US consumer inflation hit a 40-year high of 8.5% in March,1 home prices have jumped 19.8%,2 and the ongoing pandemic and Russian sanctions continue to add pressure to rising commodity prices and global supply chain disruptions. All this points to inflation persisting for longer than expected.
Meanwhile, rising prices have weighed on household reserves. The US savings rate as a percentage of disposable income dropped to 6.2% in March from 26.6% a year ago,3 exacerbating concerns of an economic and corporate earnings slowdown. Mitigating these dual headwinds requires looking beyond traditional markets and including inflation-sensitive assets such as real estate investment trusts (REITs), natural resource equities, infrastructure equities, inflation bonds, broad commodities and gold in portfolios.
These alternative exposures may be beneficial over the near term and have the potential to create a more robust risk-aware strategic asset allocation for the long term.
Incorporating Inflation-Sensitive Assets
Whether through their underlying company operations, direct exposure to tangible assets like property or commodities, or promissory notes obligated to pay returns based on the rate of inflation, inflation-sensitive assets tend to benefit from rising and elevated inflationary environments. And given the sensitivity of these assets to monthly changes in US consumer prices, they can be used as substitutes for both equities and bonds.
The “equity real assets” of global infrastructure, REITs and natural resources all carry higher beta to US Consumer Price Index (CPI) compared to both US and global equity indices. Additionally, they offer correlations to a global 60/40 stock-bond mix ranging from 0.70 to 0.89 over the prior 20 years, as shown in the following chart. Therefore, adding these assets to help shield portfolios from inflation delivers the additional benefit of increased diversification.
Given that specific sectors may be more volatile than a broad traditional beta exposure, investing in a diversified basket of these inflation-sensitive equity themes and industries may be a reasonable approach.
Inflation-sensitive assets also can complement traditional bond allocations. Global core bonds, while providing a low correlation to equity segments of portfolios, are likely to remain under pressure from both inflation eroding the value of coupons and rising interest rates leading to duration-induced price declines. Bonds’ negative beta to inflation, as shown in the following chart, illustrates the trouble bonds have during periods of increasing inflation.
Treasury inflation-protected securities (TIPS) and gold are alternatives to traditional bonds and may help combat inflation and increase diversification. Both exhibit low correlations to the global portfolio, but carry a higher sensitivity to changes in consumer price levels
Inflation Sensitivity versus Correlation to Traditional Assets
Among the inflation-sensitive alternatives evaluated, broad commodities exhibited the highest sensitivity to changes in inflation, as shown in the preceding chart. This is not surprising as two of the largest contributors to consumer price indices — energy and food costs — are based on commodities. Yet, while broad commodities have showcased high inflation beta over the past 20 years, today’s inflationary environment is more extreme. Taking a longer view showcases the differences between broad commodities and gold.
Using Gold to Defend Against Inflation and Macro Risk
As shown in the following chart, if we go back and include the period of stagflation during the 1970s, gold also has a track record of protecting against periods of extremely high inflation (periods with greater than one standard deviation above the average CPI level). During these limited inflationary shocks, the real return for both gold and commodities was better than that of stocks, bonds, and REITs. And compared with commodities, gold offers the additional benefit of maintaining real returns during periods of extreme disinflation or even deflation.
Performance Based on Inflation Regimes
While inflation remains critical to monitor, the confluence of complex macro risks make volatility a material risk to traditional portfolios. Year to date, gold has outperformed the S&P 500 Index by 14.17%,4 showcasing its ability to protect against equity market pullbacks. Meanwhile gold’s track record of providing diversification to financial assets is well documented with a long-term correlation to stocks and bonds of 0.00 and 0.07,5 respectively.
