Rethinking Gold's Reliability as an Inflation Hedge

As inflationary pressures continue to mount in global economies, many investors are looking to gold as a potential hedge against the erosion of their purchasing power. Gold has long been considered a store of value and a safe-haven asset in times of economic and political turmoil. Being a tangible asset with a limited supply, Gold offers a degree of protection against currency debasement and can serve as a reliable store of value during inflationary periods.

The Shifting Performance Drivers of Gold

The performance of gold is influenced by an intricate web of factors, making it a complex and multifaceted asset. While long-term trends and macroeconomic forces are crucial in determining gold's overall trajectory, short-term price movements are shaped by a diverse array of influences, including market demand shifts, geopolitical tensions, and changes in investor sentiment. As a result, the drivers of gold prices are constantly shifting, reflecting the dynamic nature of the global economy and the investment landscape.

• Opportunity Costs - Real Interest Rates: A critical factor in determining gold prices is the dynamic relationship between real interest rates and inflation. As real interest rates decline, the opportunity cost of holding gold decreases, rendering the precious metal more attractive to investors. In contrast, when real interest rates rise, investors may shift their focus towards alternative assets that offer higher returns, consequently exerting downward pressure on gold prices. The degree to which gold prices respond to real rates is influenced by the prevailing economic climate, particularly whether the real rate adjustment occurs amidst concerns about economic expansion or within an environment of growth optimism.
• Geopolitical Tensions: During times of economic or political turmoil, gold is widely regarded as a safe-haven asset, which drives up demand and, in turn, leads to price increases. For example, the COVID-19 pandemic has caused uncertainty and volatility in global markets, leading to an increased demand for gold as a safe-haven asset. The same can be said for other crises, such as military conflicts or political upheavals, which have historically driven investors towards the relative safety of gold. However, the impact of geopolitical tensions on gold prices varies depending on the situation. Geopolitical events involving the US tend to have a much bigger positive effect on gold prices. This could be due to the fact that the USD itself often acts as a safe-haven asset when tensions arise in other parts of the world. But when the US itself is affected, investors tend to go into gold as a hedge of last resort, driving up demand and prices.
• Fear: When uncertainty and risk increase, investors shift their preference towards safe-haven assets like gold, driving up its prices. Fear is the primary medium to short-term driver of gold, and preference shifts towards gold as uncertainty rises. The growth rate of the money supply, volume and quality of debt, political uncertainty, confiscation risk, and attractiveness of other assets all influence investor preferences in relation to gold. The fear of a decline in confidence in government and its currency leads to hoarding and an increased demand for gold, as it is perceived to be a safe store of value.

• Expected and Unexpected Inflation: As we have observed in recent weeks, gold prices can be influenced significantly by unforeseen shifts in central bank policies and unexpected inflation, particularly in the short term. The inherently difficult-to-predict nature of unanticipated inflation emphasizes the importance of inflation-sensitive assets like gold, which typically outshine traditional assets in high or escalating inflationary environments.
• Central Bank Policies: Monetary policies enacted by central banks across the globe have a profound influence on the trajectory of gold prices. To curb inflation, several monetary authorities have recently initiated tightening cycles, resulting in higher bond yields. This development has led to downward pressure on gold prices, as investors seek better yields in fixed income assets. However, uncertainties surrounding the pace and extent of such tightening persist, which could potentially limit its negative impact on gold prices. For instance, if central banks tighten policies too aggressively, the risk of recession looms large. In such scenarios, gold's reputation as a safe-haven asset is bolstered, as investors seek refuge from the turmoil in the broader markets. This renewed interest in gold has the potential to offset the downward pressure exerted by higher interest rates.
• Central Bank Credibility: Central banks' policy decisions, and their credibility in carrying out these policies, influence investor behavior and affect gold prices. In the current environment of tightening policy and persistent recession concerns, the tactical direction of gold will be determined by shifts in the Fed's priority function between fighting inflation and supporting growth. Moreover, central banks' commitment and ability to maintain inflation at or near their target can anchor medium and long-term inflation expectations, reducing the uncertainty around future price developments. Public trust in central banks is, therefore, necessary for efficiently managing inflation expectations and influencing investor behavior.
• Supply and Demand Dynamics: Gold prices are affected by both supply and demand dynamics. On the supply side, new gold deposits and changes in mining production can impact overall supply, which in turn affects prices. Technological advancements in mining and exploration, as well as geopolitical factors in gold-producing countries, contribute to fluctuations in supply. On the demand side, central banks play a significant role in the gold market as they hold substantial reserves of the metal. Changes in central bank buying or selling can have a substantial impact on gold prices. The World Gold Council estimates that only 25% of global above-ground gold stocks are held for private investment purposes. The remaining stocks are utilized in jewelry, central bank reserves, and industrial applications. This diverse demand base helps to shield gold prices from extreme fluctuations and provides a solid foundation for its value.
• Currency Exchange Rates: Since gold is priced in US dollars, the trend in the greenback has historically impacted performance meaningfully. When the value of the US dollar declines, gold prices tend to rise, as it becomes cheaper for investors holding other currencies to purchase the metal. This correlation has been mostly consistent, albeit with some deviations along the way, as gold prices also tend to be firm on the back of safe-haven flows.

