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Inflation and Gold, hedging the unexpected?
In a world of increasing government debt with greater emphasis on the issuance of nominal bonds, the structural decline in trend growth rates which has been demonstrated (by Reinhart and Rogoff, 2010) as government debt ratios extend beyond 90% considerably increases the temptation for governments and central banks to solve their debt problems by springing an inflation surprise. The rapid rise in the price of Gold in recent years has been attributed, by some analysts, to the desire of investors to hedge the possibility of such inflation surprises. Whilst Roy Jastram, in his book The Gold Constant, ably demonstrated that Gold has been a very poor hedge against realized inflation over the very long run, can the same be said with respect to unexpected, or surprise, inflation?
One way to measure unexpected, or surprise, inflation is by taking the differential between actual inflation and some measure of forward consumer price expectations. The upper chart does that, subtracting one year median forward inflation expectations in the US University of Michigan consumer survey from actual inflation. Whilst inflation surprised positively in the late 1970s and negatively in the last few years, over much of the period there has been very little difference between expected and realized inflation.
Not only is Gold a very poor hedge against inflation in the long run, it also has very limited ability to predict future inflation trends (see “The unreliability of Inflation Indicators” by C Steindel et al, April 2000). So, how good is Gold for hedging against unexpected inflation or inflation surprises? The bottom chart shows the 5-year unexpected inflation (realized minus expected) on the x-axis (horizontal) vs. realized Gold returns on the y-axis (vertical). The positive slope of the line shows that the more inflation surprises on the upside, the higher Gold returns are, reflecting an adjustment in the price of Gold to higher-than-expected inflation, whilst lower-than-expected inflation tends to be associated to lower Gold returns, with investors re-assessing what the price of Gold should be given the lower-than-anticipated inflation environment. Over a 5-year period, unexpected inflation explains 37% of the variation in Gold prices, indicating that Gold is a far from effective hedge against inflation surprises: it is a modest, partial hedge at best.
Are equities any better? If we regress 1-year equity returns on unexpected inflation over the same 1-year period, the coefficient of determination (R-Square) of the regression is 0.01, meaning that there is virtually no relationship at all between these two variables. If we extend the time horizon to 5 years, the results are unconvincing, as shown on the middle chart that plots 5 years annualized equity returns (vertical) vs. 5 years unexpected inflation (realized minus expected) (horizontal). The R-Square is higher (0.23) meaning that there is a link - albeit weak - between inflation surprises and equity returns over a 5-year period, but this relationship is actually negative: the higher or the more positive inflation surprises turn out to be, the lower or the more negative equity returns are. If anything, equity returns tend to behave in the opposite way of inflation surprises. The S&P500 does a poor job of hedging inflation surprises at a 1- and f5-year horizon.
Whilst Gold clearly does a better job of hedging inflation surprises over a 5-year horizon, the ability of Gold to hedge is partial at best and the available evidence suggests that the Gold price, in itself, is also a very poor predictor of future inflation trends.
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