Investing in gold and profiting from higher inflation

Gold is a widely known and highly trusted inflation hedge.

By this, we mean that investors as a general rule expect that gold will hold, or even increase in value during periods that consumer prices are rising rapidly.

The desire for inflation protection has become particularly important for investors around  the globe in 2022, including in Australia, with inflation rates spiking to multi-decade highs in the aftermath of the COVID-19 pandemic.

This spike, which follows a multi-decade cycle of declining rates of consumer price increases that began at the start of the 1980s can be seen clearly in the chart below, which displays both headline and core inflation rates.

Chart: Annual inflation rates in the United States

Source: Cleveland Federal Reserve, Bureau of Labor Statistics

By the end of June 2022, the annual inflation rate in America topped 9% (it’s since fallen a little), while core inflation, which strips out more volatile food and energy prices sat at 5.9% by end June, and has continued to rise in the months since, printing at 6.3% in the year to end August.

Australia has also seen a spike in inflation in the last twelve months, with consumer prices rising by 6.1% in the last financial year.

The problem is likely to get worse before it gets better, with Dr Phillip Lowe, Chairman of the Reserve Bank of Australia, and the Australian Treasury stating that they are expecting to see inflation rates head to the 7%-8% range by the end of 2022.

Skyrocketing energy prices on the east coast of Australia, which will hit nearly every Australian’s hip pocket, and will be seen in the inflation data going forward, only exacerbate the problem.

This article explores three areas relevant to inflation and to gold, namely;

• Why gold is a trusted as an inflation hedge

• The outlook for inflation

• Why markets aren’t prepared for higher inflation

Why gold is trusted as an inflation hedge

While gold can offer far more benefits to investors than inflation protection, there is little doubt higher rates of inflation are one of the primary motivators encouraging investors to add gold to their portfolio today.

Historically, investors that have held gold as an inflation hedge have been well reward, with the precious metal delivering some of its strongest returns in periods that inflation is high.

The 1970s were a terrific example of gold’s ability to not only protect but enhance capital in an era of high inflation. Average inflation rates, and annual gold price returns in both Australian and US dollars can be seen in the chart below.

Source: ABC Bullion, ABS, LBMA, Bureau of Labor Statistics, RBA

World Gold Council analysis on gold price returns and inflation rates between 1971 and the end of 2021 found that

• The average annual return for gold priced in US dollars was 13.86% in the years that inflation in the United States averaged 3% or more

• The average annual return for gold priced in Australian dollars was 20.29% in the years that inflation in Australia averaged 3% or more

Those returns demonstrate gold’s ability to not only preserve, but actually increase the real value of a portfolio through periods of high inflation.

Few asset classes do well during periods of high inflation or stagflation

Gold’s ability to hold, and even increase in real terms during periods of high inflation is particularly valuable for investors given highly inflationary environments are typically unrewarding for holders of traditional assets like stocks and bonds.

For example, a Schroders study also found that since 1973, gold was by far the best performer in stagflation (high inflation and low growth) environments, generating average annual returns of 22%. Equities fell by 1.5% per annum in those periods, while bonds and cash were basically flat.

Gavekal, a highly respected investment firm, also published a detailed study looking at the returns for share markets going back to the 1880s, looking at equity market returns in both high and low inflation environments.

They found that almost all of the growth that has occurred in the stock market in the last 140 odd years took place during periods of low inflation. Stock markets barely returned anything at all when inflation was high.

Past performance is no guarantee of the future as the saying goes, but history suggests that high inflation is bad news for the stock market.

Given gold’s market leading track record in periods stock markets fall, the negative impact high inflation has on stocks only reinforces the case for gold.

Three reasons inflation is here to stay!

Markets move in long-term cycles.

As mentioned briefly at the start of this article, investors have enjoyed a roughly forty-year period of falling inflation rates. Dating back to the beginning of the 1980s, this era of low inflation lasted right through to the current price surge that we are seeing in the aftermath of the COVID-19 pandemic.

Given this prolonged period of decelerating inflation (or disinflation as it’s often referred too), it shouldn’t be a huge surprise to investors if the next ten to twenty years are characterised by rates of inflation that are far higher than those we’ve become accustomed to.

Note that this isn’t to say inflation will stay near 9% per annum like it currently it is in the United States for the entire period, but a long-period of inflation rates closer to the 5% per annum level (which is well above the inflation rates central banks tend to target, in the 2-3% per annum range) would not surprise.

Indeed, beyond the long-term cycle that markets go through, there are several reasons to suggest inflation will remain elevated going forward. These include but are not limited to:

• ESG factors:

Environmental, Social, and Governance (ESG) factors are front and centre for policy makers, for corporates, and indeed for many investors around the world today.

ESG factors are likely to lead to higher rates of inflation going forward, most notably through their impact on energy markets.