Expected vs Unexpected Inflation

Investors often employ gold as a hedge against unexpected inflation, as it is more disruptive to their portfolios compared to expected inflation, which is already factored into asset prices such as bonds. Treasury bond prices, for example, are notably affected by unexpected inflation arising from unforeseen events, as their current prices carry the expected real interest rate, an expected inflation rate, and a risk premium. An unexpected surge in inflation typically causes the expected inflation embedded in the yield to rise and the bond price to fall. If the new level of expected inflation is permanent, bonds with higher durations will be more sensitive than those with shorter durations. Commodities, particularly gold and energy, show stronger performance as they often contribute to inflationary pressures. Notably, unexpected inflation poses significant risks for equity investors.

Gold, on the other hand, demonstrates unique performance patterns during periods of expected and unexpected inflation. Unexpected inflation, calculated as the realized inflation level minus the expected inflation typically uses the change in the inflation rate as a proxy. Alternative and more advanced statistical models, such as autoregressive time series models, can help derive the expected inflation rate, which can then be used to gauge unexpected inflation. However, Ang 2014 suggested that simpler models are a good approximation compared to other forecasts methods such as surveys.

Inflation beta, a widely utilized measure by practitioners and researchers, captures the sensitivity of diverse assets and investment strategies to unexpected inflation. Generally, bonds and equities exhibit negative inflation betas, while assets like gold or trend-following strategies display positive betas.

As shown in the chart below, commodities such as gold and real estate have demonstrated high unexpected inflation betas, ranging from 2 to 8 over the past five decades. In the case of gold, this implies that a 1% increase in unexpected inflation could potentially result in an 8% price increase. Conversely, equities and bonds have proven to be less effective in mitigating the effects of unexpected inflation.

It is worth mentioning that a comprehensive study conducted by Erb and Harvey (2013) explores the long-term efficacy of gold as an inflation hedge. Their research indicates that gold's considerable volatility undermines its reliability as a hedge, with its performance primarily fueled by the extraordinary appreciation during the oil shock of 1979 to 1980, subsequent to the Iranian revolution. This period witnessed the real gold price skyrocketing to an unprecedented high, while inflation rates surged to approximately 13%.

Evidence of comovement between unexpected inflation and gold performance varies across countries. Positive comovement is consistently observed between US unexpected inflation and gold, whereas episodes of negative comovement transpire in other countries, particularly during negative unexpected inflation periods. This asymmetric relationship between gold and inflation shocks underscores the importance of gold as a strategic asset in hedging against the detrimental effects of unexpected inflation on investment portfolios.

Structural Changes - Is Gold still an effective inflation hedge?

Historically, gold prices were closely correlated with consumer price inflation. According to a study by the World Gold Council using data since 1971, gold has returned 15% per annum on average when inflation has been higher than 3%, compared to just over 6% per annum when inflation has been sub-3%. However, evidence suggests the interaction between the gold price and inflation is now weaker, arguably since the early ‘90s, and it’s important to understand the cause to determine whether it is a permanent breakdown.

The abolition of the Bretton Woods system in 1971 does for many mark a major structural change for the gold market since now it become something like a true free market that is free to react to the interplay of supply and demand.

