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Analysis
Hedging inflation with gold

Hedging inflation with gold

Commodity valuable in a diversified portfolio

by Aimee Bowkett in London

Thu 18 Oct 2018

Gold has fallen out of favour in financial markets. In August, it hit a 19-month low, after experiencing five consecutive negative monthly returns.

This is unsurprising. The Standard & Poor's 500 last month reached all-time highs. Higher short-term interest rates are increasing the opportunity cost of holding gold. There is little inflationary pressure. The dollar is strengthening. These factors are often synonymous with a weaker gold price.

However, gold is a real asset and investors regard it as a good hedge against rising inflation. Since the gold standard was dropped in 1971, no country has seen average inflation below 2% and only 28 have seen it average below 5%.

Investors usually turn to gold when there are concerns around inflation rising too rapidly. The commodity holds a valuable place in a diversified portfolio as a long-term hedge against an inflation-induced 'melt-up' situation – a general improvement of the value of the stock market unrelated to improvements in the fundamentals of the economy.

The Federal Reserve is reducing its balance sheet. But if this programme ends early, or the flattening of the yield curve persuades the Fed to pause in increasing rates, the economy could overheat. Ultimately, this could result in a 'flight to quality', as investors sell off risky investments to purchase safer ones. The New York Fed's underlying inflation gauge could be a cause for concern, given that it has been rapidly increasing and is back at pre-2008 crisis levels.

Gold could be particularly attractive in this kind of scenario as a haven against equity market crashes. This cannot always be expected from other real assets such as inflation-linked bonds, which typically carry a liquidity premium that can prevent them being resilient when markets are stressed.

Importantly, since stock prices often start to recover after a severe negative shock, gold loses its safe haven appeal in the long-run. Historically, the first few days after a stock market crash have often provided most of the upside for gold, highlighting how critical timing can be. Trying to time the next equity market crash is difficult, so as market volatility picks up in the latter stages of the economic cycle, the need for portfolio hedges becomes ever more important.

Although gold's recent performance has been weak, it is important to remember the asset's long history. Arguably, real gold prices still appear elevated, so there could be further downside if risks do not materialise, inflation remains contained and interest rates normalise.

Indeed, more unconventional monetary policy, including helicopter money or more deeply negative interest rates, could be possible during the next downturn and investors could look at gold as one of the stores of value.

Aimee Bowkett is an Asset Allocation Investment Specialist at Legal and General Investment Management. This article first appeared on the LGIM Macromatters blog.

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