Team USA brought home nine gold medals from the Winter Olympics in South Korea, but other events along that peninsula have pushed investors to grab a lot more of the yellow metal.
Over the past year – a period that began with North Korea launching four missiles into the Sea of Japan in March last year, through Donald Trump threatening to unleash ‘fire and fury’ in August, to the latest reports of a planned meeting between the president and Kim Jong-un – a net total of $5.3 billion has been allocated to gold ETFs, according to monitoring firm TrackInsight.
The heaviest inflows over that period, though, did not come during bouts of elevated international tension. Instead, they came in early February when market volatility spiked. In the week of February 5, when the S&P 500 dropped by 5%, $4.6 billion was put into gold ETFs.
However, that did not prove to be much of a safe haven: That same week, the gold price slipped by 1.5%.
New research suggests that investors should not have been surprised by that: Gold is more of a hedge against geopolitical risk, not financial volatility.
Of course, geopolitical risk is hard to quantify objectively, but for their recent study, Dirk Baur of the University of Western Australia Business School and Lee Smales of Curtin University Business School drew upon work by two economists at the Federal Reserve, Dario Caldara and Matteo Iacoviello, who created their own Geopolitical Risk Index last year.
Caldara and Iacoviello defined geopolitical risk as those risks associated with wars, terrorist acts and tensions between states that affect the normal and peaceful course of international relations, including both the risk that these
events materialize and the risks associated with
an escalation of the existing conditions.
Indexing in vexing times
To construct an index reflecting these risks, the Federal Reserve economists used an automated text search of 11 leading global newspapers between January 1985 and November 2017. This tracked the incidence of words related to geopolitical tensions each month across several different categories: explicit mentions of geopolitical risk; references to military-related tensions involving large regions of the world and US involvement; words directly related to nuclear tensions; threats of war and terrorist threats; and press coverage of actual adverse geopolitical events, rather than threats or speculation, such as terrorist attacks or military conflict.
The resulting Geopolitical Risk Index documents the proportion of news articles discussing geopolitical risk in each month, normalized to a value of 100 for the decade beginning in 2000. An index level of 200 therefore indicates that newspaper mentions of rising geopolitical risk in that month were twice as frequent as the average during the 2000s.
Reviewing a chart of this index – freely available online – suggests that this methodology does effectively capture spells of heightened geopolitical tension. The index peaked in March 2003 at 536 when the US invaded Iraq, while other notable spikes occurred around the September 2001 terror attacks and the Ukraine crisis in August 2014, for instance.
Using this index, Baur and Smales identified a positive and highly significant relationship with gold: Increases in geopolitical risk were associated with increases in the gold price and vice versa. A one standard deviation change in the Geopolitical Risk Index, for example, yielded a 0.8% gold price return.
However, this pattern was only observed with gold, and not with other precious metals such as silver, palladium or platinum. Baur and Smales deemed this to be ‘consistent with gold’s role as a safe haven during times of heightened geopolitical risk.’
The academics also investigated the relationship between the Geopolitical Risk Index and both the S&P 500 and copper – a purely industrial metal closely correlated with global economic growth. Baur and Smales supposed that greater geopolitical risk would be associated with negative returns in both assets, which they determined was indeed the case.
Pre-empting enquiries from crypto enthusiasts, the pair also considered how bitcoin fared during periods of geopolitical risk. The virtual currency did in fact display ‘a comparatively large and positive response to an increase in geopolitical risks,’ but Baur and Smales noted that this was not statistically significant, attributing it to ‘the extreme volatility of bitcoin.’
‘This similarity to the reaction of gold is not surprising given that both assets share key features, such as a constrained supply, costly mining, decentralization, independence of any government and global and continuous trading,’ Baur and Smales remarked.
So when the VIX is in the headlines, don’t rely on gold. But when war hits the front pages, that bullion ETF may prove its worth. Investors should also remember that the largest gold ETF out there is not the cheapest: The $36 billion SPDR Gold Trust costs 0.4%, while the $11 billion iShares Gold Trust is available for just 0.25%.