Upon rising nearly 20 percent over the past 12 months, gold prices are making headlines and sparking intrigue among investors. While investors may be tempted to associate increased equity volatility (as measured by the VIX Index) to gold’s recent price appreciation, we examine how gold has historically performed in different market periods.
A brief history
Gold’s role in commerce is a history of monetary systems. During the Roman Empire, under a gold-backed monetary regime, the Romans used gold and silver coins to facilitate trade, support capital projects and fund military expeditions. Eventually these costs accumulated relative to the finite supply of silver and gold entering the empire. In response, Roman officials devalued their currency by decreasing the purity of the coins to increase the supply in the market. It was effective to a point. Eventually the diminished coin quality led to hyperinflation, contributing to the demise of the Roman Empire.
Fast forward to the immediate aftermath of World War II, allied nation leaders tied foreign exchange rates to the U.S. dollar and pegged the U.S. to gold at $35 per ounce. That monetary arrangement, The Bretton Woods System, lasted until 1971 when U.S. President Richard Nixon closed the gold window. Since then, global policymakers have generally favored the floating rate fiat currency arrangement in place today.
Unlike other assets whose returns are driven primarily by their ability to generate cash flows, the price of gold is driven primarily by supply and demand. Since the supply of gold is relatively static, the demand for gold is the primary driver of price appreciation. Many investors believe the demand for gold rises when prospects for economic growth weaken, such as in high inflationary or volatile market environments, so we put this assumption to the test since it is key to the price of gold.
Putting gold to the test
Investors are more interested in gold when economic growth expectations taper. This is evidenced by the fact that real interest rate expectations move inversely to gold. Falling real interest rate expectations indicate investors expect a lower rate of return from financial assets in the future, and gold prices are negatively correlated with expected real interest rates. This means gold rises when expectations for real interest rates fall. Investors, however, do not have a good track record of predicting where real interest rates are going. Actual realized rates deviate materially from expected real interest rates, which in turn, affects the return of gold over time.
Proponents of gold argue its price should rise during periods of high and rising inflation, suggesting inflation reduces the purchasing power of a currency relative to a scarce resource. If this is true, the correlation between the rate of inflation1 and the return of gold2 should be sufficiently positive. Between January 1976 and June 2019, the rate of inflation and the return of gold had a correlation of 0.0765. Statistically speaking, we would say there is no relationship between inflation and gold.
Separating the data into different inflationary regimes produced similar results. Despite the common perception that gold provides protection against high and increasing inflation, gold actually has performed best in deflationary environments. Even during periods of high inflation, defined as more than 4.0 percent year-over-year, gold prices generated lackluster returns.
This brings us to another common argument in support of gold. Many believe that gold functions as a safe-haven asset during periods of market distress. To assess gold’s functionality as a safe-haven asset, we turn our focus to drawdowns on the S&P 500 Index. Focusing on those months the S&P 500 Index generated negative returns, gold proponents would expect gold prices to rise or remain static. Mathematically, if this assumption were to hold, the correlation between the returns from gold and the S&P 500 Index should be negative during these periods. We find that correlations are modestly positive during these periods.
As the graph below shows, gold has posted positive returns during moderate drawdowns in equities; however, gold prices actually fell during more severe pullbacks. On the other hand, bonds produced positive returns across these environments, indicating they provide a better ballast against equity market drawdowns.
Performance of Gold and Bonds in Down Markets
Gold, with its rich history as a monetary surrogate, remains a polarizing asset. There is little evidence gold protects against inflation or provides insurance against market drawdowns. While there will be periods when gold provides attractive returns, the inconsistency and unpredictability of these periods dissuade us from including gold in our portfolios. Instead, we recommend constructing a traditional portfolio of fixed income and equities along with an allocation to real assets.
1Defined as the year-over-year change in the seasonally-adjusted Consumer Price Index (CPI) for All Urban Consumers: All Items.
2Defined as the month-over-month change in the gold spot price.