Inflation-risk and why you should hedge your portfolio with Gold
Tags: Wealth Management, Retirement Planning, Finance, Gold, Inflation

The title of this post is mouthful so I would urge you to kindly be patient and read till the end as we attempt to connect the various dots in the unfolding story.

1. Response to a medical crisis uncorked the genie called inflation

In March of 2020 in a panic response to COVID-19 and lockdowns, stock markets around the world fell anywhere from 30% to 40%. Developed economies in response cut interest rates to almost zero (in most cases) and announced the largest ever fiscal and monetary stimulus. Since COVID-19 pandemic began approximately $32 trillion of fiscal and monetary stimulus has been pumped into the global economy. This is the largest stimulus as percentage of global GDP that the world has ever seen.

As per World Bank the actual impact of COVID-19 on Global GDP for 2020 has been approximately 4.5% (See chart below)

In 2019, the estimated Global GDP was $87.55 trillion — implying that a 4.5% drop resulted in a loss of almost $3.94 trillion in economic output. On back of vaccination etc, major economies are recovering and IMF’s forecast for 2021’s Nominal GDP for the world is approx. $93.86 Trillion.

The key point to note is that for a $3.94 trillion decline in world’s GDP, 8X times ($32 trillion) in fiscal and monetary stimulus was unleashed. Unfortunately, this scenario is far from over as a recent Reuters news article shows: “The lady isn’t tapering,” ECB President Christine Lagarde told a news conference in Sept 2021.

The massive amount of fiscal and monetary stimulus has unleashed the genie called inflation. The graph below shows how inflation has been running hot since 2021 as a direct result of fiscal and monetary stimulus (Source: “Losing the inflation anchor” article on brookings.edu)

Federal Reserve Chair Jerome Powell has called this rise in inflation transitory. You can read more in this Reuters article here.

2. Will inflation be tamed?

Friedrich Hayek, a great economist and a Nobel Laureate, once compared taming inflation to catching a tiger by the tail — it’s not an easy task when the cat has already escaped the cage.

The folks who are responsible for managing inflation fundamentally believe that the rise in prices have been due to supply chain disruption. The rise and decline of lumber and copper prices are given as an example to make that argument while ignoring the real reason for inflation. In one of the interviews in July 2021 Gita Gopinath, Chief Economist and Director of the Research Department, IMF, said: “More persistent supply disruptions and sharply rising housing prices are some of the factors that could lead to persistently high inflation”.

Unfortunately, inflation this time is more broad-based and not triggered just by supply disruption. The truth is that inflation is being caused due to massive increase in money supply. If $32 Trillion is pumped into a $94 Trillion economy, there is bound to be consequences. Unfortunately, the political eco-system is not done spending. A year after the $2.2 Trillion CARES Act, Congress passed the American Rescue Plan Act of 2021, with a hefty $1.9 trillion price tag. On August 11, Senate Democrats approved a budget resolution, paving the way for an additional $3.5 trillion spending bill, just hours after passing a bipartisan $1.2 trillion infrastructure plan. It does not help that the Federal Reserve continues to buy Treasury Bonds and mortgage-backed securities to the tune of $120 billion per month. In other words, the Fed has been adding $120 billion per month to the money supply. As per sources ECB has set a monthly target of purchasing assets between 60 billion to 70 billion Euros compared to 80 billion Euros in the past months.

The only feasible option to tame inflation is to engineer a “Volcker moment” and tighten the monetary policy by raising interest rates. Is that a feasible option? Developed economies like USA, Japan etc have trillions of dollars in government debt. If the interest rates are raised, then it would mean the governments would have to pay billions of dollars in additional interest. One of the ways to fund this increased interest burden is to increase the tax collection via raising taxes. Given the fragile nature of GDP recovery, we don’t anticipate political eco-system taking the tough decision of increasing taxes in the near future. Therefore, it is highly unlikely that inflation will be tamed any time soon. We don’t see inflation as transitory but we see an era of “persistently high inflation”.

3. How inflation affects your portfolio?

Inflation is the tax government uses when they can’t raise taxes. Inflation works against your retirement savings efforts by suppressing the growth of your purchasing power. Your real rate of return in your retirement savings is the investment return less inflation. If your investment grew by 10% and inflation in that period was 6% then the purchasing power of your savings grew only by 6%. The retirement corpus that you require is much lower when inflation is a benevolent 2% to 6% (RBI target in India) than when it is 6% to 12%.

Inflation in India is likely to stay elevated in line with the global trends. As per Ministry of Commerce and Industry, the wholesale price index (WPI) grew 12.07% during the month of June 2021, while the WPI for May was revised to 13.11%. In India, inflation is being stoked by a mix of high oil prices, high fuel taxes and elevated raw material costs.

Inflation has a negative impact on bonds and equities. Inflation is bad news for bonds because as rates go up, bond prices fall. The effect is more severe for long-term bonds. The price of an equity is determined by future cash flows of a company. In an inflation surge scenario, the input cost rises (See Nestle example here). Without pricing power companies cannot raise prices and hence see lower cash flows and decreased profits. This negatively affects the future outlook of their stock price. In an inflation surge only a select few stocks that have immense pricing power show positive return while most equities tend to do badly.

4. Gold is a good hedge against inflation

Investopedia describes inflation hedging as “An inflation hedge is an investment that is considered to protect the decreased purchasing power of a currency that results from the loss of its value due to rising prices either macro-economically or due to inflation. It typically involves investing in an asset that is expected to maintain or increase its value over a specified period of time.”

“Over the last 30 years, in rupee terms, gold has generated an annualized return of 10%. Over the last decade, the annualized return from gold has been 11%. During the same period, the CPI index has compounded at 6.3%. Hence, it can be stated that over longer periods, gold does act as a hedge against inflation,” said Nitin Shanbhag, head, investment products, Motilal Oswal Private Wealth Management (Source: Mint article). The same Mint article provides further data on gold’s performance: “In calendar year 2001 (CY01), domestic equity (Nifty50 index) corrected by 18%, while gold gave positive returns of 6%. In CY08, during the global financial crisis, Nifty50 fell 52%, while gold was positive 26%. In the recent past, from the beginning of CY18 to the end of CY20 (three years), Nifty50 witnessed extremely high volatility and generated a CAGR of 10%, while gold generated a CAGR of 19% in the same period”.

5. What percentage of your portfolio should be in gold?

We recommend that an investor has 5% to 10% of their portfolio in gold.