Commodities, Features, Gold

How gold protects investors from ‘higher-for-longer’ inflation

gold inflation

Gold has performed well so far in 2024. In fact, the year-to-date return of 16 per cent makes gold, in Australian dollars, one of the best-performing assets locally and globally (see chart 1 below).

Strong central bank purchases, spikes in geopolitical risks and investor bullish positioning have pushed gold further into all-time-high territory.

Chart 1: Gold outperforms in 2024

Major asset performances (in Australian dollars) in 2023 and up to May 2024. Image: Bloomberg, World Gold Council

As gold has reached record highs in recent months, a common question from investors is: “Has gold run its course and, if not, when would be a good entry point?”

While demand drivers remain supportive of gold, an equally important question at present for Australian investors is: “How is your portfolio set up for ‘higher for longer’ inflation and rates?”

Inflation has come down in Australia, but not at the pace the Reserve Bank of Australia (RBA) expected. According to the latest information, inflation grew by 3.6 per cent year on year (y-o-y) in the first quarter (Q1) of 2024, slightly higher than the consensus expectations of 3.4 per cent.

Similarly, both core CPI (excluding food and energy) and the trimmed mean measure for Q1 also came in above expectations.

At its May meeting, the RBA revised its inflation projections higher (see chart 2 below) citing the stronger labour market and higher petrol prices as main drivers.

This has raised concerns about the effectiveness of the RBA’s current disinflation efforts, leading local investors to intensify their expectations that rates will stay higher for longer.

Chart 2: The RBA is re-thinking inflation prospects

Quarterly Australian CPI and the RBA’s projections after Q1 2024. Image: Bloomberg, World Gold Council.

Implications for local portfolios

The combination of high inflation and elevated interest rates has led to a rising correlation between Australian equities and bonds in past years (see chart 3 below).

As interest rates climb, bond prices fall and equities suffer due to a lower net present value of future earnings discounted by a higher rate. And rising inflation erodes the real value of both bonds and equities.

Chart 3: Australian equities and bonds are now moving in the same direction

Rolling 12-month correlation between Australian equities and bonds. Image: Bloomberg, World Gold Council

Elevated inflation weakens the appeal of bonds as a diversifier (see chart 4 below). At inflation levels below 2 per cent, the correlation between global equities and global treasuries has been negative, providing diversification. But at levels above 2 per cent, this relationship starts to break down.

Chart 4: Sticky inflation comes with elevated correlation between bonds and equities

Conditional rolling three-year correlation between global stocks and bonds. Image: Bloomberg, World Gold Council

A positive correlation between bonds and equities undermines the value proposition of bonds as a portfolio diversifier, resulting in Australian bonds contributing a much larger share of total portfolio risk (see chart 5 below).

Chart 5: Bond’s risk contribution to the portfolio has been surging

Risk contribution of bonds in a 60:40 portfolio. Image: Bloomberg, World Gold Council

Looking ahead, rates are not likely to go much higher. This may improve the return prospect of fixed income assets. But risks exist: persistent inflationary pressures remain the primary obstacle to monetary easing.

The lessons here are two-fold:

  • the contribution to portfolio risk from bonds is now much greater
  • there is no guarantee that bond and equity correlations will turn negative again or remain stable, particularly considering the potential for inflation volatility.

It is important, therefore, to have assets that can help in these scenarios rather than relying solely on government bonds as a portfolio diversifier.

Gold as a shining diversifier for Australian investors

Gold has been an effective diversifier for equity risks. Our analysis shows that gold, in Australian dollar, held up well and provided attractive returns when local stocks suffered the most severe pullbacks in history (see chart 6 below).

Chart 6: Gold has provided positive returns during Australian equity market pullbacks

Performances of gold and bonds during the worst ten quarters of Australian equities. Image: Bloomberg, World Gold Council

We understand that consistent negative correlation is not the ‘holy grail’ for investors. While it protects investor portfolios in market downturns, it can also undermine overall gains. As such, it is important to highlight gold’s unique relationship with equities: providing downside protection and sharing upside potential (see chart 7 below).

And this unique characteristic stems mainly from gold’s diverse drivers: it fulfils both safe-haven demand and wealth expansion needs in its capacity as a financial asset and a consumer good.

Chart 7: Gold offers the correlation investors want

Correlations of gold and bonds with Australian stocks over the past 30 years. Image: Bloomberg, World Gold Council

World Gold Council (WGC) research shows that investors can benefit from taking a longer-term strategic view when it comes to gold.

Looking beyond gold’s short-term staggering performance, historical data shows that it has provided a stunning 9 per cent average annual return since 1971 in Australian dollars (see chart 8 below). And with geopolitical risks spiking more frequently, and central bank gold purchases extending, WGC is confident that gold will remain an important strategic component of modern portfolios.

Chart 8: Gold has provided attractive long-term returns

Gold and other major asset performances during different periods. Image: Bloomberg, World Gold Council

The RBA recently revised up its expectations for future inflation, causing investors to anticipate a much higher rate in Australia than previously.

The combination of sticky inflation and elevated rates usually leads to increasing correlation between bonds and equities. As inflation is likely to remain stubbornly elevated, the correlation between bonds and equities could remain high, reducing diversification within portfolios.

We believe it is important for investors to utilise gold’s role as an effective diversifier – across various rates, inflation, and volatility environments. While gold provides downside protection when equities pull back as a safe haven, it also benefits from economic prosperity when stocks rise through consumer demand.

Gold’s attractive long-term return combined with its performance amidst geopolitical and macroeconomic uncertainty, make gold a key component of robust investment strategies.

Words by Ray Jia, World Gold Council senior research analyst.

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