As the global economy continues to show signs of recovery from the pandemic-led recession, investor focus has shifted to inflation risk. Reflationary pressures emanating from rising growth and economic activity (both consumer and manufacturing) are a core source of these inflationary concerns. In response, many have turned to gold as a potential hedge against this form of inflation.
While gold has historically served as a refuge during periods of extreme price inflation and deflation, the risk of extreme levels of price inflation currently remains low. Instead, investors should concentrate on the risk of monetary-led inflation (originating from dovish policies and higher liquidity) leading to US dollar (USD) weakness — and the potential benefits gold could offer in that environment.
Quiet but real: Inflation through currency devaluation
The inverse relationship between USD and US inflation expectations tracks closely over time. This stems from the fact that a weaker dollar is inherently an inflationary action because it reduces the purchasing power of US consumers, investors, and debt-holders (see Chart 1). Monetary and fiscal policies geared towards a weaker dollar could greatly aid in reducing debt burdens through this inflationary effect — with a weaker dollar supporting growth through exports and reducing the burden of existing debt levels.
Furthermore, fiscal stimulus tends to weaken a currency’s medium-term outlook. The prospect of more US deficit spending to combat the economic effects of Covid-19 and fund other domestic priorities such as infrastructure keeps the medium-term outlook muted for USD, but is potentially supportive of gold.
Gold’s negative correlation to USD is well established, and its strong performance compared to equities, broad commodities, and bonds during USD bear markets over nearly five decades is highlighted in Chart 2. During USD bear markets since 1973, gold has posted an average 142% cumulative return, while — not surprisingly — experiencing an average drop of 7% during USD bull markets. This asymmetry highlights that over time, the benefit of holding gold to protect against currency weakness far outweighs any drag during periods of currency strength.
Further, the prior peak for the USD spot price was on Dec 28, 2016, and since then the greenback has fallen approximately 11.5%. This, compared to the average cumulative drop during USD bear markets of 28% (as illustrated in Chart 2), indicates the potential for further weakness on the horizon. Fiscal spending, coupled with lower for longer policy interest rates, may serve as headwinds for USD, but they potentially remain strong tailwinds for gold.
Inflation through monetary stimulus and liquidity
Another type of inflation that gold investors should be tracking is monetary inflation. While this is closely linked to fiat currency devaluation, there is an important distinction to highlight as it relates to rising financial asset valuations. Central banks globally have continued to add debt to their balance sheets in response to the Covid-19 pandemic. Their playbook has been very similar to the response following the 2008 Global Financial Crisis. To date, the G-4 central banks — Federal Reserve, Bank of England, European Central Bank, and Bank of Japan — have increased their debt holdings to nearly US$24 trillion ($32.3 trillion), amounting to 55% of aggregate GDP of these economies.
This stimulus-related activity by the G-4 has created a tremendous amount of liquidity in global capital markets, pushing up valuations in risk assets and reducing the value of reserve currencies. In response, gold holdings have increased commensurately as a potential offset against this rising liquidity and monetary inflation risk. In fact, global gold holdings among investors and global central banks have risen steadily since the extreme monetary policy actions began in 2008 (see Chart 3). As long as central bankers continue their strategy of adding liquidity through issuing debt, investors can expect more volatility with risk asset valuations and fiat currency depreciation, factors that are likely to continue to buoy gold demand as a potential hedge against monetary inflation.
Let’s get real about price inflation
Price inflation, as measured by baskets of goods through the consumer price index (CPI), is the most common metric that investors use to gauge the level of inflation. While gold serves as a strong store of value over time, its sensitivity to moderate price inflation has historically been more limited. In contrast, compared to other real assets such as infrastructure and natural resources, gold’s correlation — and more importantly, its beta to monthly changes in CPI — is actually the lowest (as highlighted in Chart 4).
Gold’s overall inflation beta to CPI (0.58) is on a par with a global 60/40 stock/bond portfolio (0.52), but as illustrated in Chart 5, gold has maintained a lower correlation to the diversified global 60/40 portfolio. While other real assets may offer higher inflation sensitivity to CPI, this comes at a cost of higher equity correlations and exposure to equity risk factors. Gold’s lower correlation to diversified stock/ bond portfolios indicates the potential for diversification without a drop-off in sensitivity to changes in CPI over time.
In 2021’s rapidly changing risk landscape, gold’s consistently lower correlation to global portfolios compared to other real assets could be an important advantage. Gold’s low correlation over time reinforces its stronger diversification potential during a range of business cycles — providing efficient diversification to reduce portfolio risk and potentially improve portfolio returns. This risk mitigation capability against multiple forms of risk, not just inflation, is a key reason to consider a strategic allocation to gold along with other real assets.
Maxwell Gold, CFA, is head of gold strategy at State Street Global Advisors
