Although gold is no longer a central cornerstone of the international monetary system since the breakdown of Bretton Woods, it still attracts considerable interest from investors. Owing to the increasing complexity of financial markets, diversifying a portfolio through hedging has become increasingly important. In a nutshell, gold may act as a hedge or a safe-haven asset for portfolio investors. One reason is that commodity prices are generally considered to be able to incorporate new information faster than consumer prices.
Gold prices seem to be appropriate regarding the reflection of inflation expectations since, in contrast to many other commodities, gold is durable, relatively transportable, universally acceptable, and easily authenticated. An increase in expected inflation will force investors to buy gold, either to hedge against the expected decline in the value of money or to speculate due to the associated rise of the gold price.
This generates a purchasing pressure that yields to an immediately rising price of gold in a time of the upward revision in inflation expectations. Changes in expected inflation will cause changes in the price of gold and investors with knowledge regarding future inflation will cause changes in the price of gold and investors with knowledge regarding future inflation to have the ability to gain excess revenues by purchasing and selling gold in spot and futures markets in anticipation of prospective market adjustments.
Therefore, the gold price acts as a leading indicator of the level of inflation and hence, gold could be used to hedge against future inflation. The costs of carrying gold are also affected through changes in interest rates by expected inflation. If those costs offset revenues from speculation, the price of gold is not affected by changing inflation expectations.
To understand the main characteristics of gold prices, a brief description of supply and demand factors is necessary. According to the World Gold Council the supply of gold, such as the supply of other commodities, is relatively inelastic, owing to the difficult extraction process and the tedious establishment of new mines. Central banks also still keep maintaining passive stocks of gold, independently of the patterns of the real price of gold.
Hence, the gold supply remains relatively stable while the gold demand is rapidly changing in response to global economic occurrences. The total demand for gold can be separated into three categories: the demand for jewelry as well as for industrial and dental, and investment demand. While demand for jewelry as well as for industrial and dental is largely determined by consumer spending power and thus, attached to the business cycle, the investment demand for gold could act counter-cyclical due to an increased demand for gold in times of global crises and recessions.
An Inflation Hedge
The total gold demand can be separated into two categories, namely the ‘use demand’ which combines the first two categories above, and the ‘asset demand’, where gold is also used by governments, fund managers, and individuals as an investment to hedge inflation and other forms of uncertainty.
Although gold may act as an inflation hedge in the long-run, the price for gold also displays significant short-run price volatility. The relationship between consumer prices and gold prices has undergone several structural changes since the early seventies: the breakdown of Bretton Woods in 1973, two major oil price shocks in 1973 and 1979/80, the collapse of the USSR in 1991, and the subsequent democratization of Russia as one of the top producer of gold worldwide, the burst of the ‘dot-com bubble’ in 2001 and the recent financial and economic crises that started in 2007.
If gold acts as an inflation hedge, exogenous factors such as major economic shocks or changes in economic policy may have an influence on the path of the gold prices. The change in the gold price is positively related to the change in inflation, inflation volatility, and credit risk while a negative relationship concerning the U.S. dollar trade-weighted exchange rate and the gold lease rate prevails. The gold price contains significant information for future inflation in several countries, especially in those that have adopted formal inflation targets.
There is an intensity between the price for gold and the general price level. Gold is only useful as a hedge if prices adjust to deviations from such a long-term relationship. If prices do not adjust, buying gold may not be able to shield a portfolio with respect to future price movements during a specific period.
Gold bullion is partially able to hedge future inflation against deflation in the long-run. This ability tends to be stronger for consumer prices in general as well as for the USA and the UK compared to Japan and the Euro Area. The adjustment of the general price level seems to be appropriately characterized by regime-dependence. One regime may account for times of turbulence and the other for what an economist would call ‘normal times’ which are unaffected by major shocks. Thus, the different adjustments of the price level may depend on the occurrence of economic turbulences. The gold price should be considered when aiming to appropriately forecast the inflation rate.
