Gold, by contrast, held its own and increased in price, rising 8% in yen over the same period.¹⁰

This robust performance is perhaps not surprising.

Gold has consistently benefited from “flight-to-quality” inflows during periods of heightened risk. It is particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses (download the full report to see Chart 25) Importantly too, gold allows investors to meet liabilities when less liquid assets in their portfolio are difficult to sell, undervalued or possibly mispriced.^11,12

As a safe-haven asset, gold also complements the Japanese yen. While the yen has thus far proven to be a reliable safe-haven due to the repatriation of overseas capital by Japanese investors and the unwinding of yen carry trades by their international counterparts  during times of crisis, the mounting macroeconomic challenges confronting the nation and the growing limits to monetary and fiscal remedies mean that investors can no longer be complacent over the safe-haven qualities of the yen. In this environment, gold plays an increasingly relevant role as a safe-haven asset in the portfolios of Japanese investors. 

But gold’s correlation does not just work for investors during periods of turmoil. It can also deliver positive correlation with stocks and other risk assets in positive markets.

This dual benefit arises from gold’s dual nature: as an investment and a luxury good. As such, the long-term price of gold is supported by income growth. Our analysis bears this out, showing that when global stocks rally their correlation to gold can increase (Chart 5), likely driven by a wealth-effect supporting gold consumer demand, as well as demand from investors seeking protection against higher inflation expectations.

3. A deep and liquid market

The gold market is large, global and highly liquid.

We estimate that physical gold holdings by investors and central banks are worth approximately ¥403 trillion (tn),  with an additional ¥98tn in open interest through derivatives traded on exchanges or the over-the-counter market.¹³

The gold market is also more liquid than several major financial markets, including Japanese stocks, German Bunds, euro/Yen and the Dow Jones Industrial Average, while trading volumes are similar to the S&P 500 (Chart 6). Gold’s trading volumes averaged ¥16tn per day in 2019. During that period, over-the-counter spot and derivatives contracts accounted for ¥8.5tn and gold futures traded ¥7.1tn per day across various global exchanges. Gold-backed ETFs offer an additional source of liquidity, with global gold-backed ETFs trading an average of ¥218 billion (bn) per day.

The scale and depth of the market allow it to comfortably accommodate large, buy-and-hold institutional investors. In stark contrast to many financial markets, gold’s liquidity does not dry up, even at times of acute financial stress. 

4. Enhanced portfolio performance

Long-term returns, liquidity and effective diversification  all benefit overall portfolio performance. In combination, they suggest that a portfolio’s risk-adjusted returns can be materially enhanced through the addition of gold. 

Our analysis of investment performance over the past two, five, 10, and 20 years underlines gold’s positive impact on an institutional portfolio. It shows that the average Japanese pension fund would have achieved higher risk-adjusted returns if 2.5%, 7.5% or 10% of the portfolio were allocated to gold. (Chart 7) and (Table 1). The positive impact has been particularly marked since the global financial crisis.

Looking to the future, stronger dynamics apply. Our analysis shows that Japanese yen-based investors can benefit from a material enhancement in performance if they allocate between 2% and 10% of a well-diversified portfolio to gold (Chart 8a).¹⁴

The amount of gold varies according to individual asset allocation decisions. Broadly speaking, however, the higher the risk in the portfolio – whether in terms of volatility, illiquidity or concentration of assets – the larger the required allocation to gold, within the range in consideration, to offset that risk  (Chart 8b).

Our analysis indicates that gold’s optimal weight in hypothetical portfolios is statistically significant even if investors assume an annual return for gold of between 2% and 4% – well below its actual long-term historical performance.

This works equally for investors who already hold other inflation-hedging assets, such as inflation-linked bonds,¹⁵ and for investors who hold alternative assets, such as real estate, private equity and hedge funds.¹⁶

Table 1: Gold increases risk-adjusted returns by reducing portfolio volatility and drawdowns across various time horizons

Comparison of an average hypothetical Japanese pension portfolio and an equivalent portfolio with 7.5% gold over the past two,  five, 10 and 20 years*

* As of 31 December 2019. The composition of the hypothetical average portfolio is based on a survey conducted by the Pension Fund Association on 18 January 2019 (for data as of FY2017), and as described on Chart 7 Ibid.

Source: Bloomberg, ICE Benchmark Administration, World Gold Council

Conclusion

Japan was once one of the largest importers of gold in the world, and while it is currently a net exporter we believe the environment is ripe for gold and can be embraced once again. Given the current macroeconomic conditions in Japan, the merits of holding gold in a portfolio are becoming increasingly relevant to the local investor.  

Perceptions of gold worldwide have changed substantially over the past two decades, reflecting increased wealth in the East and a growing appreciation of gold’s role within an institutional investment portfolio worldwide. 

Gold’s unique attributes as a scarce, highly liquid and un-correlated asset highlight that it can act as a genuine diversifier over the long term. 

Gold’s position as an investment and a luxury good has allowed it to deliver average returns of approximately 8.4% for nearly 50 years, comparable to stocks and more than bonds and commodities. (see Chart 2)

Gold’s traditional role as a safe-haven asset means it comes into its own during times of high risk. But gold’s dual appeal as an investment and a consumer good means it can generate positive returns in good times too.

This dynamic is likely to persist, reflecting persistent political and economic uncertainty, persistently low interest rates and economic concerns surrounding stock and bond markets (see 2020 Gold Outlook).

Overall, extensive analysis suggests that adding between 4% and 13% of gold to a Japanese yen-based portfolio could make a tangible improvement to performance and boost risk-adjusted returns on a sustainable, long-term basis. (see Chart 7).

Footnotes

¹See (Chart 7) for more details behind the composition of the hypothetical average Japanese pension fund portfolio.  
In addition, refer to important disclaimers and disclosures at the end of this report.

²Willis Towers Watson, Global Pension Assets Study 2018, February 2019 and Global Alternatives Survey 2017, July 2017. https://www.willistowerswatson.com/en-US/insights/2017/07/Global-Alternatives-Survey-2017

³As of 31 December 2019

⁴During the gold standard, the US dollar was backed by gold and the foreign currency exchange rates were dictated by the Bretton Woods System: https://www.imf.org/external/about/histend.htm.

⁵For other return metrics and y-o-y performance download the full report to see Appendix.

⁶Qaurum is a web-based quantitative tool that helps investors intuitively understand the drivers of gold’s performance that can be explained by four broad sets of drivers.

⁷Download the full report to see Chart 11 on page 10.

⁸Oxford Economics, The impact of inflation and deflation on the case for gold, July 2011.

⁹See the demand and supply section at Goldhub.com.

¹⁰Based on the LBMA PM gold price from 1 December 2008 to 30 November 2009.

¹¹Download the full report to see Chart 24 in the Appendix.

¹²Download the full report to see Chart 25 in the Appendix

¹³Download the full report to see Chart 10 and Figure 1 on p9 as well as the holders and trends section at Goldhub.com.

¹⁴Analysis based on the re-sampled efficiency methodology developed by Richard and Robert Michaud and praised as a robust alternative to traditional mean-variance optimisation. See Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Oxford University Press, January 2008.

¹⁵Gold as a tactical inflation hedge and long-term strategic asset, July 2009.

¹⁶How gold improves alternative asset performance, Gold Investor, Volume 6, June 2014.

¹⁷See: Gold: the most effective commodity investment, September 2019, and Gold: metal by design, currency by nature, Gold Investor, Volume 6, June 2014.