The long and short of it: gold, cryptos, inflation, risk and uncertainty

Are we on the cusp of a historic economic turning point? Will decades of “low-flation” and falling yields give way to high inflation, yet gold underperforms, and cryptocurrencies become the hedge of choice?

We believe it’s well worth considering long-term performance across asset classes. Direct explanations for the relative performance of gold and cryptos are an interesting alternative angle on the current growth/inflation conundrum. 

Why excavate gold only to bury it in vaults?

Warren Buffet once quipped that he couldn’t see the point of gold: People dig it out of one hole in the ground (a mine), only to lock it away in another (a vault). Indeed, gold has little real economic use beyond jewellery and limited industrial applications nowadays.

Yet, gold’s economically pointless extraction and hoarding may be precisely its financial purpose. Gold, a safe-haven currency without a country, can provide risk mitigation during uncertainty, inflation, deflation and stagflation. This comes from the idea that gold has almost always been trusted as a verifiable, tangible substance that can be exchanged for goods, services or assets at will.

The utility of gold may have much less to do with its cost – the energy, money, time spent on exploration, extraction or storage – or intrinsic value from economic use, than its insurance value. In our view, gold has provided useful portfolio insurance compared to other major financial asset classes - through thick and thin.

Gold generated positive real and nominal returns during the entire, post Bretton-Woods, fiat-currency era until COVID-19. This was the case in all macro regimes based on US data (Figure 1) – high inflation (defined as periods with above target inflation in which the Fed was tightening); stagflation (below trend growth with above target inflation – the 1970s); NBER-designated recessions; and balanced growth with near-trend growth/near-target inflation. Gold also performed in line with US Treasuries in real and nominal terms over the entire post-Bretton Woods era. (Figure 2).

On the face of it, this performance suggests that gold has done reasonably well as a source of portfolio insurance. That said, unlike conventional financial assets, it has been highly volatile with no running yield to cushion price movements, especially in periods of rising real interest rates.

So why is gold lagging now amid inflation risks and geopolitical threats, after millennia as the go-to hedge against instability and uncertainty? The simplest explanation is probably the best. Gold is steady at high levels because inflation is high. The pandemic persists and geopolitical and geo-economic tensions are elevated – yet all these threats of macro instability are being contained.

• First, inflation is proving to be higher and more persistent than hoped but may yet be controlled, as most central banks have begun to normalise policy, reducing the appeal of gold. Economic growth recovery and higher inflation as well as slowing central bank asset purchases and higher policy rates imply higher yields, likely diminishing the appeal of gold as a zero-yield investment.
• Second, central banks have repeatedly reduced extreme tail risks, reducing the need for insurance.  Central banks did whatever it took to prevent severe deflation during the Global Financial Crisis, the Eurozone Crisis and the pandemic. Now they’re moving to address the threat of high inflation. Gold is therefore less in demand as insurance against the extreme tail risk scenarios of severe deflation or uncontrolled inflation.
• Third, much of today’s inflation pressure may be driven by economic adjustment to a late-/post-COVID environment. Demand has rebounded with reopening in much of the world, but supply seems to be lagging because of bottlenecks, shortages and labour market mismatches. Lack of investment during the extended period of on-again, off-again lockdowns has also played its part.
  
  East Asia provides much of the world’s manufacturing capacity at a time when goods demand is up, and with a COVID zero-tolerance policy, is occasionally shutting factories or ports. Logistics, shipping, trucking and other services are short-staffed in much of the world for various reasons – lack of vaccination in many emerging markets; lockdowns in some; income support in many rich countries, or other labour mismatches.
  
  Tightening monetary policy is unlikely to solve these shortages and may impede the required investment and supply response – though it should help manage the demand pressures contributing to inflation. 
• Finally, like inflation, geopolitical and geo-economic tensions are high, but aren’t spiralling out of control from competition into confrontation, let alone conflict. Escalation of elevated tensions is apparently being limited by dialogue and shared circumstances, like economic integration, and shared interests in stability and climate risk mitigation. This mix probably helps account for high gold prices, which, although down on March 2020 highs, remain well above pre-pandemic levels.

Crypto as an e-inflation hedge, disrupting gold?

Many now argue that the bitcoin/crypto rally with gold languishing as inflation rises, signifies that cryptos are starting to displace gold as an inflation hedge. Yet, other issues may be at play. The zero yield, high volatility and costs of cryptos are shared with gold. But cryptos face restrictions on their use in many jurisdictions, unlike gold. Many central banks – a major source of gold demand in recent years – are unable or unwilling to buy cryptos.

Furthermore, the lure of innovation may be at work in the crypto space more than fear of inflation. This includes the potential of the underlying distributed ledger technology and decentralisation in reimagining the financial system. It may also be that cryptos are better suited to tax, regulatory or other legal arbitrage - testified by widening regulatory restrictions – than the gold market, where central banks and other mainstream investors are major players.

Finally, worst-case scenario - in a full-blown geopolitical crisis or an outright, major conflict, beyond the capacity of central banks to manage – gold could be seen as superior insurance to cryptos. This is because cryptos would require continued, near-normal operation of financial transactions – unlike physical gold at least.

Getting down to brass tacks on gold

The threat of persistently high inflation, downside risks from new COVID variants, waves or regional lockdowns, and elevated international tensions calls for keeping some exposure to gold. On balance, conventional inflation protection in short-dated/cyclical assets of issuers plus tail-risk insurance, including some gold makes sense.

Portfolios are probably best geared to economic normalisation because the world still seems likely to exit the pandemic, even if in fits and starts.