From an investor’s point of view, the effectiveness of gold as an inflation hedge crucially depends on the time horizon. Over the very long-run, gold is useful as a partial hedge against high inflation since a cointegrating relationship prevails. However, during some periods where no price adjustment is observed, gold is not able to shield a portfolio. This may be illustrated by a simple example of an investor who buys gold at the beginning of a period with no adjustment and sells at the end of the corresponding period. Another appealing question is how does gold perform against other potential inflation hedges such as stocks, bonds, real estate, or other commodities.
The global equity and fixed income markets have a combined value of about $90 trillion. Institutional and individual investors own most of the outstanding supply of stocks and bonds. At current prices, the world stock of gold is about $9 trillion. Yet investors own only about 20%, or less than $2 trillion, of the outstanding supply of gold. A move by institutional and individual investors to “market weight” gold holdings would require them to off the already existing gold owners, a price attractive enough to incent them to part with their gold, probably sending nominal and real prices of gold much higher. Should investors target a gold “market weight”? Could they achieve a gold “market weight” even if they wanted to?
Remarkably, the new supply of gold that comes to the market each year hasn’t substantially increased over the last decade even though the nominal price of gold has increased fivefold according to the Federal Reserve. There are a number of popular stories that are used to justify some allocation to gold, such as inflation hedging, currency hedging, and disaster protection.
Gold has had an amazing recent run. From December 1999 to March 2012 the U.S. dollar price of gold rose more than 15.4% per annum, the U.S. Consumer Price Index increased by 2.5% per annum, while U.S. stock and bond markets registered annual gains of 1.5% and 6.4% respectively. A recent Gallup poll found that about 30% of respondents considered gold to be the best long-term investment, making gold a more popular investment than real estate, stocks, and bonds.
Though some might use historical returns to establish long-run forward-looking expected returns, it is implausible that the expected long-run rate of return on gold is 13% per year (15.4% nominal minus an assumed 2.5% annual inflation). Yet, it is essential to have some sense of gold’s expected return for asset allocation. It is not surprising that there is so much disagreement about gold’s future. This disagreement reflects the fact that at least six somewhat different arguments have been advanced for owning gold:
- Gold provides an inflation hedge
- Gold serves as a currency hedge
- Gold is an attractive alternative to assets with real low returns
- Gold is a safe haven in times of stress
- Gold should be held because we are returning to a de facto world gold standard
- Gold is “under-owned”
The debate over the prospects for gold resembles in some sense the parable of the six blind men and the elephant. Different perspectives, different models, lead to different insights. Depending upon which rationale, or combination of rationales, one embraces, gold is either very expensive or attractive. The contest framework suggests that the price of gold is not determined by what you think gold is worth. What matters is, for example, what others think others think gold is worth.
While the possible value of all the gold ever mined is about $9 trillion, only a small amount of gold trades in financial markets. The demand for gold is characterized by positive price elasticity. This is one way of referring to momentum investing. As a result, even though historical measures of “value” might suggest gold is very expensive, it is possible that the actions of a relatively small number of marginal, momentum buyers of gold could drive the real and nominal price much higher (especially if the marginal buyers are not focused on “valuation”).
Gold As An Inflation Hedge
Probably one of the most widely held beliefs about gold is that it is an inflation hedge. Some have pointed out that historically gold has been a poor hedge of inflation in the short run though it has been a good hedge of inflation in the long run. It is worth asking “for whom might gold be an inflation hedge”? That is, even if gold provides a potential inflation hedging ability, it might not be accessible for investors.
For example, in the United States, private ownership of gold was outlawed by President Roosevelt in early 1933 with the signing of Executive Order 6102. Private ownership of troy ounces of gold of real value was restored when Public Law 93-373 went into effect on December 31, 1974. If different countries have different laws regarding the ownership of gold then investors in different countries face different realities with regard to the legal inflation hedging of gold.
Additionally, when an investment is outlawed in a country then it is questionable as to whether or not investors in that country are able to observe “market prices” for the outlawed investment. As a result, exploring the various arguments for investing in gold requires selecting, and being constrained by, a country perspective and a legal perspective. It is also desirable, and important, that if one invests in a legal inflation hedge that the position remains a legal hedge until at least a fraction of a second after the position is sold. The United States perspective is a convenient country perspective and the focus is largely on the time period in which it has been legal to own an ounce of gold and precious metals in the United States.