Exposure to a broad commodity index may offer portfolio diversification benefits, but not to the same extent or as efficiently as gold does in terms of downside risk mitigation. For instance, broad commodities are up 30% year to date but the average 30-day volatility of returns has been 22.57%. Comparatively, the gold price is flat year to date6 and its volatility has been just 13.72%,7 40% lower than broad commodities. Gold’s volatility is also in line with its historical average while commodities is 70% greater than its own average.8
The power of gold in this capacity can be further demonstrated, beyond our brief sample size above, when comparing its up-market and down-market of equity returns to individual commodities and broad commodity indices historically. Commodities such as oil, copper, and even silver are inherently more cyclical than gold and tend to have a higher correlation to market and economic cycles because their demand depends more on pro-cyclical consumption.9
Upside/Downside Capture of Commodities to Equities
As a result, commodities historically capture more of the upside movements in global equities compared to gold. But they also experience more of the downside when equities fall. The end result is that commodities’ upside/downside capture ratio of equity returns is less than 1.0 on average, making the asset class a less effective portfolio diversifier. 10 Gold, on the other hand, may not outpace commodities when equities rise, but it provides protection by averaging only a slight negative capture of 1.8% during periods of negative global equity returns.11
Particularly in an environment of elevated volatility due to economic and geopolitical uncertainty, increasing exposure to assets with low correlations and an attractive downside capture ratio is key to creating truly diversified portfolio allocations that result in an asymmetric total portfolio return experience over time.
Adding inflation-sensitive alternatives may help mitigate the impact of elevated inflation and volatility driven by economic and geopolitical uncertainty. Consider:
A distinct gold exposure for inflation and volatility management
An actively managed diversified real asset strategy for risk-managed exposure
A real asset equity position with high inflation sensitivity for differentiated beta
1 Bloomberg Finance, L.P., State Street Global Advisors. Based on headline US Consumer Price Inflation (CPI) Index based on year over year percent change as of March 31, 2022. 2 Bloomberg Finance, L.P., State Street Global Advisors. Based on S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index year-over-year percentage change as of February 28, 2022. 3 Bloomberg Finance, L.P., State Street Global Advisors. Based on US Personal Saving as a % of Disposable Personal Income as of March 31, 2022. 4 Bloomberg Finance L.P. as of May 13, 2022 measuring S&P 500 total return index and gold spot price (US$/oz) 5 Bloomberg Finance L.P. & State Street Global Advisors; S&P 500 monthly correlation is from 8/31/1971 to 04/30/2022 and Bloomberg Barclays U.S. Aggregate Bond Index monthly correlation is from 3/31/1976 to 04/30/2022. Correlation measures the degree to which the deviations of one variable from its mean are related to those of a different variable from its respective mean. Stocks represented by S&P 500 Index; Bonds represented by the Bloomberg Barclays U.S. Aggregate Index. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. 6 Gold spot price (US$/oz) year to date is -0.28% as of May 16, 2022. 7 Bloomberg Finance L.P. as of May 16, 2022 based on the 30-day volatility of the spot price of gold and the Bloomberg Commodity Index 8 Bloomberg Finance L.P. as of May 16, 2022 based on the 30-day volatility of the spot price of gold and the Bloomberg Commodity Index from 2017-2022 9 World Gold Council, " Gold, commodities and reflation” March 2021. 10 Bloomberg Finance L.P., State Street Global Advisors. Data from January 1, 1989 to April 30, 2022. 11 Bloomberg Finance L.P., State Street Global Advisors. Data from January 1, 1989 to April 30, 2022.
Beta Measures the volatility of a security or portfolio in relation to the market, with the broad market usually measured by the S&P 500 Index. A beta of 1 indicates the security will move with the market. A beta of 1.3 means the security is expected to be 30% more volatile than the market, while a beta of 0.8 means the security is expected to be 20% less volatile than the market.
Bloomberg Commodity Total Return Index The index is composed of futures contracts and reflects the returns on a fully collateralized investment in the BCOM.
Commodities A basic good used in commerce that is interchangeable, or “fungible,” with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services For example, crude oil is a commodity that is used to make motor fuels, and heating oil and lubricants.
