Over the last three decades, commodities have had a statistically significant and largely consistent positive inflation beta, or predicted reaction to a unit of inflation. The research, led by Sue Wang, Ph.D., an assistant portfolio manager in Vanguard Quantitative Equity Group, found that over the last decade, commodities' inflation beta has fluctuated largely between 7 and 9. This suggests that a 1% rise in unexpected inflation would produce a 7% to 9% rise in commodities.1
The discussion about equities as an inflation hedge is trickier. Our research reveals a sharp contrast in the hedging power of equities compared with that of commodities. "Equities have a love-hate relationship with unexpected inflation," Ms. Wang said. The contrast presents itself as an inconsistency manifested in three distinct stages over the last three decades.
relationship between inflation and gold index
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The 1990s marked the "hate" stage of the love-hate relationship, Ms. Wang said. More than a decade after the Federal Reserve under then-Chairman Paul Volcker raised interest rates to double digits to combat inflation, the Russell 3000 Index, which represents about 98% of the U.S. equity market, had an unexpected inflation beta ranging from around negative 2 to around negative 9. That means a 1% rise in unexpected inflation would equate to a 2% to 9% decline in the index.
The index's unexpected inflation beta increased and at times turned positive in the 2000s, after the dot-com bubble burst. In the low-growth, low-inflation era of the 2010s, the markets determined that a little inflation wouldn't be a bad thing, and the unexpected inflation beta turned positive and stayed there. "Any signs of inflation after the global financial crisis were a positive signal for equities," Ms. Wang said. The beta has remained positive but has weakened in recent years, suggesting a market less sanguine about what inflation might mean for returns in the years ahead.
Industrial-Metals Prices as an Inflation Indicator. It is no coincidence that highs in commodity prices coincide with highs of inflation, as indicated by such measures as the consumer price index (CPI). Figure II shows how the CPI tends to rise more rapidly after industrial-metals prices rise, and to decelerate after they decline. To show this, the sample of 39 years is divided into three subsamples in which metal prices changed to different degrees. The average path of the CPI is shown for each subsample separately.
Least-squares analysis confirms that movements in industrial-metals prices, as with gold, are leading indicators of inflation. But in further testing, the correlation with subsequent CPI movements is not as close as for the precious metals, nor do industrial metals move as early.3
Figure II illustrates the fact that precious-metals prices are, in turn, a leading indicator of industrial-metals prices. Again, the 39-year sample is divided into three equal subsamples in which the price of gold changed to different degrees. The average path of the industrial-metals index is shown for each subsample separately. As price movements in industrial metals anticipate inflation, price movements in precious metals anticipate the industrial metals.
Figure III suggests that it takes two or three years to reach the widest divergence in prices in different gold-price environments. There is a strong correlation between gold and both immediate and subsequent price movements in industrial metals. The average time lag is about six months.
Response of Different Commodity Groups to the Price of Gold. Gold prices change more rapidly than other indicators of inflationary pressure, including commodity prices. Figure V illustrates the leading role of gold in influencing the price behavior of several commodity groups - textiles and fibers, foodstuffs and crude oil. The data suggest a wide range of price sensitivity to gold in different commodity groups. But in all cases, it takes at least three years for the effects of a change in the price of gold to be fully reflected in the prices of any of these commodity groups.
Comparative Influence on Metals Prices of Changes in the Dollar and Changes in National Output. The relationship between one variable and another can be summarized by their correlation coefficient, and Table I shows correlation coefficients between industrial-metals price movements and the two economic variables with which they are most closely connected.
The table demonstrates, first, that the relationship between real gross domestic product growth and changes in metals prices is purely cyclical. In other words, the effect growth has on prices does not last. This can be seen by recalculating the correlation using longer and longer time frames. Growth is positive and quite strong in the short run, but diminishes and eventually reverses itself over longer periods. The middle column of Table I illustrates this pattern, comparing the correlation between annual changes in the data with the correlations between two-year, five-year, 10-year and 20-year changes.
