- The simplest way to think about this relationship is to first consider gold’s role as a diversifying and defensive asset in most investor’s portfolio. Investor’s have historically sought to hold gold during periods when there have been sharp jumps in risk aversion and when equity markets typically move lower. But as the variability of equity prices has risen, the variability in gold prices has also been pushed up as excess demand for gold has come into the market from investors looking for defensive assets. The rise in variability in gold prices has in turn pushed up the expected future variability in gold prices as implied from option prices causing the risk aversion level in gold markets to rise. Overall this should be seen a benefit to holding gold as it reaffirms its defensive qualities during periods of rising risk aversion in other asset markets, notably equity markets.The most interesting pattern we can perhaps observe in the chart is the positive relationship between the level of risk aversion (the gold volatility risk premium) and the gold price which is the opposite of what would typically be observed in other asset classes where a negative relationship would be more common. In the chart below spikes in the level of risk aversion above +10% were always accompanied with strong increases in the price of gold.
Source: Bloomberg LP; Treesdale Partners calculations; past performance is no guarantee of future performance.
- The sharp fall in risk aversion in October 2013 where the indicator dipped to -10% coincided with a period of strongly rising equity prices and sharply lower gold prices as the desire to hold defensive assets, in particular gold, fell out of favor and saw the gold price retreat rapidly from its $1800 high.
- The average volatility risk premium over the 10 years has been +1.5%. By way of comparison the average for the S&P 500 index over the same 10 year period is 1.1% (Source: Bloomberg LP) which is of similar magnitude as in the gold market. An detailed discussion for the persistence of the risk premium over long periods of time is beyond the scope of this paper but it does speak to the extent to which investors’ expectations of future market variability impacts the pricing of risky assets
- The most recent three month period has seen the level of risk aversion jump to the current 5.4% level as the rise in global equity markets has stalled and bond yields have tumbled. The rise in the gold volatility risk premium is indicating that investors are pricing in the potential for a significant rise in future market variability and gold may be a beneficiary of this rise in risk aversion as investors once again look to gold as a defensive asset to improve the diversification of their portfolios. This should be supportive for gold prices in the short term.