There has been a lot of investor interest in gold recently which resulted in the price of the metal appreciating to all time highs. The latest burst fits with a historical pattern of episodic interest in the metal. The last time this occurred was around the 2008 Global Financial Crisis during which gold doubled from around $900 USD per/oz to just over $1900 before falling back to the $1000-1300 range where it traded from 2013-2019. These bursts of investor interest in gold are usually triggered by some sort of fear, whether it be fear of inflation, currency debasement or political instability. What begins as a fear-driven burst in price can then feed on itself as that other equally powerful investor emotion, greed, sets in.

Driving this latest bout of interest are concerns over the truly gargantuan amounts of both monetary and fiscal stimulus unleashed upon the global economy and the potential for this to spark inflation. Tied to this are concerns that the only way for policymakers to prevent the astronomical amounts of debt accumulated through this stimulus from imploding into a deflationary bust is for them to create inflation. By stoking inflation and keeping interest rates low, policy makers hope to keep real interest rates (the difference between the nominal interest rate and inflation) in deeply negative territory. Negative real rates are of course hugely damaging for savers but beneficial for borrowers as it serves to erode debt loads. Whether or not policymakers are likely to succeed in creating inflation is the topic of much debate, but the fact is no one knows. What we do know is that the collective view of all investors is expressed in observable market prices. The best market gauge of future inflation is called the “Breakeven Rate” which is the difference between the yield on a conventional government bond and the real yield on an inflation-linked bond of similar maturity and credit quality. The 10-year breakeven rate is telling us that the market thinks that inflation in 10 years will be 2.0% which is in the middle of the range over the past 10 years of roughly 1.5-2.5%. So, the market, in its collective wisdom, is not expecting a rampant acceleration of inflation over the next 10 years.

But let us say the market is wrong (which it certainly is sometimes) and let us assume inflation does accelerate over the coming years, how good of a hedge would gold be? The answer again is no one knows. There are no markets we can look at to give us a clue as to what the future holds either. All we have is historical data about how gold has performed during prior inflationary periods. This data shows us that over the very long term, gold has kept up with inflation but the returns from gold are highly volatile which reduces its effectiveness as a hedge. Indeed, over the short-medium term, gold has often failed to keep up with inflation. For example, the gold price in 1980 was around $1900 in today’s dollars which is roughly where the price of gold is now. So over 40 years gold has more or less kept up with inflation. However only 2 years ago the gold price was only around $1200 which means that over those 38 years, gold did a very poor job of keeping up with inflation. If investors really want to hedge inflation, then there are other assets which can do this more effectively (inflation-indexed bonds or real estate for example).

What if inflation fails to materialise and instead the global economy falls into a deflationary bust? How would gold perform then? Once again, we only have historical data to look at and that data shows that gold prices fall hard during periods of deflation, but they usually fall less significantly than other assets meaning gold has maintained relative purchasing power. Similar to the hedging conclusion reached previously, there are other assets which have provided more reliable protection in a deflationary environment (long duration bonds for example).

None of this means that investors should not hold a modest allocation to gold as part of a well diversified portfolio. The future will look different than the past and there are other reasons beyond inflation why an investor might want to hold gold in their portfolio. For example, gold has proven to be store of value over the long term and for an investor worried about currency devaluation gold could play a role as a useful hedge. Ultimately gold is a speculative asset versus a traditional asset with cash flows which can not be valued using conventional investment analysis. And as with all speculative assets, an investor in gold must be prepared for substantial volatility and be comfortable that, because there is no valuation underpinning the price, there is no price that is either “too cheap” or “too expensive”.

In my next post, I will comment on some of the many ways investors who are interested in gold can obtain exposure it.

Author: Alex Da Costa

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