Thus, the positive relationship between metals prices and GDP disappears with the passage of time. Although positive for the first two years, the years that follow show a negative correlation. The relationship is positive on a cyclical basis, probably reflecting the influence of economic growth on the supply-and-demand picture for metals. But on a longer-term basis the relationship is inverse, probably reflecting the negative influence of inflation (as expressed by metals prices) on economic growth.
Table I also demonstrates that the relationship between price movements in metals and gold works very differently. The correlations in the right-hand column are strong, and become stronger still over longer time frames. Thus, there is both a cyclical and long-term relationship between gold and other metal price movements.
The relationship between real gross domestic product growth and changes in industrial-metals prices is purely cyclical. The correlation is quite strong in the short run, but diminishes and reverses itself over longer time frames. The first column of Table I compares the correlation between annual changes in the data with the correlations between two-year, five-year, 10-year and 20-year changes.
Table I demonstrates that the positive relationship between metals prices and GDP diminishes over time. Changes in the prices of industrial metals account for about one-fourth of the change in GDP one year later. Although positive for the first two years, the years that follow show a negative correlation that may disappear over time. These results show a positive relationship on a cyclical basis, probably reflecting the influence of economic growth on the supply and demand picture for metals. But on a longer-term basis the relationship is inverse, probably reflecting the negative influence of inflation (as expressed by metals prices) on economic growth.
The second column of Table I shows that the relationship between the price movements of metals and gold works very differently. This correlation is also strong, and also becomes even stronger as the time frame for expressing changes in the data lengthens. The relationship with gold is both cyclical and long term.
Conclusion. The prices of industrial metals and other commodities are correlated with gold, but take time to respond fully to movements in gold prices. When gold plunged in April 2013, industrial metals prices dropped as well. The reason is not a matter of supply and demand in the usual sense; we measure all these prices in U.S. dollars, and the value of the dollar simply rose. Since June, the dollar has been falling, the price of gold has been rebounding and metals prices have begun to climb back too. While lagging behind gold, industrial-metals prices perform in advance of inflation.
1. The relationship between gold prices and the value of the dollar is explored in R. David Ranson, "The High Cost of a Cheap Dollar," National Center for Policy Analysis, Issue Brief No. 131, October 24, 2013. Available at
During times of economic instability or recession when the value of the dollar plummets, investors flock to stable, solid investments like physical gold and silver as a way to store their wealth. As a result, this demand boosts precious metal prices and helps give investors a hedge against inflation and the devaluing of the dollar.
The value of silver generally fluctuates more than gold due to the many industrial applications that tie the white metal to the fortunes of numerous industries. Platinum and palladium, other rare metals that are often invested in as a hedge against inflation, are similarly prone to fluctuation.
Inflation can cut into a portfolio just as much as any other form of risk. The declining value of the dollar can put pressure on stocks, as well as savings accounts and bond holdings. Gold, silver, and other precious metals can be a safe way of avoiding these pitfalls and keeping a wise investor immune from the forces of hyperinflation and inflation. When diversification is the goal for an investor, gold can always be a segment of their portfolio.
In a high inflation environment, as central banks raise rates, the interest one can earn with excess cash can be expected to increase. In contrast, the opportunity cost of owning gold increases, as gold does not pay an income like investment options such as term deposits or other fixed income investments. In these circumstances, investors could potentially be expected to favour income-generating investments over gold.
The AUD/USD rate historically has been positively correlated to the USD gold price. Looked at another way, past performance of gold prices suggests an inverse relationship between the USD/AUD exchange rate and the USD gold price. This is shown in the graph below.
A positive correlation between the AUD/USD rate and the USD gold price suggests that as gold increases in value, the AUD has historically gone up as well. The result is that gold price returns denominated in AUD have been cut short by the changing exchange rate in previous cycles. 2ff7e9595c
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