Hedging your bets

Kerry Craig

Markets will be dominated by news from the US in the coming weeks as the political showdown over the funding of the US government continues. So far, the government shutdown has not created high levels of anxiety in markets. This is because the shutdown itself is not the big problem for investors or US politicians, but failure to reach an agreement on the debt ceiling might be.

If the US did default on Treasury debt, the damage to the economy would be huge. The US is expected to reach its borrowing limit around the middle of October, but there is potentially enough cash down the back of the sofa for the US government to continue to meet obligations for another couple of weeks after this without additional borrowing. However, the closer we come to the debt ceiling deadline, the more uncertainty there will be in the markets and more likely it is that investors will drift towards safer assets such as gold until the picture becomes clearer.

Traditionally, demand for gold has largely been driven by those investors seeking a safe haven asset, a hedge against inflation, or an overall portfolio diversifier – gold has a relatively low historical correlation with traditional asset classes. The idea is that since gold is a physical asset it should always hold some tangible value, even if financial assets do not. However, the situation in the US is largely noise against the broadening momentum in the global economy, and if investors are considering changing their allocation towards commodities at this time, they may be well served to refocus that allocation to take advantage of the economic upturn.

Commodities suffered over the first three quarters of the year, largely driven by the rising US dollar on the back of a potential tapering of the US Federal Reserve’s quantitative easing programme and the growing fears over the impact of a slowdown in China. Tapering has been delayed and economic data from China suggests that the economy is stabilising, resulting in better performance from commodities over the three months to September. The recovery is still only in its fledgling stages in some regions, but broadly the data suggests that a continued strengthening of the global economy is likely.

There is a large amount of variability across commodities as they have different supply and demand dynamics and price drivers. As such, investors should not consider specific commodities in isolation, but as part of a range of investable commodities, including precious metals like gold and silver, industrial metals like copper, as well as energy and livestock. In the same way investors generally try to avoid holding an overly concentrated position in a single stock, placing too much weight in a single commodity can expose investors to unnecessary risk.

As the global economic recovery broadens, it will be important to consider the role of monetary policy and, in particular, the actions of the US Federal Reserve. Even though the economic environment is improving, central banks will keep monetary policy loose until the economy really gains traction. In advanced markets, central banks have pumped vast quantities of money into economies to stimulate growth. This increase in the money supply has not translated to higher rates of inflation as was initially feared. However, while inflation is not a problem now, it may become one in the future. As the economic recovery is in its infancy, central banks may be prepared to accept higher future inflation if it means faster economic expansion. This may see a rise in the gold price as investors hold it to hedge against inflation. However, gold is not the only option in this respect: commodities in general can provide a similar inflation hedge.