Historically, gold has been widely considered as an inflation-proof investment. Investors from all across the world purchased record volumes of physical gold ETFs and other exchange-traded products in 2020, driving gold prices to all-time highs of over $2,000 per ounce (in August) – The precious metal had the highest yearly return of all major asset classes.
Since that time, the circumstances have been altered. Recently, major geopolitical conflicts, high volatility, and increasing inflationary pressure have surfaced as investors' primary concerns, and gold has not yielded the expected returns.
In this article, we will explore the relationship between gold and inflation, as well as explain the various ways in which investors can get involved with the precious metal.
A short refresher
Inflation is defined as a prolonged rise in the general price level of goods and services in an economy. Since 2020, after a period of reduction, inflation has been on the increase. In April 2022, the annual inflation rate in the United States remained at 8.3%, a level unseen since the 1980s.
Inflationary pressures have extensive economic consequences. First, they diminish purchasing power by increasing retail prices. Risk-induced increases in interest rates can also boost borrowing costs. Inflationary pressures can fuel additional inflation, creating a feedback loop. As consumers spend more quickly to limit the amount of time they spend holding depreciating currency, the money supply exceeds demand, leading the buying power of currency to decline even more rapidly.
During the recovery from the outbreak, job creation and wage growth have been substantially greater than they were following the Great Recession over a decade ago. In contrast to the years following the recession, inflation is currently increasing and eroding market confidence.
Inflation and gold, an inverted relationship
Gold has historically been seen as a hedge against inflation – Gold's price increases with inflation as it is a commodity priced in dollars.
Furthermore, due to its limited quantity and tangible nature, its value tends to remain stable during periods of rapid inflation. Investors who have repeatedly witnessed gold defy inflation tend to purchase gold when they anticipate inflation.
However, it is important to note that historical evidence reveals a varied performance during earlier periods of inflation. During several of the most recent periods of high inflation in the United States, gold has provided negative returns for investors.
For instance, investors in gold lost an average of 10% between 1980 and 1984, when the annual inflation rate was approximately 6.5%. During periods of inflation, returns on alternatives such as Treasury Inflation Protected Securities (TIPS), Real Estate Investment Trusts (REITs), and commodities are superior.
Nonetheless, according to FED data, the proportion of U.S. government reserve assets kept in gold has increased over time. In 2020, reserves reached a record $494 billion, up from $277 billion in 2015.
This figure emphasizes that the U.S. government engaged in considerable gold accumulation as a response to both the financial crisis of 2008 and the Covid-19 outbreak, illustrating the value of gold in economic climates that are fraught with uncertainty.
Various allocation methods
Other than purchasing and retaining gold, which can be quite cumbersome and costly, there are numerous allocation options.
Gold can be purchased by investors using derivatives such as futures contracts. The value of derivatives is derived from the value of the underlying asset. CFDs, futures, and forward contracts provide indirect exposure to gold without requiring investors to physically possess the commodity.
Investors can also indirectly invest in gold by purchasing shares of gold mining firms. These businesses typically track the movement of gold on the spot market. Therefore, they can give an indirect exposure to gold for investors.
Finally, gold funds are a legitimate investment vehicle for gold. They are actively managed funds meant to follow the price of gold by fund managers. Investing in mutual funds or gold ETFs, which are traded on stock exchanges, is a low-cost and cost-efficient alternative for investors to obtain exposure to gold.
On a separate note, it is important for investors to keep in mind that gold is not a passive income investment per se – it does not have any intrinsic income-generating characteristics. As such, gold trails when the stock market is expanding.
Gold, a timeless asset
Investing in gold is a proven method of portfolio diversification. The precious metal generally performs consistently, even during uncertain times. Hence, including gold in a portfolio may be a tool to consider for achieving a balance between volatility and rewards. In addition, gold is exceptionally resistant to extraordinary occurrences. Despite the fact that a catastrophic economic crisis or stock market crash can have a devastating effect on the majority of the market, gold is likely to be standing up.
The rate of inflation around the world is expected to keep climbing in the years to come. Because of this, the prognosis for the market could remain negative, which would boost the attractiveness of gold. In point of fact, the price of gold might rise much higher if inflation were to explode to the upside and even beyond the high estimates that are already in place.
Ultimately, a diverse range of factors influences not only the value of gold but also the part it plays in the portfolios of investors. But in any case, the value of gold as an investment has a long and reputable history.
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