Could gold bugs have their day?

Today’s debate on inflation has refocused market attention on gold. The precious metal has proven to be popular with investors through the ages, with fear (of inflation, or other sources of market volatility) often being a key draw. Is it once again time to add exposure to gold?

Is it once again time to add exposure to gold?

Unlike most major financial assets, gold is unique in the sense that it does not generate any yield – it needs to keep rising in value just to keep up with cash in the bank. Despite this, history has shown gold can still deliver reasonable returns in specific market environments. The key, in our view, is the path of real (net-of-inflation) bond yields. This, together with gold’s diversification benefits, mean we see a case for a modest investment in gold within a well-diversified investment allocation.

Keeping it real

Since gold does not generate any yield, the real (net-of-inflation) bond yields are a good indicator of how gold is likely to behave because the real yield represents the opportunity cost of holding gold. Generally speaking, gold tends to rise as real yields fall, and vice versa.

Generally speaking, gold tends to rise as real yields fall, and vice versa.

Predicting where the real yield will go, though, remains far from simple. We expect nominal bond yields to rise gradually over the coming year as economic growth remains well-supported, inflation remains elevated at least for another few months and the Fed starts to hike policy rates in 2022.

How inflation ends up behaving, though, is equally important for the path of real yields. We expect inflation to ease over the next year which, on its own, should mean higher real yields and lower gold prices. However, if inflation rises further or is longer-lasting, then real yields could fall and gold could rise further.

Is gold a good inflation hedge?

One of the most common arguments cited in favour of owning gold is that it helps hedge against inflation. Today, this argument sounds tantalisingly attractive – US CPI inflation is at a 30-year high and much of the market debate centres around whether this is a temporary, pandemic-driven anomaly or whether it is signalling a period of higher inflation ahead.

In the 1970s, gold rallied from USD 35 at the start of the 1970s to almost USD 800 at the end of that decade. However, we’d be careful about blindly extrapolating this experience. The inflation experience of the time was driven by an oil price shock when oil comprised a much larger share of household spending than it does today. It is far from clear whether inflation today is indeed likely to sustain, or moderate through 2022 as supply chain disruptions gradually ease. The 1970s also marked a structural shift away from the gold standard, as the US dollar was delinked from the value of gold.

We’d be careful about blindly extrapolating the experience of the 1970s

Having said that, there may be some merit in gold’s role in an inflation hedge. At Standard Chartered’s CIO Office, we looked at gold’s role as an inflation hedge in a variety of environments.

• Gold has indeed historically outperformed many other major asset classes during periods of rising inflation, though equities still performed better as long as growth was also rising.
• The level of inflation was also important – gold historically outperformed equities when inflation sustained at very high (eg. above 4%) levels. However, this was not the case when inflation was more modest, likely because firms have pricing power up to a point.
• The central bank reaction, though, was key. Gold would fail to perform as an inflation hedge if central banks also turned hawkish and helped push real yields sharply higher. Holding gold alongside other inflation-hedge assets, such as a broader commodities basket or private real estate, could have helped, but it does emphasise the importance of real bond yields.

Does gold improve my portfolio?

Diversification is indeed the only free lunch in investing, to quote an overused but still very important point. We remain of the view that the bulk of a diversified investment allocation should remain devoted to core equity and bond holdings. However, gold can help offer a hedge against the risk that inflation does indeed move higher, or persist longer than we expect.

A World Gold Council study, for example, showed that adding a modest allocation to gold in a multi-asset class portfolio helped improve overall returns per unit of risk taken. Our own models propose about a 5-6% weight to gold across most risk profiles. Besides the portfolio benefits, we expect this allocation to provide a hedge against the likelihood of further worries about inflation, even if price levels do end up moderating over the coming year.