The performance of gold as an asset class is usually assessed in US dollar terms. This approach overlooks differences in
currency performance over time, which can significantly distort returns. For example, gold would have been a much better
investment in a high-inflation country with a depreciating currency than in a country with low inflation and a stable currency.
An examination of the gold price over the last 30 years would call into question gold’s largely unquestioned status as a store of value.
This study looks at the Australian dollar gold price, using data from the Perth Mint[1].
Exchange rates and inflation
are two big factors that obfuscate the true underlying performance of gold. As
the chart below shows, the stellar performance of gold we hear so much about loses a bit of its lustre once exchange rates and inflation are taken into account.
In Australian dollar terms,
gold has proven to be quite a volatile commodity over the last 39 years. The
chart below shows the inflation-adjusted gold price since the days of the Whitlam prime ministership,
with prices rebased to Sept 2013 levels using the ABS inflation series and
interpolating inflation rates between quarters.
The most noticeable fact from
this chart is that despite the decade-long bull market, we have nowhere near
approached the highest recorded modern price of gold when inflation is taken
into account. The short, sharp spike in 1980 is generally explained as occurring due to a confluence of
extraordinary geopolitical events, such as the Soviet invasion of Afghanistan
and the storming of the US embassy during the Iranian revolution.
Looking through this one-off spike and rebasing the series to an index where the gold price on 2 January 1975 is set at 100, the chart below emerges.
This chart makes it easier to see the long periods over which gold did not hold its real value. When the series falls below the x-axis, gold was worth less than its 1975 value. The choice of starting point does not make a big difference. The real gold price at the start of 1975 would be witnessed again in 1979, 1989, 1993, and 2006. Other than the period between 1979 and 1989, gold did not hold its value between those points in time.
The longest such interval
is the 13 years someone who bought gold in 1993 would have had to
wait for his investment to merely recover its original value. If we ignore the rally in the preceding years, this bear market lasted almost two decades, from 1990. This long
underperformance is partly explained as caused by the offloading of gold by
central banks. Another likely explanation is that the economic boom that arose off the back of the IT revolution made gold a relatively unattractive investment option.
Nonetheless, this chart should
help dispel the mystical aura that seems to surround gold and its status as a
safe haven. An investment that can take up to 16 years to become positive and
can fall by up to 30% in a matter of months is not low-risk in my book.
30 years would usually be
considered to represent the ‘long term’, as it spans the majority of
most people’s working lives. Yet as the chart above shows, since the
abandonment of the gold standard, there have been several points when gold
investors would not have maintained their initial investment after inflation, even after holding gold for 30 years. Buying and holding gold up to today would have proved
very costly if it was bought at one of the peaks in the 80s, especially when
opportunity cost is taken into account.
Of course, historical performance is no guide of future performance, and it is possible that gold may hold its value better in future. But the historical data we have so far from the end of the gold standard is not encouraging. It is also interesting that the volatility of gold has not affected its status as a safe haven.
In countries with high inflation, the perennial depreciation of the domestic currency makes gold look like a good investment and works as an effective inflation hedge. For example, the Indian rupee has moved in only direction since independence. It has gone from parity with the US dollar in 1947 to more than 60 rupees to a dollar today. Assets priced in foreign currencies, such as gold, have thus held their value, and delivered big returns in local currency terms.
However, simply holding foreign currency may be a safer strategy. Given the difficulty in obtaining and storing foreign currency and the traditional attraction to gold, it is not difficult to see the preference for gold as a popular store of value in countries like India. In the absence of a stable fiat currency, gold continues to play its ancient role as a store of value. In China, negative real returns on savings increase the relative appeal of gold as an investment. Together, India and China represent half of the world's demand for gold.
It could be argued that such monetary settings will provide a support for real gold prices as these countries continue to industrialise. As their populations become wealthier, they may continue to store their wealth in gold. However it should be noted that the Indian government recently slapped a tax on the importing of gold, as it was being blamed for its ballooning current account deficit. It is also questionable whether such monetary settings would be consistent with China’s stated aim of increasing consumption and reducing reliance on exports.
Another important question
facing Australian gold investors is gold’s relationship with the exchange rate.
Gold is priced in US dollars, which means that movements in the exchange rate
can lead to a significantly different investment return in Australian dollars,
compared to the underlying movement in the gold price. As the first graph
reveals, the significant appreciation of the Australian dollar significantly
cut the peaks of the gold price bull markets. If two investors in Australia and
America had each bought a gold bar in June 1991 in their home currencies, at
the peak of the gold bull market, the American would have enjoyed a nominal price
appreciation of more than 5 times his initial investment, while the Australian’s return in his home
currency would have been well under 4 times.
A study of Australian dollar gold prices and the exchange rate shows that there is a negative correlation between the two, meaning that they tend to move in opposite directions. The monthly return of gold has a correlation coefficient of -0.4 with the change in the exchange rate. This seems logical – being priced in US dollars, all else being equal, the AUD value of gold should rise when the Australian dollar falls and vice versa.
Finally, in exploring gold’s ability to preserve wealth, a logical point of comparison would be the share market. Another tenet amongst investors is that equities outperform other asset classes in the long run.
A look at the All Ordinaries accumulation index from 1984 shows that shares soundly beat gold as a store of value over the last three decades, despite the 1987 Wall Street crash and the 2007 financial crisis. A dollar invested in the share market was mostly able to hold its real value over extended periods of time. Even if you had bought at the peak just before the Wall St crash in 1987, you would have recovered the purchasing power of your initial investment by 2005, and it would be worth roughly the same today. Of course, we don't know yet how long investors who bought at the 2007 peak will have to wait to recover their investment.
Yet again, the numbers are sobering when inflation is taken into account. While the All Ords with dividends reinvested is a staggering 7.4 times its 1984 level in nominal terms, in real dollar terms that performance is whittled down to a more modest but still impressive 2.6 times.
The volatility of the All Ords dwarfs the movement in the gold price. A casual observer will be able to notice the daily swings and hence conclude that shares are risky. Yet the graph above indicates that over the long run, the share market is better as a store of wealth. This should not be surprising considering that the sharemarket is an aggregation of an economy's companies, which are generally able to reflect inflation in the prices they charge their customers.
Fundamentally, economic value arises from the profitable provision of goods and services that are in demand, which is precisely what listed companies do. It is hence empirically sensible that investing in a diversified group of companies providing a strong proxy to economic activity is likelier to be a good store of value. On the other hand, the demand for gold is driven largely by investors and speculators, and its total supply is determined by mining activities. New engineering and scientific breakthroughs may make it easier to mine and refine gold, leading to an increase in supply.
In conclusion, this short study goes some way in showing that in Australia at least, recorded history in the age of fiat currency does not suggest that gold is a safe store of wealth. It also illustrates just how powerful inflation can be in masking true investment performance.