Using a factor decomposition model, allows us to isolate the primary drivers of gold prices over time. This is particularly noteworthy during the aforementioned Second Oil Crisis which witnessed the real gold price soaring to a record high. The period between 1979-1982 (left chart), which is the Second Oil Crisis, had the following key factors pushing up the gold price:

• Political risk: The period was marked by geopolitical tensions, such as the Soviet invasion of Afghanistan and the Iran hostage crisis, which raised political risk.
• Inflation: Inflation was high during this period due to the oil supply shock caused by the Iranian revolution.
• Changes in real interest rates: Real interest rates were negative during this period, which increased demand for gold as a store of value.
• Weaker US dollar: The US dollar was weakening during this period due to a combination of high inflation and political uncertainty.
• Financial stress: The period was marked by high levels of financial stress, which further increased demand for gold as a safe haven asset.

In contrast, the financial crisis period from 2007-2010 (right chart) had a different set of factors influencing the gold price:

• Depreciation of effective dollar exchange rate: The US dollar was weakening during this period due to concerns over the health of the US economy and the impact of the global financial crisis.
• Heightened levels of financial stress and high default premiums: The financial crisis led to increased uncertainty and risk aversion, which boosted demand for safe haven assets such as gold.
• Federal Reserve's quantitative easing policy: The Federal Reserve's policy of quantitative easing, which involved large-scale asset purchases and an expansion of the monetary base, raised concerns about medium-term inflation and increased demand for gold as an inflation hedge.

As visible now, there are many constantly shifting factors that impact gold's correlation with real rates which result in an overall inconsistent reliability of gold as an inflation hedge. Key factors like concerns over economic recessions and elevated central bank buying have contributed to gold's resilience in an environment of fluctuating real interest rates. Going forward, there may be additional factors that need to be taken into consideration:

• Geographical shift in economic power: The relative position of the US is likely to change as the economic power shifts towards fast-growing emerging economies, especially in Asia. This may affect the gold market by altering its structure and potentially generating a new long-run equilibrium for gold prices.
• Rapidly growing EM demand: The demand for gold is rapidly growing in Asian markets, including China and India, as they have traditionally been strong sources for both jewelry and as a store of wealth. The increasing income and wealth levels in these countries are now driving up the demand for gold, which could result in gold prices consistently rising at a faster rate than the US inflation rate, generating a positive return on gold holdings. Furthermore, emerging market central banks are diversifying their assets by adding to their gold reserves to maintain political neutrality. This increased demand has provided a level of price support for gold, regardless of inflationary pressures in developed markets.
• Technological advancements and the rise of digital currencies: Cryptocurrencies like Bitcoin, with their algorithmic scarcity, share some similarities with gold's scarcity. However, Bitcoin is untested as an inflation protection asset, with less than a decade of quality data and no experience in an inflationary regime. Additionally, the sharp decline in bitcoins' performance in 2022 has led to a shift in perception, with gold and digital assets now considered complementary rather than competing assets. This change in perception was further fueled by the implosion of FTX in November 2022, sparking a renewed appetite for gold investments. Although cryptocurrencies remain volatile and subject to regulatory risks, their adoption as an alternative store of value and investment diversification tool may impact gold's appeal in an inflationary environment in the long run.
• Increasing mining costs: Assuming that all easy sources of gold are exhausted, rising production costs are likely to limit supply if prices fall back too far from their current high levels. The competitive nature of the market may cause these supply constraints to feed into gold prices, resulting in a rise in the value of gold, in real terms, over time.
• Inflation is now measured using a more sophisticated methodology, which takes into account a wider range of factors. This means that the inflation rate is now more closely aligned with the real economy, and is less susceptible to distortions caused by external factors such as changes in the price of oil.
• Intangible capital: The nature of companies has changed, with much of the capital deployed being intangible, such as trade secrets and proprietary software. These intangible assets may be more resilient to inflation, potentially reducing the role of gold as a hedge against inflation.

Gold vs. Bitcoin

Gold and Bitcoin, both considered debasement hedges due to their limited supply, have been increasingly utilized as inflation hedges amidst ongoing geopolitical conflicts, market volatility, and rising inflationary pressures. However, their performances as investment assets have been notably different. Gold, a defensive real asset, saw a 10% rally in the first three months of 2023 and has historically demonstrated negative correlation to equities during market downturns. Its strong performance has been supported by increased non-speculative demand from jewelry buyers, central banks, and recession hedging investors.

In contrast, Bitcoin's value has dropped, even after considering its recent 50% rally in Q1 2023,? more than 60% since its peak in November 2021. The cryptocurrency's high volatility and sensitivity to financial conditions are likely to persist until it develops more real-world applications. Tighter financial conditions are anticipated to have a more significant impact on Bitcoin returns compared to gold, as Bitcoin adoption has been fueled by easy financial conditions.

