Due to its long history as a store of wealth and current use in jewelry and technology, gold is often considered a safe-haven hedge against inflation, as it is perceived to provide a dependable means of guarding against the risk of losing purchasing power. A sinking stock market and increasing inflation are two possible risks for investors. Unprecedented levels of inflation are occurring right now, yet this trend is not being reflected in the prices of gold. Instead, gold's value versus the US dollar has dropped by more than 10% this year, casting doubt on the idea that it is an efficient hedge.
In this article, we will look into gold's ability as an inflation protection. So, without further ado, let’s dive in.
What Is The Impact Of Inflation On Gold Prices?
Inflation typically affects commodities like gold indirectly because rising prices encourage investors to buy more precious metals to preserve the value of their money. For instance, the demand for this yellow metal surged by 12% in the first quarter of 2022, while the year-to-date growth in consumer prices was 9.1%. In the eight years with significant inflation in the US between 1974 and 2008, gold prices rose an average of 14.9% year over year.
Although some claim there is a connection between inflation rises and rising gold demand, it is impossible to say whether rising inflation was the direct cause of the expansion in gold demand during those times. While increased demand may contribute to rising gold prices, other elements, including supply dynamics and future financial markets trading tendencies may have a bigger impact. In addition, the outlook for many investors might affect the prices of gold.
Past Performance Of Gold's Inflation Hedge
Looking back at the 1970s, a time when significant American inflation began, can shed light on the usefulness of gold as a hedge against investments. Due to fluctuations in the price of oil and energy shortages, the US's average annual inflation rate soared to about 8.8% during the same period of time. As a result, gold gained popularity as an inflation hedge and offered gold investors a respectable 35% annual return.
Gold's reputation as an inflation hedge was entrenched in the 1970s, but its performance since then has been subpar. Gold prices plummeted by 10% year on average between 1980 and 1984 despite average annual inflation of 6.5%, producing returns that not only fell short of inflation but also lagged behind those of real estate, commodities, and the S&P 500. Similar to this, between 1988 and 1991, prices of gold decreased by an average of 7.6% annually despite annual inflation hovering around 4.6%.
How Does Gold Perform As An Inflation Hedge Today?
In 2023, prices of gold are on the rise again, rising 14% between November 2022 and February 2023. In contrast to the 6.8% average annual growth in the U.S. consumer price index, prices of gold only had a 1% average annual growth rate in 2021 and 2022.
According to some studies, this precious metal has been a successful inflation hedge for more than a century, but over shorter periods of time, its adjusted price tends to change dramatically. Research shows that since 1972, the ratio of the price of gold to the CPI has averaged 3.6, showing value variations. According to the current gold-to-CPI ratio of 6.4, if gold were a trustworthy inflation hedge, its value should stay mostly unchanged in relation to the CPI.
Recent events have caused substantial changes in gold's position relative to other asset classes like stocks, currencies, and bonds. For a variety of reasons, including changes in the economy, adjustments to monetary and fiscal policy, and other variables, these asset classes operate independently of one another.
Since other forms of asset classes see unique price swings that depend on a variety of factors, including supply and demand, gross domestic product, the current structure of interest rates, and more, investors should view each asset class as equally important.
Best Inflation Hedges: Which Options Stand Out?
Allocating funds to asset classes that typically perform better in times of high inflation is one strategy that investors can use to reduce the effect of higher inflation.
The commodities market includes a wide range of goods like wheat, beef, orange juice, natural gas, and oil in addition to financial instruments like foreign exchange. Commodities have a special connection to inflation because they may predict it before it happens. The cost of products that use a given commodity rises in tandem with its cost.
Real estate investment trusts, or REITs, are companies that manage and run real assets with income potential. Property values and rental revenue frequently increase as a result of inflation. Investors can participate in the real estate market and earn dividends from the rental income by purchasing REITs. The Vanguard Real Estate ETF is a good option for investors looking for broad real estate exposure with moderate costs.
Stocks have the greatest potential for growth over the long term. Companies with little capital requirements typically benefit from inflation, whereas businesses reliant on natural resources typically suffer from it. At the moment, 35% of the S&P 500 index is made up of companies that provide technology and communication services. These sectors are theoretically well-positioned to profit from inflation as they are capital-light industries.
Since it maintains its purchasing value over longer periods of time, gold is frequently thought of as a good hedge against inflation risk. The prices of gold tend to be more stable than those of equities and other assets, which occasionally undergo large changes.
But, the prices of gold can still fluctuate in the short term, and they normally do not appreciate as much over time as equities or bonds do. Due to this, financial experts typically advise individuals to only invest 10% of their portfolio in gold.
Before you buy gold, it's crucial to carefully weigh the benefits and drawbacks of doing so, as well as your financial goals, risk tolerance, and available funds.