Dealing with Inflation and Instability
With another major economic stimulus package finally approved, the market's reaction to date has been anything but confident.
While investors forecast and await the full impact of the plan, special attention is being paid to the magnitude of the package, leaving some to wonder what the implementation of this historically massive government deficit-spending plan may have on the value of the dollar and the potential for a long-term inflationary period. For inflation-wary investors who contemplate a loss in purchasing power, there are several options to consider. Equities, Treasury inflation-protected securities (“TIPS”), real estate, and commodities (including gold) have all historically provided a degree of protection against inflation. However, gold's unique characteristics to protect against both inflation and economic instability make it a particularly attractive alternative to consider in a well-diversified portfolio during periods of turbulence, such as the present.
Prior to implementing inflation-hedging strategies, investors must also understand and consider the trade-offs inherent to each of these strategies, including return, volatility, and duration of protection. Before addressing the specific attributes of gold investments, we will review the other alternatives that history has shown to help preserve purchasing power.
Equities provide a terrific inflation hedge over long time horizons. Corporate business earnings tend to rise and fall with inflation as a result of adjustments to pricing. However, the lack of principal protection makes an additional allocation to equities a risky alternative, particularly given recent levels of volatility. TIPS, which are backed by the full faith and credit of the U.S. government, provide direct inflation protection by adjusting the principal on the underlying U.S. Treasury bonds every six months proportionally to changes in the consumer price index. However, due to the six month lag in principal adjustments and interest payments, TIPS bear some maturity risk and are not a perfect hedge against inflation. Real estate offers a natural hedge against inflation, since changes in the consumer price index are factored into rent adjustments. However, given the oversupply of real estate, this is not an attractive asset class to increase investment exposure at this time.
Commodities are favored by investors and businesses for strategy specific risks or to specifically address inflationary opportunities. Commodity prices tend to rise during periods of inflation and, in a self-fulfilling manner, the rise in their prices are an inherent cause of inflation. Commodities are particularly prone to speculation, however, which leads to higher volatility and the inherent timing / pricing risk compromises their marginal level of maturity risk.
Investment in gold can come in a variety of different forms, all with varying elements of risk, liquidity, and cost.
Of all commodities, gold is popularly known as a safe haven during turbulent economic times. Being a durable, tangible, store of value grants gold the ability to maintain its purchasing power and counter the effects of inflation and currency fluctuations. Because of gold’s relatively fixed supply, an ounce of gold will retain its buying power even as prices rise, making it an accurate proxy for inflation. Investment in gold is also considered a portfolio diversifier, due to its negative correlation with equities and real estate. Coupled with its low relative levels of volatility compared to other commodities, gold’s diversifier characteristics make it a viable option for investment in dislocated and agitated markets. Further, gold is unique in that it does not carry a credit risk. Gold is no one’s liability and is not subject to another party’s ability to pay.
Although the pressure of falling relative prices does not help the price of gold, the instabilities that accompany falling prices may. Recent global financial-market uncertainty has been the underpinning of the demand for gold. However, it is important to note that the price of gold, and investors’ subsequent return on investment, is exclusively dependent upon supply and demand, since gold does not pay out dividends or make interest payments. With supply relatively fixed, return on an investment in gold is at the whim of market demand.
Investment in gold can come in a variety of different forms, all with varying elements of risk, liquidity, and cost. The most direct form of investment is actual ownership of the asset through purchase of gold bullion or coins. Although this method tracks gold dollar for dollar, commissions, premiums, and minimum investment requirements tend to be high. Gold bullion can also carry concerns about authenticity and purity, as well as the burden of significant storage and insurance costs.
When gold prices move higher, publicly traded gold mining companies with high levels of production tend to see an increase in their bottom line. Investment in mining companies, via stock or mutual funds, offers exposure to gold with the potential added benefit of an income stream (if the company or fund pays out dividends). Mining companies, like all other corporations, however, are not impervious to government legislation, taxes, geopolitical risk or market volatility, making the risk of this type of investment relatively high compared to the other alternatives. In addition to these risks, investment in mining companies does not track the performance of gold as closely as purchase of bullion or investment in exchange-traded funds.
Investment in exchange-traded funds offers the highest level of liquidity with minimal tracking error and fees. The share price of SPDR Gold Shares (GLD) tracks the price of gold and represents an investment in gold bullion, without the hassle of storage and insurance. The fund’s $24 billion-plus market capitalization, currently the eighth largest gold holding in the world, gives it ample liquidity.
Specific market conditions often lead to market inefficiencies. For example, bond prices tend to fall in inflationary periods, but the resulting yields on the bonds that suffer the price decline may temporarily provide an attractive premium over inflation. Similarly, if stocks are highly overvalued (arguably not an immediate concern), they can become less effective at fighting inflation. Looking long term, no single asset class will serve as a perfect hedge against inflation. There can, however, be a rational response considering historical trade-offs of these assets.
If the objective is to mitigate the risk of an extended period of inflation and global economic instability, the best strategy may involve diversification among some or all of the asset classes described above. As you consider the positioning of your portfolio in the current environment, it may be helpful to readdress the long term purchasing power of your assets.
