Use price dips for 10% allocation as gold continues to lose lustre

Use price dips to build a 10% allocation to gold

Gold, long viewed as the quintessential safe haven for investors, has faced a tumultuous year. Having begun on a strong note, it has been on a downward trajectory over the past three months. Experts say investors should continue with their allocation to the yellow metal even though it may continue to disappoint for the next few months.

Driven by US Fed action

In March-April 2023, gold’s price surged in response to the risk aversion in the United States (US) as several regional banks collapsed in quick succession. 

The market expected the US Federal Reserve (Fed) to undertake multiple rate cuts in 2023 to deal with the expected financial instability. 

The US debt ceiling issue and fears of a potential default by the government also supported gold.

“Once it became clear that the pain in the US banking sector would not spread, and the debt deal also got approved, the markets realised that the US Fed would not be compelled to cut rates soon. From multiple rate cuts, the expectation changed to at most one rate cut in 2023,” says Ghazal Jain, fund manager, Quantum Mutual Fund.

While the Fed paused in June, it hiked the Fed funds rate by 25 basis points in July.

“Now, the market doesn’t expect even a single rate cut in 2023,” says Jain.

After July’s hike, both bond yields and the dollar index firmed up.

“The strengthening of the US dollar caused a decline in gold’s price as the two are inversely correlated,” says Joseph Thomas, head of research, Emkay Wealth Management.

Real interest rates in the US are in positive territory.

Real interest rates and gold, too, have an inverse relationship,” says Manav Modi, analyst, commodity research, Motilal Oswal Financial Services.

Investors flock to gold in recessionary times.

At the start of the year, investors feared a recession in the US.

“That fear has not materialised. This has also impacted gold adversely,” says Modi.

Underperformance may continue

The economic data coming out of the US points to a sluggish but a fundamentally robust economy. While consumer price index (CPI)-based inflation has moderated towards the 3 per cent mark, it is still far from the Fed’s 2 per cent target.

“There is a sense that it could be difficult for the Fed to bring down inflation from the current levels as the effect of a high base will also go away over the next few months,” says Jain.  

Adds Thomas: “The Fed may undertake another 25-basis-point hike before the end of this calendar year.”

This could mean more downside for gold, at least over the next three months.  

Turnaround once rate hikes end  

Gold’s price could move up once the Fed indicates that it is done with rate hikes.

“The US dollar would then lose ground and gold would gain,” says Thomas.

According to Jain, gold could also revive if an event akin to the regional banking crisis of March-April recurs, or if US economic growth slows down considerably, forcing the Fed to cut rates. 

Modi adds that an escalation of geopolitical tensions, say, between the US and China, or an intensification of the war between Russia and Ukraine would also be positive for the yellow metal.

The central banks of China, Russia, Kazakhstan and India have been building their gold reserves in recent times. “Continued central bank purchases of gold would also provide support,” adds Modi.

Maintain allocation

Returns from gold tend to be lumpy. “Since gold doesn’t offer consistent returns each year, one needs to have a longer-term allocation to it,” says Thomas.

Hold the yellow metal with at least a seven-year horizon. It is imperative to maintain at least a 5-10 per cent allocation to gold in one’s portfolio.

Investors who don’t have the requisite allocation to gold should use the expected period of price volatility (due to a possible Fed rate hike) to build their allocation. Jain suggests avoiding lump-sum investments and going for staggered purchases.

Existing investors should also hold on to their allocation and avoid exiting gold despite the recent spell of underperformance.