Gold's lower duration and defensive properties make it a better portfolio diversifier than Bitcoin in times of tighter financial conditions. While gold prices may continue to rise with anticipated rate hikes, Bitcoin's potential as an inflation hedge remains uncertain due to its volatility and dependence on the development of real use cases beyond speculative interest. Furthermore, Bitcoin's price fluctuations are not isolated from economic events. During the COVID-19 crisis in March 2020, Bitcoin dropped more than 50% as investors sought safe-haven assets like US Treasuries. However, as the outlook improved, Bitcoin soared over 800% in the following 12 months. This indicates that Bitcoin is a speculative asset with a positive beta against the US market and may not consistently provide positive real returns during periods of unexpected inflation.

Lastly, examining returns on a risk-adjusted basis using the Sharpe Ratio (see below), Bitcoin only surpasses gold when bought 6-7 years ago. Later purchases, while yielding higher absolute returns, face increased volatility.

Portfolio View

Gold's role in diversifying investment portfolios has evolved over time. As a non-yielding asset, gold may not be an ideal choice for investors seeking regular income or high capital appreciation. As a strategic asset, gold's low correlation to traditional financial instruments enhances its diversification potential in a multi-asset portfolio. Historically, the correlations between gold and equity and fixed income benchmark returns have been low, with recent correlations around 0.2 for equity and 0.4 for fixed income.

The inherent stability of gold as a real asset with established use cases lends itself to improved portfolio performance, particularly in times of tightened financial conditions. Consequently, this stability bolsters the Sharpe Ratio of a diversified portfolio, even when gold's returns may be comparatively lower. In a multi-asset portfolio, a gold allocation of over 5% is recommended to enhance the Sharpe Ratio of a traditional 60/40 portfolio, ensuring a more favorable risk-return balance. This allocation becomes even more crucial in the current climate, characterized by heightened inflationary pressures or a confluence of lower inflation rates and reduced GDP growth. Given these macroeconomic factors, investors should consider increasing their gold exposure beyond the minimum threshold to fortify their portfolios against market volatility and economic uncertainty, while simultaneously reaping the diversification benefits inherent in the precious metal.

Short-term view

As inflation continues to hover above target levels, central banks are expected to raise interest rates and implement tightening measures, which may lead to higher bond yields and pressure gold prices. However, the exact degree of policy intervention remains uncertain due to the delicate balancing act required to prevent an economic recession.?

Gold may benefit from sustained periods of heightened inflation as a powerful catalyst, though this depends on the Federal Reserve's response. If the Fed convincingly demonstrates its commitment to bringing inflation back to the 2% target, gold prices could face downside risk. Alternatively, gold prices may rise if the Fed exhibits an inflationary bias akin to the 1970s, shifting its focus away from inflation reduction. A successful soft landing in the US economy appears increasingly narrow, bolstering gold's safe-haven status and offsetting the impact of higher real rates on the metal, while adversely affecting the broader commodity complex. To truly decouple gold from the dollar and real rates, market participants must begin to question the Fed's dedication to its inflation target, as witnessed earlier this year or during the 1970s. Furthermore, the current low levels of ETF fund inflows and the notably depressed gold net managed money positions may offer a source of downside support.

Reference

• Ang, A. Asset Management: A Systematic Approach to Factor Investing. Oxford: Oxford University Press; 2014.
• Erb, CB, Harvey CR. The Golden Dilemma. Financial Analysts Journal. 2013;69(4):10-42.
• Conlon T, Lucey BM, Uddin GS. Is Gold a Hedge Against Inflation? A Wavelet Time-Scale Perspective. Review of Quantitative Finance and Accounting. 2015 Oct 6;46(2):341-57.
• Oxford Economics. The impact of inflation and deflation on the case for gold. July 2011.
• Neville H, Draaisma T, Funnell B, Harvey CR, van Hemert O. The Best Strategies for Inflationary Times. SSRN Electronic Journal. May 25, 2021.

Disclaimer: This information is provided for general informational purposes only and does not constitute fiduciary investment advice or a basis for investment decisions. Past performance is not indicative of future results. The material does not offer a distribution, invitation, recommendation, or solicitation to buy or sell securities or engage in investment activities, nor has it been reviewed by any regulatory authority.