GLD: Excellent Addition To An Equity Portfolio – But Ignore The Narratives

It appears that over the past few years, SPDR® Gold Shares ETF (NYSEARCA:GLD) and gold more broadly have not done a great job at reducing risk for all-equity portfolios.

Since 2022, both the S&P 500 (SP500) and the GLD ETF have been moving in unison, with the latter deliver similar returns to the equity market since my first article focusing specifically on the exchange-traded fund (“ETF”).

But before you jump to conclusions and assume that the shiny rock has no place in one’s portfolio, consider how bonds have done during the same time frame.

With 10-year Treasury yield (US10Y) still above 4%, bonds now appear as a good alternative to gold when it comes to combining them with an all-equity portfolio. However, in reality the precious metal should remain as an asset class of choice when it comes to equities.

But before we go into further detail on why this is likely to be the case, we should first debunk some popular myths about gold that are causing many investors to stay away.

It’s Only Noise

Holding the GLD as a mean to offset inflationary pressures is one of the most popular misconceptions out there. There is some truth that gold retains its real value in inflationary periods, but this is not the case over very short periods of time.

This is exactly what happened during 2022-23 period, when we saw inflation accelerate at its fastest pace since the 1980s.

During the same time-frame, however, the GLD and the price of the precious metal have gone nowhere (see below). Naturally, this has been a bitter pill to swallow for short-term investors – and anyone who has been wrongly expecting for gold to appreciate just as inflation is picking up.

Another important misconception about gold that you need to be aware of is the notion that there’s always an inverse relationship between the price of the precious metal and real interest rates. As we see on the graph below, such a relationship does not exist if we monthly date for the past 10-year period.

If this inverse relationship was constant, then we would expect that either the price of gold should come down sharply or that real interest rates are heading lower. As we will see in the next section, the latter is a possibility, but it will bring significant problems with it that will likely propel the GLD to new highs.

Not only is the inverse relationship between gold and real interest rates not constant, but during certain periods of time it could actually become positive. This has been the case for the past 2 years, when the risk for the global monetary system has increased dramatically.

This leads us to the main reason why gold is attractive at the moment and would likely remain for the foreseeable future: namely, the rising risks for the existing global monetary regime and the need for a change.

The Uncertainty Ahead

Fluctuations in the GLD ETF could be expected in the short-term, but as your investment time horizon increases, the potential downside is being reduced. The reason being that we are gradually moving toward a change of the current monetary system that appears to be inevitable.

Even if such change is not necessarily a bad thing for the global economy, the sole fact that there is uncertainty about the existing regime is enough to provide a long-lasting tailwind for the GLD ETF.

As before, a pending recession could be a major trigger event for more uncertainty regarding the stability of the current system, and right now it appears that an economic slowdown is in the cards.

Historically, recessions are associated with significant increases in the fiscal deficits as a share of GDP, but this time around we will be entering a potential recession already with significant budget deficit.

An economic slowdown should cause a drop in tax receipts, which in turn will widen the budget deficit even further, thus limiting the potential for fiscal stimulus without a significant increase in debt levels.

More borrowing would likely be a problem, with net interest expense of the U.S. Federal Government already being off the charts.

All that essentially puts the U.S. government between a rock and hard place when it comes to the current monetary regime.

On one hand, higher interest rates would lead to higher budget deficits which could easily trigger more inflationary pressures as the government needs to navigate the road out of a recession. Higher inflation would then keep interest rates at elevated levels which would trigger the whole process once again.

On the other hand, central banks could come to the rescue once more and reverse course on their declining holdings of U.S. Treasuries. This, however, will cement the view that the current system cannot function properly on its own and would require an ever-growing presence of central banks.

In my view, both of these scenarios will provide a tailwind for the price of gold and the GLD even in the case of higher interest rates, hence the positive relationship between the price of gold and real interest rates we saw above.

Investor Takeaway

The GLD is still an excellent addition to an all-equity portfolio, even though the correlation with the S&P 500 has turned positive. Since my last thought piece on gold, the uncertainty for the current monetary regime has continued to increase and with that gold is in a very good position to break-up from its current resistance levels.