Gold a bad inflation hedge

Investors seeking protection from inflation would have been better off in US stock market

(PARIS) An enduring dogma of global finance is that gold is a haven. The precious metal is billed as a hedge against inflation - the ultimate insurance against geopolitical risk and protection during periods of turmoil.

With the credit crisis and the US Federal Reserve's response to it - cutting the federal funds and discount rates and injecting huge sums into the banking system - the emphasis on gold's value has focused lately on market dislocations and inflation, although with Iran and the Middle East, not to mention other hot spots, the spectre of political risk is ever-present.

Investors - and there are many - who buy into these suppositions may as well believe in the tooth fairy. Here's why. Gold reached a record US$850 an ounce in January 1980. If its spot price since then had kept pace with US inflation as measured by the Consumer Price Index, gold would now be selling for US$2,119.84. Instead, it was trading at US$732.05 in London last week - about a third of what it should be if it were truly an effective inflation hedge.

History shows that since 1988, the correlation between bullion and US inflation expectations is just 36 per cent, according to Goldman Sachs. That means the price of gold rises and falls with inflation expectations 36 per cent of the time. The relationship between gold and US consumer-price inflation is less, at only 23 per cent. And the metal's correlation with US core inflation, which excludes food and energy costs, is even lower, at 7 per cent.

'Gold is often described as an inflation hedge, but in fact there are few instances in the past 20 years when gold has moved in sync with either core or headline inflation,' says James Gutman, a London-based commodity economist with Goldman Sachs International. Gold therefore should not be used as an inflation hedge, he says.

Investors seeking protection from inflation would have been better off in the US stock market. On Jan 30, 1980 the Standard & Poor's 500 Index stood at 115.20. Adjusting the index to compensate for the increase in the CPI since then would put it at 287.30 today. Yet on Oct 3, the S&P 500 closed at 1,539.59 - more than five times the inflation-break-even level.

As for political risk, the inflationary expectations associated with the Sept 11 terrorist attack on the US - arguably the most dire threat to American security since the 1962 Cuban Missile Crisis or even World War II - had no lasting impact on the price of gold.

Bullion was selling at US$276.25 an ounce on Aug 31, 2001, less than two weeks before the attack. And after rising to as high as US$295.10, it was back at US$274.25 by Oct 23 that year.

Whatever effect inflation has on gold is transmitted through the dollar's exchange rate. Since 1988, gold has moved in tandem with a basket of currencies consisting of the Australian and Canadian dollars, South African rand, euro, yen and Indian rupee 91 per cent of the time, according to Goldman Sachs. And dollar weakness is often associated with inflation.

Even so, there is little to explain movements in gold prices once the currency relationship is accounted for, says Goldman's Mr Gutman.

In any event, with the 1997 introduction of Treasury Inflation Protected Securities (TIPS) in the US and similar products in other countries, there is no reason to use gold as an inflation hedge. TIPS are US Treasury bonds whose principal increases at the same rate as the CPI. The interest payment is then calculated from the inflated principal and paid at maturity.

Not a current concern

What's more, inflation isn't a problem currently, even though the Fed last month cut its funds rate by half a percentage point to 4.75 per cent, and traders are betting there's a 70 per cent chance it will fall to 4.5 per cent later this month.

American consumers expect a US inflation rate of 3.1 per cent in a year, according to the Reuters/ University of Michigan preliminary September index of consumer sentiment.

Still, the CPI fell to 2 per cent year-on-year in August, down from 2.4 per cent in July and 2.7 per cent in June. 'It's far too early to expect higher inflation,' says David Abramson, Montreal-based chief currency and commodity strategist at BCA Research.

Gold has been on a roll. It is up 15 per cent so far this year, climbed to a 27-year high of US$747.90 an ounce on Oct 1 and is on course to rally for the seventh consecutive year. Behind its rise has been the abundance of global liquidity and, more recently, the Fed's relaxed monetary policy and weaker dollar.

Bullion has also benefited from strong jewellery demand in emerging-market countries such as China and India, shrinking global mine production, especially in South Africa, reduced net central bank gold sales and the growth of gold exchange-traded funds, which make it easy for individuals to invest in gold and which have US$17.7 billion in assets, according to Morgan Stanley.

This shows that although gold may be a poor hedge, it is not necessarily a lousy investment. 'It should be invested in for the right reasons,' says Goldman's Mr Gutman.

Nonetheless, bullion has no direct link to economic growth as do other commodities, does not earn a return, offers limited hedging advantages and has not kept pace with inflation. Moreover, the world's biggest holders of gold, major central banks, are not overly eager to keep owning it.

For investors who decide to hold gold, things may not be as easy as the past few years. -- Bloomberg