On Gold as Inflation Hedge

June 20 2018

Is gold truly a solid hedge against inflation? Not quite, at least according to a study by Credit Suisse and the London School of Economics (LSE). They looked at the performance of gold and stocks from 1900 to 2012 and concluded that gold prices are too volatile and that stocks enjoy better returns. Whereas an investor exclusively invested in gold earned an annual return of 1.1 percent over the same period and suffered several heart attacks in the meantime because of the high volatility, a stock investor would have enjoyed a remarkably higher return at an average annual (real) return of 5.4%. Moreover, gold does not earn a yield, contrary to stocks.

Another conclusion from the same study is that stocks are not a sound inflation hedge. Gold, of course, is the quintessential inflation hedge. Although … MC Investments seems to think otherwise.

A year ago, this investment boutique wrote in a special publication that gold should no longer be considered a safe haven. Their evidence? Let me cite their line of reasoning: “Since mid-2009 gold has underperformed the S&P 500.”

Now, if upon reading their defense you think: “what a nonsense to draw conclusions about gold no longer being a safe haven because of its return since 2009”, then you are completely right. It is (a) preposterous to look at the performance of gold and stocks over such a short timeframe and subsequently draw a radical conclusion about gold’s safe haven status and (b) even more preposterous given the fact that this brief period is also a period of an unprecedented monetary experiment; an experiment that, as even a child knows, has pushed up stock prices to dazzling heights. This is akin to concluding that because the Islandic soccer team managed to reach the quarterfinals by beating the football giant England, this tiny Nordic country must be an European powerhouse. Nonsense, of course. Historically, Iceland has been a rather weak country in football terms. The fact that it qualified for the Euro Cup in 2016 and now also for the 2018 World Cup in Russia, is especially pleasant news for its citizens and the rest of the world – underdogs are always appreciated. Yet to say that it is a matter of time before this tiny country becomes the next world champion, would be rather a stretch …

Or what to think about the following: “If we discard the 1970s for a moment, then the relation between gold and inflation turns out to be rather weak.” This statement comes from a fellow called Brian Lucey, professor in international finance at Trinity College in Dublin. This fine fellow ignores for convenience sake theperiod in which you would be rather pleased to have held gold as inflation hedge and merely focuses on periods in which annual inflation was actually on the decline to conclude that gold does not offer any protection against inflation. To continue our World Cup analogy: you might be aware that unfortunately the Netherlands is absent in the 2018 World Cup in Russia. Following Lacey’s line of reasoning, the Dutch national soccer association could argue that, discarding the games in which we lost points, the Dutch squad actually very much deserved a ticket to the World Cup. In the 1970s, gold was a very effective hedge against inflation, but that is irrelevant since, according to Lacey, “inflation was high in that period which is not something that is bound to happen again.” Someone should give this fellow the highest recognition that an academic professor can earn as soon as possible, since he apparently is able to predict the future!

When someone argues that stocks enjoy higher returns than gold in the long run, then he or she is simply stating a mere fact. You should certainly not respond to this statement with: “I do not agree”. A fact is a fact. Yet when that very same person tells you that, as a consequence, you better ought to invest in stocks rather than gold, then you have every reason to speak up and protest. What do I mean?

In effect, our imaginary discussion partner is confusing two very different concepts. When he is talking about investing and argues that stocks are better investments than gold, then he completely misses the point, because he confuses every individual that puts his or her money into gold with an investor. And that is simply not true. Of course, some people buy gold as an investment. But many others view gold primarily as an inflation hedge instead of an investment. Sure, it would be great if gold prices rise, but to them gold is at its core an insurance policy. Against inflation, that is. Based on thousands of years of prior history, a slightly longer period than the period that MC Investments considered, we can rightly conclude that gold has performed quite brilliantly as a hedge against currency depreciation.

In 1970, the price of a troy ounce of gold was fixed at 35 dollars. Say, you would have put your 35 dollars into a bank, whereas your neighbor bought a troy ounce of gold at, again, 35 dollars. Now, assume, both of you would have gone back into time with your bank account and his troy ounce of gold. Now, say, the year is again 2018 and you decide to step outside your little time-traveling machine. Your 35 dollars is now able to buy significantly less than at the time. Since 1970, total inflation in the US amounts to approximately 550 percent. To buy the equivalent of 1970 in 2018, you would need 228 dollars. Nonetheless, your neighbor’s troy ounce of gold has risen in value to roughly 1300 dollars.

This is all very well, but the very same historical record proves that central banks that keep interest rates too low for too long and print money, produce high inflation. For the past years, we have been confronted with zero interest rates and printing presses in full swing, yet we have not seen any inflation while gold prices have fallen by approximately 30 percent since their peak in 2011: “Perhaps gold is next to useless as a hedge against inflation,” I can hear you think.

The fact that central banks have kept, or are keeping, interest rates at zero percent for quite a long time, is entirely true. The fact that no significant inflation has resulted, is also a fact. Although … at any rate, if the latter is truly a fact and, if it is, the absence of any significant inflation implies that buying gold as an inflation hedge is useless, is precisely what we will discuss in our next seminar on the 4thof July in Amsterdam. I hope to see you there.


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