Consumer Price Index (CPI) A widely used measure of inflation at the consumer level that helps evaluate changes in cost of living. The CPI is composed of a basket of consumer goods and services across the economy and is calculated by the US Department of Labor by assessing price changes in the basket of goods and services and averaging them. Core CPI is the same series, but excluding food and energy prices, which are considered to be volatile enough to distort the meaning and usefulness of so-called headline CPI. The absence of food and energy, means the core series reflects long-term inflation trends more accurately.
Diversification A strategy of combining a broad mix of investments and asset class to potentially limit risk, although diversification does not guarantee protecting against a loss in falling markets.
Down-Market Capture Ratio The down-market capture ratio is the statistical measure of an investment manager's overall performance in up-markets. It is used to evaluate how well an investment manager performed relative to an index during periods when that index has dropped.
Inflation An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
Equities An instrument that signifies an ownership position, or equity, in a corporation, and which represents a claim on its proportionate share in the corporation’s assets and profits.
MSCI World Index The MSCI World Index is a free-float weighted equity index. It includes about 1,600 stocks from developed world markets, and does not include emerging markets.
Real Estate Investment Trusts (REITs) Companies that own and operate commercial properties, such as office buildings and apartment complexes.
S&P 500® Index A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
S&P GSCI Total Return Index A production-weighted index that tracks the performance of 24 commodity futures contracts. The index tilts to commodities that are more heavily produced globally.
TIPS, or Treasury Inflation-Protected Securities Treasury inflation protected securities (TIPS) refer to Treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are backed by the US government and are thus considered an extremely low-risk investment. The par value of TIPS rises with inflation, as measured by the Consumer Price Index, while the interest rate remains fixed.
Up-Market Capture Ratio The up-market capture ratio is the statistical measure of an investment manager's overall performance in up-markets. It is used to evaluate how well an investment manager performed relative to an index during periods when that index has risen.
Volatility The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
The views expressed in this material are the views of Michael Arone, Matthew Bartolini, and Maxwell Gold through the period ended May 18, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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Investing involves risk including the risk of loss of principal.
Diversification does not ensure a profit or guarantee against loss.
Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in the value of the underlying property owned by the REITs, while mortgage REITs may be affected by the quality of credit extended. REITs are subject to heavy cash flow dependency, default by borrowers and self-liquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline).
The major risks associated with investing in the natural resources sector, including large price volatility due to non-diversification and concentration in natural resources companies.
There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries.
Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable.
Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates.
Commodities and commodity-index linked securities may be affected by changes in overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes, or political and regulatory developments, as well as trading activity of speculators and arbitrageurs in the underlying commodities.
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Investing in commodities entails significant risk and is not appropriate for all investors.
Important Information Relating to GLD and GLDM:
GLD and the World Gold Trust have each filed a registration statement (including a prospectus) with the Securities and Exchange Commission (“SEC”) for GLD and GLDM, respectively. Before you invest, you should read the prospectus in the registration statement and other documents each Fund has filed with the SEC for more complete information about each Fund and these offerings. Please see each Fund’s prospectus for a detailed discussion of the risks of investing in each Fund’s shares. The GLD prospectus is available by clicking here, and the GLDM prospectus is available by clicking here. You may get these documents for free by visiting EDGAR on the SEC website at sec.gov or by visiting spdrgoldshares.com. Alternatively, the Funds or any authorized participant will arrange to send you the prospectus if you request it by calling 866.320.4053.
None of the Funds is an investment company registered under the Investment Company Act of 1940 (the “1940 Act”). As a result, shareholders of each Fund do not have the protections associated with ownership of shares in an investment company registered under the 1940 Act. GLD and GLDM are not subject to regulation under the Commodity Exchange Act of 1936 (the “CEA”). As a result, shareholders of each of GLD and GLDM do not have the protections afforded by the CEA.
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