Gold As Inflation Hedge (Pros, Cons & An Alternative)
Gold is often touted as a traditional inflation hedge. Moreover, gold is a store of value and is regarded as a safe haven asset class.
However, the track record of gold as an effective hedge against inflation has been inconsistent, especially since it yielded negative returns during some of the highest inflationary periods in the US.
We’ll also introduce you to an alternative investment asset (fine art) that historically acted as a hedge against rising inflation.
Why Gold is Regarded As An Inflation Hedge
A. Gold’s Performance During the 1970s And Early 1980s
During the high inflationary periods between the 1970s and early 1980s, there was a massive spike in inflation in the US. This was partly because of rising oil prices.
However, the price of gold soared during this period of higher inflation:
- In 1972 inflation doubled to 8.8%, while gold prices reached $38 per ounce in August of that year.
- The gold price went from $65 per ounce in 1973 to around $195 by the end of 1974 — a 200% increase over two years. Between 1973 and 1974, gold prices increased by 60% while the S&P 500 dropped by 20%.
- In 1976 gold prices nosedived to around $100 but by 1979 it bounced back to $500 per ounce.
- By 1980 inflation reached 14%, while gold’s price peaked at $850 in January.
In short, the price of this precious metal increased by a whopping 2,100% from 1972 to 1980.
It’s no surprise that this precious metal won over many investors looking for inflation protection during a period dominated by rising price levels.
It’s important to note that the performance of gold as an inflation hedge has been subpar from 1980 to 1984. During this time, the average annual inflation rate was 6.5%, yet gold prices dropped an average of 10% each year.
The returns from buying gold not only failed to keep up with inflation but also did worse than other investments, such as real estate, the S&P 500, and other commodities like silver.
B. The Price Of Gold Is Not A Function Of Interest Rates
Data shows that there has only been a 28% correlation between interest rates and gold prices since 1970.
In the long term, gold market prices largely depend on supply and demand. While increases in supply can result in a drop in the price of commodities, demand usually plays a more crucial role.
The level of physical gold supply changes slowly — it takes a decade or longer for a newly discovered gold deposit to become a gold-producing mine.
In fact, according to the World Gold Council, global gold demand increased 12% year over year to 2.189 tons in the first half of 2022.
Thus, rising interest rates may increase gold prices because they negatively affect earnings and the stock market.
Data from 1975 to 2001 indicates that the S&P 500 Index, stocks, and bond yields are highly correlated with inflation and interest rate changes. In most cases, rising interest rates lead to a declining stock market, which prompts investors to look elsewhere for better returns
One way investors rebalance their portfolios is through gold investment.
Why Gold May Not Be A Reliable Short-Term Inflation Hedge
Let’s look at how gold isn’t an effective hedge against inflation during shorter periods:
A. Gold Is An Effective Inflation Hedge Over Long Periods
Some studies have found that gold is a good inflation hedge and can protect purchasing power over long periods of time: typically more than a century. However, gold’s performance as a short and medium-term inflation hedge is less promising:
- Long-term: According to data from 1895–1999, the price of gold increased by around 0.3% annually — meaning gold maintained its value over a century.
- Medium-term: During the period 1980–2001, nominal gold prices decreased by around 70% when the inflation rate averaged 3.71% per year.
- Short-term: From 1988 to 1991, gold yielded a negative 7.6% return — when inflation was about 4.6% per year.
Additionally, since 1971, gold’s correlation to higher inflation or inflation expectations has been relatively low — at 0.16 (a correlation of 0 indicates no relationship, while a correlation of 1 indicates they move parallelly).
If the precious metal was a good inflation hedge, its price ratio to the US consumer price index (CPI) should ideally remain somewhat consistent over the years.
But that has not been the case:
- The ratio between gold prices and CPI inflation (changes in consumer prices) has experienced volatility over the past 50 years, going from a low of 1.0 to a high of 8.4, according to Wall Street Journal columnist Mark Hulbert.
- Since 1972, the ratio of gold’s price to the consumer price index has averaged 3.6. But it now sits at 6.5 (Aug 2022).
B. Gold May Not Hedge As Well Against High Inflation
In March 2022, gold prices were trading at $2,000 per ounce. However, gold prices didn’t meet inflation expectations and trended downwards, even when US inflation was at its highest level since 1981.
This is partly because the Federal Reserve (the central bank in the US) introduced significant interest rate hikes to combat surging inflation and high consumer prices. Higher interest rates in the US tend to attract foreign investment, increasing the value of the US dollar.
The US dollar reached a two-decade high — 16% higher than other major currencies.
However, a stronger dollar weakens the purchasing power of other currencies, decreasing the demand for and value of dollar-denominated gold.
C. Holding Gold Does Not Usually Generate A Fixed Income
Some financial market experts believe that high-interest rates lead to a drop in physical gold prices.
This is because higher interest rates usually lead to higher opportunity costs for holding a non-interest-bearing asset class like gold. As a result investors look to other higher-yielding assets like bonds.
For example, in 2015 gold prices fell due to the Federal Reserve Bank and its talks about interest rate hikes. Conversely, November 2022 saw the spot gold price increase by 0.6% when the Federal Reserve decided to slow down interest rate hikes.
Like other asset classes, gold has not replicated past trends, and it’s impossible to know how your gold investment will perform.
Looking for an alternative asset for inflation protection?
Consider investing in contemporary art.
An Alternative Long-Term Inflation Hedge: Contemporary Art
Here are a few reasons why blue-chip art can act as a good hedge against surging inflation:
- Present-day performance: The first half of 2022 concluded with one of the highest auction sales ever — a grand total of $7.4 billion. In the latest art world news, Sotheby’s, Christie’s, and Phillips sold a record-breaking $3.2 billion worth of art in the fall of 2022. These impressive results happened as the stock market tumbled, and the US annual inflation rate was at about 7%.
- Historical performance: When inflation in the US was at around 9% each year from 1973 to 1981, the fine art market had an average appreciation of 33.2%. On the other hand, gold averaged an annualized growth of 31.1%.
Contemporary art also appreciated more than the S&P 500 and other inflation hedges like gold over the last 26 years.
- Low correlation to traditional assets: A Citi Private Bank report found a long-term correlation of 0.12 between the fine art market and the S&P 500 Index.
- Intrinsic value and buyer sentiment: Art also has an intrinsic value in the owners’ eye, which can’t be diminished by inflation. The fine art market depends heavily on buyer sentiment. So, it can still appreciate during high inflation.
For investors looking to diversify without shelling out millions of dollars, they have the option to invest in fractional shares of contemporary paintings.
Masterworks is an art investment platform that lets you invest in shares of museum-grade paintings by famous artists with established track records, including Sam Gilliam, KAWS, Vincent van Gogh, and more.
Here’s how the platform works:
- The Masterworks’ research team identifies which artist markets have growth potential.
- The team then locates the piece and purchases it.
- Masterworks files an offering with the Securities and Exchange Commission (SEC) to securitize the artwork.
- After you’ve invested in shares, all you need to do is wait. Masterworks can hold the painting for 3–10 years. If the piece is sold at a profit, you’ll receive pro rata returns after fees are subtracted.
- Alternatively, you can sell your shares on the secondary market.
All of Masterworks’ eleven recent exits have handed investors +9.2% net returns.
Ready to own shares of multi-million dollar paintings?
Fill up the Masterworks’ membership application to get started.
Net returns refer to the annualized internal rate of return net of all fees and costs, calculated from the offering closing date to the date the sale is consummated. IRR may not be indicative of Masterworks paintings not yet sold, and past performance is not indicative of future results.
See important Reg A disclosures: Masterworks.com/cd