Gold and key inflation inputs
- Rising inflation intuitively looks good for gold, but academic literature shows that gold has been an imperfect inflation hedge
- Gold has tended not to be directly impacted by food and energy prices but has remained sensitive to these inflation inputs
- But rising food and energy prices have had wider geopolitical and economic consequences that were gold friendly
An Imperfect Hedge
Inflation hasn’t been a serious and persistent economic problem for developed markets for decades, but this is changing as inflation is rising globally. What do increases in inflationary pressures mean for gold? As a universally recognised and traded hard asset, it can be argued that inflationary periods should be good for gold. Yet, this is often not the case. Despite this intuitive reasoning, there has been no compelling argument historically for gold as an inflation hedge. Indeed, the academic literature supports the view that gold has, on balance, been an imperfect hedge at best.
A review of gold’s historical performances as an inflation hedge shows that much has depended on when in the inflation cycle gold was purchased. Academic studies show that gold has been a reasonably good inflation hedge over the long run, but this can mean 50 years or more and, therefore, isn’t of much use to individual investors. Over shorter time horizons, gold’s correlation with inflation has been 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, outlined arguments that gold has been an unreliable hedge in the short term because of its volatility. This was initially identified by C.B. Erb and C.R. Harvey in the ‘The Golden Dilemma’ (2013). In addition, extended historical evidence presented by Erb and Harvey (2013) suggests that gold has been an unreliable equity and business cycle hedge.
Earlier this year, when gold pushed to $2,069/oz (3 March), it moved into the vicinity of the inflation-adjusted peaks of January 1980 and August 2011. In 1980, gold was supported by worries that the US economy would continue to experience low, stagnant real economic growth and high inflation (stagflation). However, inflation moderated, and from January 1980 to January 1985, inflation averaged 6.3% per year, with the nominal price of gold falling 55% and the real price of gold dropping 65% in that period. In 2011, some were concerned that the Fed’s policy of quantitative easing would lead to a high rate of inflation.
But from August 2011 to August 2016, inflation averaged 1.2% per year and the nominal price of gold fell about 28%, while the real price of gold fell about 33%. Currently, some are concerned that the heretofore excessive monetary and fiscal spending, supply chain disruptions, the impact of war in Ukraine and other contributors to inflation may rally gold. But if gold did not reward inflation fears in 1980 and 2011, why should it reward such fears now?
If gold did not reward inflation fears in 1980 and 2011, why should it reward such fears now?
Food and Fuel
This does not mean that many investors are still not attracted to gold in times of rising prices. Retail coin and bar demand, which has been mostly higher for months, characterises the inflation concerns felt by consumers worldwide. However, their enthusiasm for gold, at least from an inflationary perspective, has not been shared by the institutional and professional investor community.
Food and energy tend to be more volatile than other components of the inflation index. High food and energy prices have a greater impact on those with lower incomes and can trigger social unrest and geopolitical risks, which we examine later in this report. Leaving the broader price indices aside, what impact might food and energy have on gold? Using data from Bloomberg Crude Oil Historical Index (OILPHIST) and UN Food and Agriculture Organization (FAO) World Food Price Index (FFPI) , we examine the possible economic relationship between gold, food and crude oil prices with variables such as inflation and market instability.
Do gold, food and crude oil prices tend to move together? To what extent are they correlated and influenced by each other? How can we articulate this relationship statistically? Using regression analysis, we studied the relationship between global food and gold prices from January 1990 to June 2022 (Chart 1) and found that they exhibited an R2 of 0.7888. When we similarly examined the relationship between gold and crude oil price movements from January 1972 to June 2022 (Chart 2), we found that they also showed a high R2 of 0.6273.
Retail coin and bar demand, which has been mostly higher for months, characterises the inflation concerns felt by consumers worldwide.
Chart 1. Historical price levels show gold and food prices have exhibited a stronger relationship…
Chart 2. …than gold and oil prices
What does this mean for food, energy and gold? These findings depict a strong correlation historically between gold and food and crude oil price movements. The relationship between gold and food has tended to be more consistent than that of gold and oil, possibly due to the sheer volatility of oil prices as opposed to the comparatively greater stability for food prices. But we note that these are non-stationary data points and are not statistically rigorous.
A statistically more rigorous approach gives us even less compelling findings
How do the relationships between gold, food and crude oil prices look if we examine the stationary data? If we take the six-month percentage changes in prices of gold and examine the relationship with the six-month percentage changes in food prices, compared with its non-stationary counterpart, the relationship between gold and food prices has been notably weaker, with an R2 of 0.1100 (Chart 3). Replicating this analysis for oil prices gives us similar results, with an R2 of 0.0917 (Chart 4).
We also examined whether these relationships remain relevant. When we consider only the post-2010 data – as indicated by the gray diamonds in Charts 3 and 4 – we note that the relationship has notably weakened for both oil and food prices. In other words, when looked at over a long period of time, movements in gold prices can be somewhat ‘explained’ by corresponding movements in food and oil prices. But if we focus on more recent periods, the relationships have broken down considerably. Our analysis suggests that only gold and food prices continue to exhibit a marginally positive relationship.
Thus, we agree that gold has been an imperfect inflation hedge. But when looked at in more granularity, perhaps gold has reacted more to certain types of inflation other than oil and food inflation.
Escalating food and fuel prices have led to political violence and supported gold in the past.
Chart 3. Historically, gold prices can still be partly explained by food and oil prices…
Chart 4. …but in recent times, the relationship has broken down
More than Meets the Eye
Rather than focusing on how higher food and energy prices have directly impacted gold, perhaps the real question to ponder is whether they have had impacts on wider fronts, which in turn may have indirectly supported gold?
According to the UN’s Food and Agricultural Organization, the last time the world experienced a combined food-price shock similar to current levels, it helped to set off the Arab Spring. The uprisings resulted in the ouster of four long-serving presidents, as well as civil wars in Syria and Libya. This coincided with a period of rapidly rising gold prices. Currently, the war in Ukraine has destabilised global grain markets and prices, and energy markets have also been similarly impacted.
One reason why high food and energy prices may be more impactful on the world and gold is that food and fuel are necessities. While purchases of other goods or services may be delayed or abandoned entirely, this cannot be the case for food and fuel. Moreover, poorer nations are disproportionately impacted. Should governments attempt to subsidise food and fuel, public debt-to-GDP ratios could rise. Gold is also seen to be sensitive to increases in public debt.
Currently, the war in Ukraine has destabilised global grain markets and prices, and energy markets have also been similarly impacted.
Gold has been sensitive to geopolitical risks. In a report published on 25 June 2022, The Economist pointed to the historical relationship between food and fuel price inflation and political unrest. Escalating food and fuel prices have led to political violence and supported gold in the past. Drops in living standards and resultant unrest have had adverse impacts on financial markets, ending up supporting gold. Political violence – even if it does not result in a change of government – has added to economic dislocation. Social disorder has deterred both direct and portfolio investment. This has reduced GDP, weakened equity markets and boosted safe-haven buying in gold. Although gold may still be more sensitive to monetary policy and US dollar levels than overall inflation, food and energy – in certain circumstances – may nonetheless exert influence on bullion.
This helps reaffirm our views that while gold prices are most likely headed lower as a consequence of tightening monetary policies, more moderate fiscal policies and a strong US dollar, these likely losses should be tempered and measured. In our view, geopolitical risks and food and energy increases, as well as strong retail coin and bar demand, will moderate any potential price declines.
We wish to acknowledge the contribution of Katherine Wu (Intern, HSBC Securities (USA) Inc) in the production of this report.