Despite the common perception gold provides protection against high and increasing inflation, gold actually has performed best in deflationary environments. Although evidence suggests gold offers protection during periods of stock market distress, historically it loses its luster during severe market corrections. While there will be periods when gold provides attractive returns, the inconsistency and unpredictability of these periods dissuade us from including gold in our capital market allocations. Instead, we believe an allocation to real assets provides a proper inflation hedge with solid return characteristics and income generation.
Gold prices climbed in the early months of the COVID-19 pandemic, followed by a period of moderation through early 2021, and have rebounded since March as the stock market rally has continued sparking a renewed interest among investors. While investors may be tempted to associate increased equity volatility (as measured by the VIX Index) to increases in gold prices, we are reminded of the popular quip “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” In this paper, we examine what role gold should play, if any, in a portfolio.
A Brief History
Gold’s role in commerce is a history of monetary systems. During the Roman Empire, under a gold-backed monetary regime, the Romans used gold and silver coins to facilitate trade, support capital projects and fund military expeditions. Eventually these costs accumulated relative to the finite supply of silver and gold entering the empire. In response, Roman officials devalued their currency by decreasing the purity of the coins to increase the supply in the market. It was effective to a point. Eventually the diminished coin quality led to hyperinflation, contributing to the demise of the Roman Empire.
There are numerous other cases of monetary regimes vacillating from gold- to fiat-based systems. Throughout regime changes, a common theme emerged: the balance between monetary flexibility and trust in a monetary system.
Fast forward to the immediate aftermath of World War II, allied nation leaders tied foreign exchange rates to the U.S. dollar and pegged the U.S. to gold at $35 per ounce. That monetary arrangement, The Bretton Woods System, lasted until 1971 when U.S. President Richard Nixon closed the gold window. Since then, global policymakers have generally favored the floating rate fiat currency arrangement in place today.
Unlike other assets whose returns are driven primarily by their ability to generate cash flows, the price of gold is driven primarily by supply and demand. Since the supply of gold is relatively static, the demand for gold is the primary driver of price appreciation. The rule-of-thumb is the demand for gold rises when prospects for economic growth weaken, such as high inflationary or volatile market environments, so we put this assumption to the test since it is key to the price of gold.
Putting Gold to the Test
Proponents of gold argue its price should rise during periods of high and rising inflation, suggesting inflation reduces the purchasing power of a currency relative to a scarce resource. This makes sense, conceptually. If this is true, the correlation between the rate of inflation and the return of gold should be sufficiently positive. Between January 1976 and June 2019, the rate of inflation and the return of gold had a correlation of 0.0765. This suggests a positive, but immaterial, relationship between inflation and gold.
Separating the data into different inflationary regimes produced similar results. The table to the right shows returns from gold were low during periods of high, stable and low inflation. In contrast to the popular narrative gold hedges against inflation, historical data shows the opposite. Even during periods of high inflation, defined as more than 4.0 percent year-over-year, gold prices generated lackluster returns. On average, gold actually performed best during periods of deflation. If we instead consider spikes in inflation, historical data (as seen in the scatter plot below) still does not support the view that gold serves as a hedge for inflation.
Our analysis shows gold performed better during deflationary periods, which historically coincide with increased volatility and equity market drawdowns. This brings us to another common argument in support of gold. Gold functions as a safe-haven asset during periods of market distress. As markets come under pressure, gold should function as insurance and prices should appreciate or remain stagnant.
To assess gold’s functionality as a safe-haven asset, we turn our focus to drawdowns on the S&P 500 Index. Focusing on those months the S&P 500 Index generated negative returns, gold proponents would expect gold prices to rise or remain static. Mathematically, if this assumption were to hold, the correlation between the returns from gold and the S&P 500 Index should be negative during these periods.
As the graph below left shows, gold tends to hold up well relative to stocks across all equity drawdown periods observed. However, while gold returns were positive for equity drawdowns within an eight percent drawdown, gold prices actually fell during more severe pullbacks. Paradoxically, some proponents of gold are in favor of owning the asset as a hedge against these more severe downturns. On the other hand, in the chart below right, bonds produced positive returns across these environments, indicating they provided better insurance against market drawdowns.
Gold, with its rich history as a monetary surrogate, remains a polarizing asset. With many heuristic biases around gold, it is advantageous to step back and focus on the data. There is little evidence gold either protects against inflation or provides insurance against market drawdowns. We do not deny there will be times when gold performs admirably and appears to be an attractive allocation within a portfolio. However, these periods either do not align with common perceptions or are difficult to forecast. For those reasons, we do not recommend a strategic allocation to gold. Instead, we recommend constructing a traditional portfolio of fixed income and equities along with an allocation to real assets.
In early 2021, Trust Point introduced a real assets fund into client portfolios to complement equity and fixed income allocations. The fund invests in commodity futures, infrastructure equities, natural resource equities, real estate equities, and Treasury inflation-protected securities designed to hedge against inflation, generate solid returns and provide income generation. Its strategy is to identify inflection points in the rates of change for economic growth and inflation to determine how to position among these asset classes. We believe this type of strategy is ideal in today’s investment environment due to:
•Higher desired inflation target by central banks
•A new era of increased government spending
•Rising inflation expectations
•Expected continued U.S. dollar weakness
•Strengthening demand met with supply constraints
•Early signs of price momentum
For more information, please reach out to any of the professionals from Trust Point.