Sprott’s Thoughts On Gold vs Inflation: It’s Not What You Expected

gold vaultDoes Gold Care About Inflation? 
Sprott’s Thoughts Digs In, & the Result Might Not Be What You Expected…

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Submitted by Sprott’s Thoughts

When it comes to gold, we hear a lot of talk about its many uses. It’s an investment in its own right, a high-flying speculation, a substitute for cash, and an insurance policy against monetary disasters. Gold bugs call it a necessary tenant in every portfolio. Skeptics call it a shiny rock with no coupon. At Sprott, while we appreciate gold’s potential to deliver considerable returns, we also consider gold to be an important diversification tool. This article illustrates how gold can be used to manage risk in a typical portfolio.

From a portfolio construction standpoint, gold is an easily accessible tool to smooth out the volatility of returns. Why? Gold is not perfectly correlated to either fixed income assets like bonds, or equity assets like U.S. stocks.

Cpi1

Why does this matter? As we all know, business cycles are inevitable: a stock portfolio may rocket upwards during a bull market, or surge lower in a bear market. As gold does not move in tandem, it can have the effect of “smoothing” out your portfolio’s performance across cycles, particularly when you look at it over a multi-year time period.

We’re not the only group who thinks this: even the standard Wall Street firm could argue the case for gold as an important part of a well-balanced portfolio. Every year, JP Morgan releases a report of expected returns for all major asset classes. They also release their anticipated correlations of each asset class.

It’s a lot of numbers to digest, so I broke down the data for you.

A correlation of 1 is “perfect,” i.e., if one moves up, the other will move up by exactly the same proportion. A correlation of -1 is “perfectly inverse.” This means if one moves up by 5, the second will fall by 5, the same factor. A correlation of 0 means the items are “perfectly non-correlated,” meaning the there is no relationship between the movements of the asset classes. Once we take a look at how gold behaves against other asset classes, an interesting picture emerges.

Cpi2

Gold & Commodities: In the gold column, the most obvious relationship is gold and commodities. Of the asset classes I highlighted above, this is one of the strongest relationships across the board. That is pretty intuitive, so we’ve got a decent sanity check on JP Morgan’s numbers here. Interestingly, the strength of the Gold and Commodities relationship is nearly the same as the Commodities and U.S. Large Cap Equities’ relationship. Conversely, Gold and U.S. Large and Small Cap Equities have nearly zero relationship.  This illustrates that gold truly does behave differently in the market place than other commodities.

Gold, Debt & Inflation: Gold is hardly related to inflation. When inflation is on the rise, gold, well, doesn’t really care. U.S. Treasuries and Bonds, however, are strongly impacted by inflation. For those with debt in their portfolios, in an inflationary environment, gold may help to sustain overall portfolio value as debt instruments take a beating.

Gold & Stocks: Now we can look at gold’s relationship to public equities, both large and small. Respectively, that’s .02 and .04 – essentially zero relationship. In fact,  in JP Morgan’s opinion, gold acts more like a U.S. Investment Grade Corporate Bond than U.S. Small or Large Cap Equities. This is the crux of our argument that gold is an important component of any portfolio. Gold moves, essentially, to the beat of its own drum.

 

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