My June 1, 2020, article “ Is it a Golden Opportunity?” examined the historical evidence on whether gold is a good inflation hedge (only over extremely long horizons, and failing dramatically over multiple decades); whether it acts as a hedge against equity risks (not perfectly, though it did increase in value in 83 percent of bear markets); whether it is under-, over- or fairly valued relative to a “golden constant” – the average real price of gold has been about 3.5 times the U.S. Consumer Price Index – (it’s overvalued); and the relationship of gold to the marginal cost of producing it (it’s well above current marginal costs). Today we’ll review new research on the hedging and safe-haven properties of precious metals (gold, silver, palladium and platinum).
Dirk Baur and Lee Smales contribute to the literature with their study “Hedging Geopolitical Risk with Precious Metals,” published in the August 2020 issue of the Journal of Banking & Finance. They examined whether there is any relationship between geopolitical risk and precious metals prices. They used the geopolitical risk (GPR) index (a monthly indicator of geopolitical risk based on a tally of articles from 11 leading international newspapers covering geopolitical tensions) of Dario Caldara and Matteo Iacoviello to examine the relationship between asset prices and geopolitical risk. Their goal was to determine if precious metals are potential hedges and safe havens. Their index captures an important dimension of uncertainty: the risk of events that disrupt the normal, democratic and peaceful course of relations across states, populations and territories.
In their 2018 study “Measuring Geopolitical Risk,” a Board of Governors of the Federal Reserve System International Finance Discussion Paper, the authors found that “high geopolitical risk leads to a decline in real activity, lower stock returns, and movements in capital flows away from emerging economies and towards advanced economies.” When they decomposed the index into threats and acts components, they found that “the adverse effects of geopolitical risk are mostly driven by the threat of adverse geopolitical events.”
In their study, Baur and Smales focused on a relatively narrow characterization of geopolitical risk, deﬁned as “the risk associated with wars, terrorist acts, and tensions between states that affect the normal and peaceful course of international relations.” Thus, their study omits events such as the dissolution of the Soviet Union (December 1991) and the Brexit referendum (June 2016). Their data sample covered the period January 1985 to October 2018. In the figure below, a reading of 100 indicates that newspaper mentions of geopolitical risk were equal to the average frequency during the 2000s. When no geopolitical news articles were published on a particular day, the index has a value of zero (88 of 8,537 observations). The index reached its high point of 536.22 in March 2003 when the U.S. invaded Iraq. The most notable spikes occurred in April 1986 (U.S. bombing of Libya), January 1991 (First Gulf War), September 2001 (9/11 terror attacks), March 2003 (Second Gulf War), August 2014 (Russia-Ukraine crisis) and November 2015 (Paris terror attacks).
Note: This ﬁgure plots the GPR Index over the period 1985-2018. Source: “Measuring Geopolitical Risk” by Dario Caldara and Matteo Iacoviello. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results.
Following is a summary of their findings:
Geopolitical risk is distinct from existing measures of economic, ﬁnancial and political risk. The response of precious metals to geopolitical risk differs considerably from that of other assets. All precious metals are positively related to geopolitical threats, but not to actual geopolitical events – they respond to geopolitical threats, but not to realizations (acts) of such threats. Treasury bond prices rise when GPR increases during periods of high GPR. For extreme geopolitical risks, among the precious metals, only gold and silver display consistent safe haven properties. The likely explanation is that palladium and platinum are also industrial metals. Bad news (negative returns) increases volatility by more than good news. The effect is positive for gold, platinum and silver (not palladium).
Increases (decreases) in geopolitical risk are associated with increases (declines) in precious metals prices. A one standard deviation change in GPR produced a gold price return of 0.107% over one day as compared to the mean daily return of 0.016%. A similar GPR change was associated with daily returns of 0.219% in palladium, 0.081% in platinum (not statistically signiﬁcant) and 0.172% in silver. This implies that gold, palladium and silver are a hedge against heightened geopolitical risks.
The lack of statistical signiﬁcance demonstrated for Treasury notes and the U.S. Dollar Index returns suggests that they are uncorrelated with changes in GPR. Thus, they may be classiﬁed as a weak hedge to geopolitical risk. Despite gold having often been considered an important inﬂation hedge, there was no statistically signiﬁcant relationship with the CPI for gold or any other asset. Gold is positively related to changes in the CBOE Volatility Index, or VIX (which negatively correlates with stock returns).
Their findings led Baur and Smales to examine eight possible trading strategies based on signals provided by the GPR (increasing exposure to precious metals when the index was at high and rising levels). They considered a trading strategy that goes long a precious metal future (or equal-weighted portfolio of futures) when a geopolitical risk trading signal is generated, and otherwise invests at the cash rate. They also considered a hedging strategy that adds a long position in a precious metal future (or equal-weighted portfolio of futures) to an existing stock portfolio (proxied by the return on S&P 500 futures) when a geopolitical risk signal is generated, and otherwise holds the stock portfolio only. Based on using actionable strategies (using available data at the time), using daily signals, only one of the eight strategies produced a higher risk-adjusted return for gold. Using monthly signals, none of the eight produced higher risk-adjusted returns. Using raw returns, none of the strategies produced superior returns for gold.
Based on their findings, the authors concluded: “The empirical analysis reveals that precious metals have some ability to hedge geopolitical risk but only gold and silver appear to possess this property consistently for both normal and extreme geopolitical risks.” They added: “The results conﬁrm that it is worthwhile for investors to maintain a holding of precious metals in their portfolio to hedge against geopolitical risk.” However, given the results of the tests of trading strategies, which did not even include trading costs, it does not appear that one can use signals on geopolitical risk to shift allocations. When drawing your own conclusions, make sure you do so based on the evidence and are not influenced by your preconceived notions (such as that gold is a good inflation hedge).