Another way to assess how effective gold has been as an inflation hedge is to examine the historical fluctuations in the real (inflation-adjusted) price of gold. If gold were a perfect short-term hedge of inflation then the real price of gold should be constant and exhibit no real price variability compared to bitcoin. Alternatively, if the real price of gold fluctuates, perhaps behaving like a valuation measure such as a stock market price-earnings ratio, then gold may be an imperfect hedge of short-term inflation.
There are at least two ways to think about inflation: the rate of inflation that investors expect and the rate of inflation that comes as a surprise to investors. An asset that hedges expected and unexpected inflation would probably appeal to a broad number of investors. If an investor possessed perfect foresight then there would be no unexpected inflation. As a result one of the easiest ways to test if an asset is a good hedge of unexpected inflation is to ask if it hedges perfect foresight of future inflation changes.
The Gold Standard
The Chief Officer of Barrick, the world’s largest gold miner, once announced that gold is the “default global currency”. In an overly literal sense, in a world in which no country has been on the gold standard since the Swiss ended convertibility in 2000, gold is not an “official” default currency. One characteristic of an official currency is that it is possible to pay taxes and purchase goods and services with the official currency. For most people, it is probably difficult, for instance, to pay income taxes with bars of gold or to get a soft drink from a vending machine with a quarter grain of gold.
While it is possible to debate whether or not the world is on a “de facto gold standard” it seems likely that this insight is basically another version of the “gold as an inflation hedge” argument. If the “de facto gold standard” argument is just another version of the “gold as an inflation hedge” argument, and if the “gold as an inflation hedge” argument provided no explanation for the high real price of gold, then it is reasonable that the “de facto gold standard” argument does little to explain variation in the real price of gold.
Why is no country on the gold standard? This line of thought relates to those who note that during the Great Depression those countries that abandoned the gold standard earliest suffered the least economic harm. One view of the “de facto gold standard” argument is that the gold standard is the worst form of currency except for all those other forms that have been tried from time to time.
The “shadow price of gold”, “gold is money”, the argument is an intriguing concept. As a result, the “gold is money” argument is essentially a restatement of the “gold as an inflation hedge” argument, and it should not be expected to more successfully explain the variation in the real price of gold. However, the “gold is money”, “shadow price of gold” argument yields a fairly specific prediction: a view of where the price of gold should be if the world actually accepted this specific view. From a U.S. standpoint, all that is needed to know where the price of gold is headed is a sense of the size of official U.S. gold holdings and the size of the U.S. “money supply”.
Investing in gold is potentially a way to maintain purchasing power. The purchasing power of gold rises and falls as the real price of gold rises and falls. Investing in gold entails a bet as to the future real price of gold, whether or not an investor even thinks about the bet. It is a fact that the real price of gold is very high compared to historical standards. A number of reasons have been advanced to explain the current real price of gold - some of these stories argue the real price of gold is too high and others suggest the real price could go even higher.
There is little evidence that gold has been an effective hedge against unexpected inflation whether measured in the short term or the long term. The USGS estimates that using current technology only 200 years supply of gold exists below the ground. Indeed, gold mine output has not significantly increased even though the price of gold has substantially appreciated over the past decade. Interestingly, the investment demand for gold has increased dramatically as the price of gold has gone up.
Finally, we examine the asset allocation problem of the average investor in a world subject to macro-consistency. The estimated value of all the gold in the world is about 9% of today’s combined capitalization of world stock and bond markets. If we look at investible gold, the share is about 2%. It is also a fact that very few investors hold 2% of their portfolio in gold. A widespread move to increase gold in diversified portfolios would lead to upward pressure on the real and nominal price of gold.
In the end, investors are faced with a golden dilemma. Will history repeat itself and the real price of gold revert to its long-term view. Alternatively, have we entered a new era, where it is dangerous to extrapolate from history? Those are the uncertain outcomes that gold investors have to grapple with and the passage of time will do little to clarify which path investors should follow.