This is because energy producing companies are in many ways being actively discouraged from deploying higher levels of capital investment into increased the production of fossil fuels, with policymaker seeking to limit CO2 emissions going forward.

For example, a Raymond James survey of 50 major companies in the oil and gas space found capital investment fell from USD $600 billion in 2013 to less than $300 billion 2020.

Nevertheless, ESG factors are holding back capital investment in the oil and gas sector, despite the boom that we have seen in energy prices since bottoming out early 2020.

To visualise this, consider the chart below, which shows capital investment as a share of operating cash flow for US energy producers, dating back to the 1990s.

At just 30%, this number is at a record low, with a Bank of America update in June 2022 noting “..there has been no supply response from US producers - their capex as % of operating cash flow has plummeted to just 30% (vs. 80-100% in 2011-16), a record low.

Higher prices typically elicit a supply side response. For fossil fuels, that may not be the case for some time.

It’s not just fossil fuels either, with industrial metals also impacted. This is made clear in the following Schroders chart, which illustrates a more than 40% decline in capital expenditure in the copper industry between 2012 and the onset of the pandemic.

This lack of investment in supply is particularly problematic given the transition to renewable energy, and the ambition of policymakers to hit net-zero emission targets will also require significant quantities of key commodities (for battery production, windfarms, electric cars etc), from copper to lithium to cobalt and even silver.

Given this backdrop, ESG factors are likely to add upside pressure to headline inflation rates for years to come.

There are good reasons to do this, but it does mean higher costs, which need to be borne by consumers and/or by companies accepting lower profit margins.

• Record high debt levels:

Raising interest rates to crush inflation was doable in the 1970s.

Attempts to replicate that process in the next few years risk causing severe damage to the economy, given how much higher debt levels as a share of economic output are.

This is made clear in the table below, which compares debt levels across various sectors (excluding the financial sector) of the United States economy in 1980, which was the end of the inflation spike, and at the end of last year.

Table: US debt to GDP ratios

Federal government debt in particular is almost four times larger as a share of GDP, relative to 1980. Household and business debt to GDP ratios are also substantially higher, with the total debt to GDP ratio in the USA doubling since 1980.

This problem is not just a US phenomenon. While there are differences between countries in terms of debt composition (for example Australia has much higher household debt, but lower government debt), at an aggregate level, there are broadly similar debt dynamics on display across the developed world.

Given how sensitive the economy is to the threat posed by higher interest rates , tolerating higher levels of inflation may be the “least-worst”, or “preferred poison” policymakers choose.

This is perhaps best visualised through the chart below, which shows Eurozone inflation rates (which have spiked to 8.6% by the middle of the year), vs a still negative 3-month interest rate.

So much for central banks being able to hike rates to conquer inflation.

This last factor is particularly relevant for gold, and the role it can play in portfolios going forward. During the period of very high inflation that we saw in the 1970s, cash rates were pushed much higher.

This meant that while inflation was a major problem, the interest rates one earned in a bank account were also rising, in part compensating for the pain felt by higher consumer prices.
This time around, given how much higher debt to GDP levels are, it’s questionable that interest rates will be able to rise anywhere near as much.

That leaves cash and term deposits more exposed than ever to inflation.

Markets aren’t prepared for higher inflation

At present, financial market participants expect the current inflation spike, as uncomfortable as it is, to be a temporary phenomenon, with inflation rates expected to return to a 2-3% range in the coming years.

This can be seen through 5-year and 10-year inflation breakeven inflation rates, which measure what market participants expect inflation to be in the next 5 years, or the next 10 years, on average.

At the end of June 2022, the 5-year breakeven inflation rate was just 2.58%, while the 10-year number was even lower, at just 2.33%.

This gives rise to the current situation where the gap between current inflation rates and expected future inflation rates is the highest on record.

This can be seen in the chart below, which shows the current headline inflation rate minus the 10-year breakeven rate (blue line), as well as the USD gold price (red line).

Chart: Inflation rates and the USD gold price

Source: ABC Bullion, Cleveland Federal Reserve, St Louis Federal Reserve

The only other time we’ve seen anything like this was in the lead up to the Global Financial Crisis, with the inflation gap hitting 3.35% back in September 2008.

For the record, gold was trading at USD $884 per troy ounce at the time. Three years later it had almost doubled, having climbed above USD $1600 per troy ounce by late 2011.

The fact that financial markets aren’t prepared for higher inflation today, coupled with how well gold performed last time we faced a similar discrepancy between current and future expected inflation rates, only reinforces the potential value of holding the precious metal as a safe haven asset and inflation hedge in a portfolio.

The fact that financial markets aren’t prepared for higher inflation today, coupled with how well gold performed last time we faced a similar discrepancy between current and future expected inflation rates, only reinforces the potential value of holding the precious metal as a safe haven asset and inflation hedge in a portfolio.

Warm regards,

The ABC Bullion Team

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