Gold is irrevocably tied to human history, sometimes flesh of the gods, catalyst of trade, transport of migration and money anchor. Today, while no longer officially a part of our monetary systems, gold is still of interest to investors.
Some consider it a refuge when the economic-financial climate deteriorates, others as a defense against changes in the American dollar value, and still others as a means to defend one’s self against inflation.
The Historical Significance of Gold
With inflation once more menacing the purchasing power of Western economies, we go through episodes of history marked by higher prices in trying to follow its origins and learn how it developed.
Inflation Simplified: Reasons and Impact on the Economy
Inflation rates in early 2020s for the United States and Europe were some of the highest since the 1980s.
We refer to high inflation when CPI inflation crosses 3.5%. Low inflation occurs when the CPI is less than 1.5%. High growth occurs when the CPI (Consumer Prices Index) exceeds 101.4 for high inflation and 100 for low inflation (the threshold for the latter is lowered due to the very few observations of lower inflation to 1.5 and a CPI above 101.4). Low growth occurs when the CPI is below 98.6.
The Role of Gold in an Inflationary Environment
While economic uncertainty and inflation menace the horizon, investors and retirees are looking for better ways to protect their retirement funds in case of market turbulence. Gold has been valued for centuries as a safe asset and an inflation hedge, but can gold really protect your savings from inflation?
Gold tend to act as an inflation hedge in the long-term, but with certain exceptions depending on the general economic situation and the stage of the Fed’s monetary policy.
Hedging inflation by investing in gold is a theoretical concept, more so in the short term. The price of gold often reacts to inflation data but not always. Although gold appreciates when living expenses increase, its correlation has weakened somewhat since the 1970s. The movement and price fluctuation correlation of gold has been weaker, in fact, since then.
Why Gold is a Hedge Against Inflation
Gold has forever been an inflation hedge, offering investors a protection when money depreciates. Inflation erodes the value of currency so that goods and services become more costly in the long term. Paper currency can be printed indefinitely, but gold is scarce. As scarce as it is, it possesses inherent value which does not diminish when currencies lose their value.
As inflation rises, the central banks reduce interest rates or put more money into circulation, which debase fiat currencies. Investors rush to gold during such periods as a store of wealth. Historically, gold prices increase in periods of high inflation, confirming its role as a safe haven. In the 1970s, for example, when inflation was rampant in the decade, gold prices soared as investors moved to shelter against rising expenses.
Gold is also highly acceptable and traded throughout the globe, making it less vulnerable to the monetary policies of a specific country. Its acceptability globally means that even during periods of uncertainty, it remains sought after. By preservation of wealth across generations, gold serves as an absorber of shocks for the erosion of money, making it a prime vehicle for protection against inflationary pressures and portfolio diversification.
Comparing Gold with Other Hedges against Inflation
Investment professionals know that the major raw materials, industrial metals and precious metals are the finest tools with which to hedge oneself against inflation. Commodities are amongst the best inflation hedges. Historical data over the long run indicate that commodities appear to be one of the classes most sensitive to inflation.
Segregating inflation into its anticipated and surprise components (the Treasury bill rate is often used to calculate anticipated inflation), surprise inflation is actual inflation minus the Treasury bill rate. Few assets perform positively with surprise inflation. In this respect, gold and commodities are obviously in a league by themselves, with industrial metals being a great surprise inflation hedge. It is noteworthy that the inflation that we’ve experienced in the past few years has largely been of a surprise nature.
Commodities also work well as a protection against expected inflation. U.S. Treasuries alone have as high a degree of exposure to expected inflation as commodities. Thus, if surprise inflation does relent, we may well continue to see commodities as a good vehicle for protection.
If inflation is high, we may remain in a high inflation/low growth cycle for longer than expected. This is not such a terrible assumption on commodities. Now that the US dollar is no longer appreciating, major commodities and gold have one less obstacle.
Commodities are more than an inflation hedge
Even though inflation has been a large concern for investors the past few years and may still be a large factor in the near future, there are more compelling reasons to invest in commodities than inflation. Commodities are generally poorly correlated with the majority of other assets. It is therefore an interesting asset to use in order to diversify your portfolio.
In fact, even in times of financial crisis (i.e. when US stocks fall by more than 5% ) these low correlations persist. On average, in all months that US stocks have fallen by more than 5% since the 1960s, commodities have fallen only 0.65%. In all months that US stocks had risen by more than 5%, commodities rose 1.13%. These figures are compared with -7.8% and 7.5%, respectively, for US stocks themselves.
Therefore, whereas commodities are cyclical (i.e., they also go down and up together at the same time as stocks), their extent of decrease is much less. Stock investors unwilling to see a fall in stocks can therefore hedge themselves with a commodities position.
Risks and Limitations of Relying on Gold
Although gold is a safe-haven asset, relying on it exclusively is risky and restrictive. One of the issues is price volatility. Although gold tends to rise during periods of economic uncertainty, its price can fluctuate wildly in the near term. This is less predictable compared to other long-term investments such as stocks or bonds that provide dividends or income.
A limitation is that gold doesn’t produce cash flow. Unlike equities that distribute dividends or bonds that distribute interest, gold’s return is solely in the form of price appreciation. Investors who have significant exposures to gold may miss out on compounding benefits that come from income-generating assets.
Storage and security are also concerns. Physical gold must be kept in secure vaults or safes, which can involve significant costs and logistical complexities. Or, investing in gold through exchange-traded funds (ETFs) or futures can expose investors to counterparty and market risks.
Moreover, gold’s performance is influenced by more than inflation, such as currency movements, central bank activities, and global demand. It will not always act as a perfect hedge, especially during deflationary times or if investors’ attitudes reverse. So while gold is a valuable portfolio diversifier, over-reliance on it will decrease overall growth potential and increase vulnerability to idiosyncratic risk.