Gold As An Inflation Hedge?

Its the eternal question that invariably pops up in most conversations with friends, colleagues and family in fact I would go so far as to say in Egypt its a public argument with proponents and antagonists Gold is often considered a safe-haven asset, believed to protect against economic downturns and currency devaluations. Real estate investment, on the other hand, offers tangible assets with income-generating potential and the possibility of long-term appreciation. This analysis will delve deeper into the advantages and disadvantages of both gold and real estate investments, aiding people in making informed decisions based on their financial objectives and risk appetite.

Let me start with what the legendary investor of our time says . In a 2012 article, Warren Buffett, a legendary investor, provided a compelling analogy to explain his skepticism towards gold as an investment. He compared the value of the world's gold stock, approximately 9.6 trillion US Dollars at that time, to potential investments in other productive assets. In a brilliant analogy he explained

At that time, the world's gold stock was worth about 9.6 trillion US Dollars. For that amount of money,

"You could buy all of the crop land in the US - 400 million acres with roughly $200 billion of annual output - and 16 ExxonMobils - each one earning $40 billion annually. Still after buying those assets, you would have 1 trillion U.S. dollars in cash leftover."

Buffett explains that a century from now, the 400 million acres of crop land will have produced a massive amount of output regardless of the currency regime at the time.

Exxon will have produced trillions of Dollars in profits for shareholders, while also growing its assets to be worth many more trillions.

The gold will have remained unchanged in size and will still be unable to produce anything.

As Buffett says,

"You can fondle the gold, but it will not respond."

Buffet's argument makes logical sense, but does it hold up under scrutiny? that with the same amount, you could purchase all the crop land in the US (400 million acres with roughly $200 billion annual output) and 16 ExxonMobils, each earning $40 billion annually, and still have 1 trillion US dollars in cash leftover. The key message here is that productive assets like farmland and thriving companies generate real value and cash flow over time, while gold remains an inert asset with no inherent ability to generate returns or contribute to economic growth. Most people would respond with but it is safe its a long term investment - you could invest in something that will bring no value . In fact this is true and really true about nearly anything but lets go further - is it really that safe ?

In an extremely interesting analysis made by investment house Goldman Sachs'argue that gold lacks income-generating capabilities, making it a less compelling asset for long-term investors who seek regular returns. Additionally, gold's price volatility can create challenges for investors looking for stable and predictable investment performance. Despite these reservations, Goldman Sachs acknowledges that gold can serve as a hedge during uncertain economic times, providing a safe haven for investors seeking to protect their wealth from market turbulence and geopolitical risks.

An inflation hedge really?

I cam upon this analysis by chance and though it may be old its gold Claude Erb and Campbell Harvey conducted a thorough analysis of gold in their 2012 paper, titled The Golden Dilemma First, they looked at gold as an inflation hedge by taking gold returns going back to 1975, to 2012, they found that gold has not been a good inflation hedge over the short or long-term due to the volatility of its real price. Honestly shocker.

According to their findings gold's real price volatility made it an inconsistent hedge against inflation over both short and long terms. Gold's price did not consistently align with changes in the Consumer Price Index (CPI), questioning its effectiveness as a reliable inflation hedge.

Erb and Harvey also examined gold's performance during periods of above-average inflation. They found that gold did not guarantee above-average returns during such periods.

To explain it with a very apt analogy

If you happen to have a debt that's due in 2,000 years, then gold might just be the perfect way to keep your purchasing power intact. Erb and Harvey did find that, going all the way back to Emperor Augustus who ruled from 27 BC to 14 AD, gold has proven to be quite the inflation hedge when measured against military pay.

Campbell and Harvey said,

"In normal times, gold does not seem to be a good hedge of realised or unexpected short-run inflation. Gold may very well be a long run inflation hedge. However, the long run may be longer than an investor's investment time horizon or lifespan."

In short, there’s no guarantee if there’s a spike in inflation, gold will also generate above-average returns. The chart above shows total returns for commodities, Real Estate Investment Trusts (REITs) and gold during inflationary periods. Gold has a mixed track record during past periods of high inflation

Real estate investment offers several advantages that gold lacks. Firstly, it provides a tangible and income-generating asset through rental income. Real estate properties can generate steady cash flow, making them a reliable source of income for investors. Secondly, real estate assets have the potential to appreciate over time, driven by factors such as location, market demand, and property improvements. Additionally, real estate serves as a natural hedge against inflation, as property values tend to rise with the cost of living. Furthermore, real estate investments can be leveraged through payment facilities, allowing investors to control a more substantial asset base with a smaller upfront investment.

Not to say that real estate investment does not involve risk - no any investment is risky by its very nature If you buying to rent property management can be time-consuming and require expertise, particularly for landlords handling multiple units. Market fluctuations and economic conditions can influence the property's value and rental demand, affecting the overall return on investment. Additionally, real estate investing requires a more significant initial capital investment compared to gold, which can be purchased with smaller amounts.

Any investment is bumpy ride

And the choices are limited to stocks, gold and real estate. But while one is a proponent of gold - how much of your portfolio you choose to invest is what is important. As Buffet put it aptly

"This is not an asset with any output. Gold will always be gold and it will be worth whatever someone is willing to pay for it. We may hope that it will maintain its real value, meaning an inflation adjusted expected return of zero, but historically it has had a very volatile real value."

Erb and Harvey also highlight an important point - being considered a safe haven on paper doesn't necessarily mean that it will safeguard the actual wealth of the owner in a true catastrophe.

Individuals who strongly advocate for investing in gold as part of a portfolio are likely not considering it as a long-term investment. Instead, they view it as a long-term insurance policy against catastrophic events such as hyperinfation.

According to Erb and Harvey's findings, the real value of gold, in terms of its purchasing power, remains relatively stable across the globe at any given time.

Let's take Brazil from 1990 to 2000, as an example. The average inflation rate during this time was 250%. The real price of gold in Brazilian terms fell by about 70%. While gold may not have been a highly successful inflation hedge in Brazil during this period, it still fared better than holding Brazilian cash, which lost almost 100% of its value.

Does that make it a good hedge?

Not really.

The actual returns of gold are not influenced by the inflation environment in a particular country. Gold remains indifferent to this and may experience significant negative real returns during a period of hyperinflation.

It can't be assumed that gold will maintain its purchasing power or generate positive real returns, simply because there was a bout of hyperinflation in the country you live in.

So to sum it up Gold is not a productive asset

It has a real expected return of zero.

It might keep pace with inflation over the very long-term, but that's probably longer than most people can wait.

Even as a safe haven, due to its low correlation with financial assets, gold falls short in a portfolio due to its non-existent real expected return.

Finally, while gold's purchasing power is unaffected by inflation, that doesn't mean that gold will maintain its purchasing power during periods of inflation, calling into question its ability to hedge against extreme currency events.