Gold bullion as a hedge against inflation
The Central banks of the world’s biggest economies are all in a ‘battle’ to devalue their currencies. By ‘printing’ enormous quantities of currency through quantitative easing, central banks are aiming to debase the value of their currency and therefore increase the competitiveness of their industry overseas. This should drive (a little – they hope) inflation which should motivate consumers to spend and invest. That is the theory.
In practice, however, this is a very risky attempt to manipulate the value of fiat currencies, which could lead to a severe currency and inflationary crisis and consumers lose faith in the value of paper money. In this environment gold could prove to be the ultimate hedge.
Quick Overview
Positives
- Gold has been a safe store of value in periods of high inflation
- It has been used as a form of exchange and currency for millennia
- Gold is easily transported
- You cannot print it
Negatives
- Gold does not provide a yield
- The gold price is volatile and in periods of low or negative inflation it can be subject to severe draw-downs
Let’s take a look at these points in more detail.
1). Gold has been a safe store of value in periods of high inflation
There is no denying that gold has fulfilled its role as a store of wealth for the last 2500 years. The gold in an aureus coin of the B.C. Roman Empire would purchase approximately the same quantum of commodities, labour, or fixed property today as it could then. No fiat currency ever introduced, even if all interest paid on it had been re-invested without taxation, has come close to passing that test over any extended period.
In 2011 Warren Buffet gave this – now infamous – view on gold, which has since been adopted as part of the gold bears’ doctrine:
“I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars – that’s probably about a third of the value of all the stocks in the United States. For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven ExxonMobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it
and fondling it occasionally…Call me crazy, but I’ll take the farmland and the ExxonMobils.”
His point is indeed very valid. However, I think Mr. Buffet would struggle to find another asset that, despite decades of inflation (the US dollar has lost 96% of its purchasing power since the creation of the US Federal Reserve in 1913!) could still buy the buy the same, if not more, assets than it could 100 years ago. In other words, gold has fulfilled its role as a secure store of value, as it has done for millennia.
2). It has been used as a form of exchange and currency for millennia
The history of Gold as money in modern coin form spans 2630 years. The earliest known use was in 643 B.C in Lydia (present-day Turkey). Gold was part of a naturally occurring compound known as electrum, which the Lydians used to make coins. By 560 B.C., the Lydians had figured out how to separate the gold from the silver, and so created the first truly gold coin.
Numerous civilizations throughout history have had obsessions with gold. The Roman empire, the Aztecs, the Incas, the Mayas and many others all had a fascination with gold. The Romans were the most successful of these in harnessing its use for trade, but it has always been used for trade or as a powerful display of wealth and social standing.
3). Gold is easily transported
Property and land are real assets that should theoretically retain their purchasing power relatively well over economic cycles. However, one would struggle to carry their property across borders. Due to the heavy nuclei in its atoms which are closely packed, gold is a heavy precious metal and therefore one doesn’t need a huge amount of it to be carrying a very valuable cargo.
The traditional gold bar stored by central banks, weighs 400 troy ounces (438.9 ounces of 12.4kg) and can therefore easily be carried, is worth about $660,000 at today’s gold price.
Moreover, property and land may be seized by governments or creditors should they have debt associated to them, or even taken over by foreign enemies in war. Other real assets such as inflation linked bonds can very quickly have their value eroded by a collapse in the currency of the bond’s denomination.
It is worth noting, however, that governments can make it illegal to ‘hoard’ gold, as happened in the US in 1933. Therefore, storage is a crucial element of owning physical gold bullion. Investors should also note that the safest investment in gold is in physical gold bullion itself as the many forms of derivatives and exchange traded funds that track its price very successfully is normal times, might be ineffective as a form of exchange in extreme events.
4). Gold cannot be printed
vs. 
The price of gold is determined by supply and demand. While demand for gold is impossible to predict, one should assume that in times distress, demand for quality assets should rise. Supply of gold, on the other hand, is a little easier to predict given there is a limited quantity of it on our planet and we are restricted by how much we can extract from the earth. It’s supply therefore should remain reasonably constant.
So the theory goes:
Gold is priced in USD
USD supply is increasing substantially through Quantative Easing le while the supply of gold is limited
The USD should therefore fall in value relative to gold. Or in other words, the gold price, in USD, should rise.
Negatives
1). Gold does not provide a yield
While property, stocks and inflation linked bonds can provide a yield through rental income, dividends or interest payments, gold provides no yield.
This is true in most environments, but with today’s ZIRP (zero interest rate policy) world, even yielding assets produce very little income. Some, such as inflation linked bonds, even give a negative yield!
2). The gold price is volatile and in periods of low or negative inflation it can be subject to severe draw-downs
Gold’s 30-day standard deviation over the last 10 years has averaged 10% vs. 12% for global equities. The peak for gold volatility was in October 2008 when it peaked at 56%, although during that period equity volatility peaked at 82%.
The issue with volatile assets is that they can be subject to severe draw-downs and gold is no exception. The worst draw-down ever in gold was between September 1980 and August 1999 when it lost 62%. Had someone bought at the top in 1980 it would have taken them 21 and a half years to recoup their initial nominal investment, see chart below.
Most commentators take very extreme views on one specific asset for an all in or out approach. That is definitely the best way to make (or lose!) a lot of money in short periods of time, but for sensible investors the key is to diversify into a number of asset classes and adapt the weighting to these as the economic cycle develops. Gold is not a guarantee for success and will be subject to severe draw-downs again in the future. However, at this juncture in the economic cycle, with uncertainty at every corner and central banks fighting to debase their own currencies, the asymmetry seems to point very much in favour of owning a portion of one’s assets in gold.
