A little over a month ago, the World Bank warned that “the danger of stagflation is considerable”, with low growth prospects and high inflation leading the agenda for the global economy. Indeed, with 0% growth predicted in the UK this year and CPI inflation at its highest level in forty years (9.4%), it would be hard to argue against this assessment. By Giles Coghlan(pictured) , Chief Analyst, HYCM
Driven by rising energy bills, record fuel prices and soaring food costs, the situation looks set to worsen into a recession, with new estimates predicting that inflation could reach 15% in the Winter months. In the current climate, central banks are doing all they can to contain spiralling figures, however, many investors will naturally be debating whether the interest rate hiking cycle will be enough. Inevitably, this raises another question – how can investors protect their portfolios in the face of an increasingly uncertain economic landscape?
Throughout periods of market instability, it goes without saying that preserving capital and reducing risk as much as possible is key. Consequently, many turn to safe haven assets – investments that characteristically exhibit low volatility and resilient performance irrespective of market conditions – to provide them with a sound hedge against inflationary pressures. In particular, gold performs well during such stagflationary periods.
However, since the 4th of July when the USD index surged above 106, gold prices have been pressured by the strength of the dollar (a headwind for gold prices) and the fact that real yields remain elevated. With this in mind, will this recession be different to those of the past, and should investors put their trust in gold?
The historical relationship between gold and stagflation
Throughout past periods of stagflation, the price of gold normally increases as investors seek to diversify their portfolios and hedge against the combination of low growth and high inflation.
For example, between 1973 and 1975, GDP in the United States declined in real terms, whilst inflation grew from 7.4% to 10.3%. Simultaneously, gold enjoyed a price growth of 73% in that period, before doubling in value during another stagflationary period in 1979, when inflation peaked at 10.75%. As such, it is clear that gold has historically shown itself to be a successful hedge against stagflation – but why?
Indeed, there are obvious factors to consider, such as supply and demand, that can impact the price of gold. Unlike stocks, shares or currencies, there is a finite amount of gold on the planet. As a result, its price rarely inflates unless significant gold reserves are discovered in a new location, making it an obvious hedge for inflation. During a recession, when prices are increasing but the value of a currency is decreasing, gold’s price therefore remains largely the same, whilst the value of stocks and share decrease as company profit margins take a hit.
Furthermore, the intrinsic value of gold means that it can act as a ‘global currency’, so to speak, as it will fetch a fair price across the world, even if the country it is stored or bought in is battling a recession or stagflationary period. That said, it is important to note that the price of gold can be impacted more by certain speculative forces – the dollar, bond yields and the political climate – than issues like supply and demand.
Whilst many governments hoard gold, no currency is backed by it. Indeed, whilst the dollar is not tied to the value of gold, its value is inversely related to the USD’s value because gold is dollar-denominated. As such, as the value of the dollar rises and falls, so too does the price of gold.
Bond yields, at face value, also have an important bearing on the price of gold, which are a return on investment for a bond. Essentially, yields are the interest rates offered by bond investments, and act inversely to bond prices. When bond prices are low, the yield is high, and vice versa. Following this logic, when yields are high, gold is less sought after, whilst the opposite happens when yields are low.
However, this does not mean that there is a solid connect between gold and the bond market. In the 70s, for example, gold was rising despite the fact that bond prices were falling and interest rates were soaring. Indeed, what really impacts gold is real interest rates – which is the rate of interest an investor receives after allowing for inflation – which can be determined by the U.S. 10-year inflation index or Treasury yields. A good demonstration of this can be found between January 2009 and January 2013, when 10-year real Treasury yields dipped into minus figures, gold prices reached its highest level in the last decade, reflecting that real interest rates are the key driver in the price of gold.
With the historical context of gold during stagflationary periods of the past in mind, as well as its proficiency for holding value, one might assume that the price of gold will be enjoying a resurgence in the current stagflationary climate. But can the history books be relied upon in 2022?
Pressures on the price of gold
In truth, this relationship between gold, yields and the strength of the USD have been pressuring gold prices in the last month, despite major geopolitical upheaval. Indeed, the USD index surprisingly surged above 106 following the 4th of July holiday, which has pushed the price of gold down.
Meanwhile, real yields are still elevated, reducing the risk in the market and weakening the case for investments into gold for the time being. Therefore, with stocks remaining as a more attractive investment option, total growth for gold prices in the first quarter of 2022 was just 6%, despite spiking to $2,051 on March 8 following the conflict in Ukraine.
Thus, this stagflationary period recession appears to be inflating gold prices to a lesser extent than they have in the past, with some investors arguing that the relationship between gold, the dollar and yields has started to change, perhaps leading some investors to start looking elsewhere for inflationary hedges.
So, how else can investors protect their portfolios right now?
Rotating to more defensive positions is one option of reducing risk in the current climate. In the stock markets for example, stocks that rely on speculative growth and consumer confidence should be avoided. Instead, investors could pivot to stocks in companies that sell consumer staples like food or hygiene products, as they will have a higher likelihood of maintaining profits during a recession or stagflationary period.
Similarly, for bonds, corporate debt may become increasingly risky during such periods, so favouring government or US held international debt could also minimise risk for investors. Furthermore, assets like real estate, commodities or infrastructure can limit exposure to inflation, whilst US government bonds can limit the impact of low growth.
Essentially, creating a more balanced portfolio will help investors navigate politically and economically adverse periods. Whilst gold has historically been a successful hedge to such situations, it seems to be behaving somewhat differently in the current period of stagflation. As such, those investors who can successfully pivot to less risky investment options will have a better chance of protecting their portfolios should the situation worsen.
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Giles Coghlan is Chief Currency Analyst, HYCM – an online provider of forex and Contracts for Difference (CFDs) trading services for both retail and institutional traders. HYCM is regulated by the internationally recognized financial regulator FCA. HYCM is a global brand name of the HYCM Capital Markets Group. The Group via its relevant subsidiaries has representations in Hong Kong, United Kingdom, Dubai, and Cyprus.