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If we look at the period from 1976 to today inflation explains nearly 44% of the variance in the price of gold. However, if we focus on the more recent period since 1997, the U.S. dollar has clearly played the leading role in this regard, accounting for almost 57% of the variance. The fact of the matter is that using gold as a hedge has lost much of its significance ever since inflation targets have become a core concern of central banks around the world. Words: 1079
In further edited excerpts from the original article* Matthieu Arseneau (www.nbf.ca) goes on to say:
Gold as an Inflation Hedge
It took more than 30 years for an investor who turned to gold at the end of the 1970s (prior to the surge) to regain his money in real terms. The least we can say is that this inflation hedge is a little slow delivering on its promise! What’s more, it took the worst global financial crisis since the 1930s, a sharp depreciation in the U.S. dollar and inflation fears related to the massive injection of liquidity in economies around the world for the return on gold to just barely top U.S. inflation. As investors, we must keep in mind that, over the long term, holding this so-called safe haven comes at a cost. Indeed, other assets afford more alluring returns over the long term.
Gold as a Safe Haven
Aside from its popularity in times of high inflation, gold’s weak correlation to other assets is often pointed to as one of its strong suits. Indeed, if diversification is the objective, then the inclusion of an asset that is uncorrelated to the market is a means of improving a portfolio’s return-to-risk ratio. However, [our analysis indicates] that the inclusion of gold in a U.S. equities portfolio does not lower the risk level enough to compensate for the rate-of-return shortfall. Though the inordinate use of gold does not appear to pay off over the long term, it can nonetheless represent a smart move in the short run.
As it happens, however, the correlation between the price of gold and the U.S. stock market since 1978 has been nil. As a result, gold played its role as a safe haven very well during the past two bear markets.
There is no denying that investors who had the prescience to make gold part of their investment strategy have had reason to rejoice of late. However, we must bear in mind that, historically speaking, the stock market has by far outperformed gold in the two years following a market trough.
Golden Rule: Keep an Eye on U.S. Dollar
Aside from gold’s status as a safe haven, the collapse of the U.S. dollar and inflation fears have also been cited to explain why the precious metal has soared in recent years. In our opinion, the first of these two factors goes a longer way towards accounting for the price surge… movements in the U.S. dollar have had a much larger impact in this regard than inflation has.
As gold is dollar denominated, there exists a negative correlation between the metal and the greenback. Indeed, when the U.S. dollar depreciates, foreign investors who were prepared to pay a given price for gold in their local currency will be willing to pay a higher price in U.S. dollars, thereby setting a spiral in motion. In addition, when the U.S. dollar declines, gold becomes more affordable for foreign investors. This tends to boost demand and, in turn, price. Finally, we must keep in mind, especially in the present context, that the U.S. dollar is also competing with gold as a safe haven.
Has Gold Appreciated Unduly?
A strong relationship existed between the price of gold and the U.S. dollar since 1997. However, in the past year, the relationship has not held up. Increases in the price of gold have largely surpassed what the value of the greenback would justify and, as such, we believe that the relationship will revert to normal in the coming quarters.
Truth be told, the events observed recently have been extraordinary.
1. there has been an unprecedented aversion to risk on the markets.
2. the sharp deterioration in the U.S. government’s budget situation is considered by some observers as a ball and chain likely to weigh down the value of the U.S. dollar over the long term.
3. the massive injection of liquidity by the Federal Reserve has raised concerns about its ability to contain inflation in future. In this regard, the measures taken by the Fed have brought the level of monetary accommodation back to where it was in the 1970s when gold was all the rage!
Fabrication Demand Declining
Investment demand for gold is what has been driving up price rising slowly until about a year ago when exchange-traded gold funds registered exceptional growth. These new vehicles have made it very easy for investors to seek shelter in gold and this has further contributed to the metal’s appeal. The downtrend in fabrication demand (which has been declining steadily for some 10 years now) and the volatility in investment demand are, to our eyes, two risk factors for the price of gold in the coming months.
Growth Factors Behind Us
In our opinion, all the factors that contributed to the recent upswing in the price of gold are set to reverse. Risk premiums are falling at breakneck speed and still have room to contract some more. As for inflation running out of control, unlike others, we are of a mind that the Federal Reserve and its counterparts around the world will not hesitate to tighten monetary policy if inflationary pressures mount. As for the currency, despite the structural challenges facing the U.S. economy, the greenback could be poised to rebound even further on the strength of cyclical forces if the Federal Reserve is forced to hike rates sooner then expected.
Conclusion
Investors who dared place some of their eggs in gold in recent years have been nicely rewarded for what they did. However, the time has come now to revise their positions.
If the past 30 years are any indication, gold does not constitute an attractive investment over the long term. Moreover, in times of economic recovery, the return on gold falls well short of the return on the stock market.
*www.nbf.ca