Gold has a unique history, attributable to its equally unique characteristics. It is the only commodity-currency to have survived into the electronic age. That gold is still seen as both a commodity but also a currency is proven by the fact that central banks still keep gold as a part of their foreign exchange reserves. In recent years central banks have added to these reserves, thus further underlining its utility.
Up until the early 1970s gold played a central role under the Bretton Woods System determining foreign exchange levels between currencies and aiding international trade. Previously the world operated on the Gold Standard although interrupted by two world wars, with much the same ends. Gold is no longer the lynchpin of the international financial system but it still occupies a key role in global finance and in the wealth accumulation and preservation of millions persons across the globe.
In order to understand the role of gold in the modern world it is necessary to ask what function does gold play. In this regard, it is good to ask under what conditions is gold utilized? What is its function? We do not intend this be an exhaustive analysis of this topic but look to touch on a couple of aspects pertaining to bullion in this regard.
Gold thrives on uncertainty, be it economic, financial, political or even social. It is safe to say the world is in a period of some reasonably high heightened uncertainty. This includes inflation uncertainty. Although inflation as measured by the Consumer Price Index is at a 40-year high it is still not entirely clear if inflation is going to be a chronic problem going ahead, or will begin to recede. Much may depend on how global central banks conduct monetary policy and therefore manage demand. Much will also depend on how quickly global supply change bottlenecks are remedied. Whether inflation rises or falls, is temporary or chronic, this leads us to the question is gold a good inflation hedge?
Not a good inflation hedge…
What do increases in inflationary pressures mean for gold? For centuries investors have purchased gold as protection against rising inflation. Despite the intuitive reasoning that higher inflation is good for gold, there is not a compelling argument for gold as an inflation hedge. A review of gold’s historical performance as an inflation hedge shows that much depends on when in the inflation cycle gold is purchased.
We use academic studies to illustrate gold’s utility as both an inflation hedge and a safe haven. Academic studies show that gold is a reasonably good inflation hedge in the longer run but this can mean 50 years or more and is therefore not of much use to individual investors. Over shorter time horizons, gold’s correlation with inflation is spotty with the timing of purchases an important factor as an inflation hedge.
In The Best Strategies for Inflationary Times (25 May 2021) Campbell R Harvey of Duke University and associates outline arguments that gold is an unreliable hedge over the short term because of its volatility. This does not mean that many investors are still not attracted to gold in a time of rising prices. Retail coin & bar gold demand – which has been mostly higher for months – characterizes inflation concerns felt by consumers worldwide. Institutional and professional investors however have tended to come down on the broad weight of academic and central bank opinion which looks for inflation to moderate as monetary policies tighten. This helps explain institutional gold Exchange Traded Fund liquidation in 2021 and moderately lower gold prices with only modest institutional demand that year. Gold has gained this year, but this may be due more to geopolitical facts than to inflation hedging.
The nature of inflation and how gold plays into it may also be examined. The disastrous period of hyper-inflation during the German Weimar Republic of the 1920s or various Latin American economies of the 1970s may not be repeated due to advances in econometric modelling and monetary theory. It is also safe to say that after battling inflation in the 1970s most central banks have anti-inflationary mentality. This may reduce incidents of extreme inflation where holding gold may be most useful.
But a very good safe haven…
While the case for gold as an inflation hedge is modest at best, gold has proven to be an excellent safe-haven asset and portfolio diversifier. Gold gains in 2020 offered a stellar example of gold performing well during a period of high and prolonged uncertainty, but history is full of other good examples. Gold was also a good safe haven earlier this decade in the Global Financial Crisis and in previous periods of uncertainty. Gold has a low correlation with other asset classes; this is essential in understanding gold’s value as safe haven as it means that it is a useful means of diversification.
Gold’s utility as a proven safe haven is supported by recent academic work. In Have the Covid 19 Pandemic and Other Crises Similarly Determined the Nexus between Currency Exchange Rates and Gold Prices? (30 November 2021), Tauhidul Tanin and Robert Brooks of Monash University and Ashutash Sharker of the University of Alberta examine gold and exchange rates between May 2007 and May 2021 – a period comprising the Global Financial Crisis, European Sovereign Debt Crisis and COVID-19 crisis. The paper reaffirms gold’s value as a safe haven although it may perform differently in non-USD currencies.
Gold gains in 2020 offered a stellar example of gold performing well during a period of high and prolonged uncertainty
Also in Is Gold a Safe Haven in all Currencies? Dirk G. Baur of the University of Western Australia (21 October 2021) analysed a global sample of 68 stock markets and gold both in local currencies and in US dollars. The results show that gold is consistently a safe haven for local investors in the vast bulk of markets and countries. Furthermore, the findings illustrate that exchange rate changes substantially influence the safe haven effect for local investors, mostly for markets that incur large losses. In other words, the safe-haven effect of gold is amplified when a local currency also declines with local financial markets.
The analysis highlights that gold’s currency hedge property works best in crisis times. A deepening of the pandemic, geopolitical risks or equity market corrections are just some of the possible scenarios that can trigger safe-haven demand and boost gold prices. Given high levels of uncertainty gold should receive support from these areas. While it may be easy to confuse gold’s rather indifferent properties as an inflation hedge and its highly rated credentials as safe haven and portfolio diversifier it is important not to do so. This does not mean investors will not turn to gold during inflation do, but how well protected they may be if inflation were to continue to rise. It is clear however that gold is more responsive to financial market volatility and financial market uncertainty.
