Gold: Inflation Hedge and Long-Term Strategic Asset

Abstract

Will today’s solution become tomorrow’s problem? An increasing number of investors are becoming wary about the outlook for price stability. What if central banks leave interest rates too low for too long or pump too much money into the economy? If they do, they risk making today’s solution into tomorrow’s problem: a sharp rise in inflation. If inflation does materialize, then traditional inflation hedges, such as gold, commodities, real estate, and inflation-linked bonds, are likely to outperform other mainstream financial assets. Gold has a long history as an inflation hedge: In the eight years between 1974 and 2008 when U.S. inflation was high (defined as CPI inflation exceeding 5%) gold rose by an average of 14.9% in real terms, outperforming other assets such as bonds, equities, and even other commodities. Still, some investors may be reluctant to add an asset intended to function primarily as an inflation hedge to their portfolio at this stage, as there are currently equally compelling reasons for inflation to remain low. This leads the authors to ask whether any of the four traditional inflation hedges can demonstrably enhance investors’ risk-adjusted returns even in a low-to-moderate inflation environment. Real returns are not, after all, the only means of assessing portfolio performance. The volatility of an asset’s returns and its interaction with other assets are also important. The authors also examine how gold has performed relative to the other three traditional inflation hedges, both individually and collectively, using a portfolio optimizer. They then explore whether a strategic case can be made for gold in the portfolio of an investor that already holds TIPS (inflation-linked bonds).

TOPICS: Commodities, financial crises and financial market history, portfolio construction, performance measurement