US TIPS vs Gold, Part 2: Inflation Hedges And Beyond

Both gold and TIPS can provide a suitable hedge for rising inflation, but which is better? In part 1 of this two-part series on US TIPS vs gold, we explained that in order to properly hedge for inflation you should understand what exactly you are hedging against, given that consumption baskets can vary substantially from household to household. In this report, we compare the relative merits of TIPS and gold when hedging specifically against two of the most important components of the CPI: housing and energy. As a first step, we examine in some detail the CPI’s housing component, known in the jargon as Owners’ Equivalent Rent (OER).

Does the CPI Adequately Measure House Price Inflation?

For those unfamiliar with the concept, OER is what a homeowner would implicitly pay themselves or would receive in income were they to rent their home to someone else. OER accounts for roughly one quarter of the total CPI calculation. Given its large weight in the overall CPI calculation, OER can have a large impact on the headline figure. One area of controversy is that OER poorly captures home price appreciation (HPA).

As we can see in Chart 1 above, OER and HPA can vary both in terms of direction and magnitude. HPA was running north of 10% a year during the period leading up to the US housing crisis turned global financial crisis (GFC). In contrast, during that time OER actually slowed from north of 4%, running to about 2% per year. More recently, some housing markets in the US have seen a healthy uptick in price during the COVID period. However, in general, HPA has been fairly steady post GFC, but even so HPA has still been running higher than OER.

Meanwhile, TIPS, on an inflation breakeven basis, have failed to keep up with OER let alone HPA. As seen in Chart 2, there was only one period during which TIPS outperformed and were over-hedging OER, and that was during the period immediately post GFC that saw a sharply lower HPA eventually hold down OER inflation for a time.

The Relative Benefits of Gold

TIPS have only been around since the late 1990s and have benefited from both a decline in overall rates (leading to price appreciation) and a relatively steady inflation backdrop. Yet as we showed in Part 1, they did not compensate every household the same given variations in consumption baskets. Meanwhile, since inception, TIPS have only outperformed gold on a total return basis (Chart 3) for a brief period when central banks around the world were selling gold, placing downward pressure on prices.

In contrast to TIPS, gold has been around since the dawn of recorded history and, as economic historians have thoroughly documented, has done an excellent job at preserving purchasing power (which is ultimately what inflation hedges should provide) over long periods of time. Indeed, for most of history, gold (and/or silver) was not only de facto but de jure money. As such, it was the numerator of all market prices and so not volatile at all. Had such a thing as ‘CPI’ existed historically, it would therefore have been close to zero, and gold – money – would have reliably preserved purchasing power.

Historical Perspective: Gold Supply and Productivity Shocks Can Impact the Price Level

There are two historical periods, however, in which a hypothetical ‘CPI’ would have indeed been volatile. One was during the 16^th and 17^th centuries, as the Spanish and others brought back huge amounts of metal from the Americas and other previously unexploited, mineral-rich regions of the world. This monetary supply shock pushed up the general price level – something multiple scholars of the Salamanca School observed and studied in detail, postulating an early version of the Quantity Theory of Money.

Another was during the 19^th century when the industrial revolution began to transform agriculture, transport and most other major industries. With the amount of gold – money – in circulation essentially fixed, growing at no more than 1-2% per year, productivity and hence economic growth rose by as much as 10% per annum. As such, the price level generally declined through these decades as standards of living rose. This benign, productivity-driven deflation in the price level sharply contrasts what would happen in post-WWI Great Britain and the 1930s Depression in the US. In both cases, however, gold either retained or grew in effective purchasing power.

TIPS Effectiveness During Periods of High Inflation

We would not predict that US inflation will return to double digits any time soon, as it did back in the late 70s/early 80s. But were that to happen, then there would also arise the risk of reinvestment, which can be significant in a high-inflation environment. As TIPS coupons are only paid with a lag, their effectiveness as a hedge declines in a high-inflation environment, in which the price level increases while holders of TIPS are awaiting coupon payment. If the price level has already increased by another percent by the time one receives a coupon calculated on a previous price level from one month ago, then the supposed hedge has already slipped by one percent in real value before it can be reinvested in some asset.

Gold and TIPS Differences Outside of the Role of Inflation Hedges

Any comparison between TIPS and gold would be incomplete without at least a brief discussion of the other key differences between the two, in particular risks other than inflation. Gold being gold, as long as it is owned in unencumbered, physical, allocated and secure form, such as in a vault with a reputable custodian, and in a secure jurisdiction with strong property rights, carries no credit or counterparty risk. Nor, in a post-gold-standard world, would it necessarily be made the subject of capital controls, were those to be imposed.

The same cannot be said of any form of government debt. History reveals that governments do, from time to time, impose some form of capital controls or restructure or default on their debts. And in many instances of government debt default or restructuring, they favour domestic over foreign creditors. Capital controls, depending on their implementation, can interrupt debt service on foreign-held securities. Debt restructuring might be a relatively minor affair, such as a temporary delay in paying coupons due to liquidity issues. Or it might be more serious, such as a full-on default and repudiation. While we would agree that the likelihood of the US imposing capital controls or failing to fulfil its debt obligations in the future is admittedly remote, and so a risk that most investors are unconcerned about, a comparison between TIPS and gold is incomplete without at least raising the point.

Gold Is Also an Alternative to Other Real Assets

While gold has not functioned as the global monetary base since the early 1970s, it continues to serve as an effective, long-term inflation hedge and has kept pace versus key categories of consumer goods, including housing, food and energy. In addition, as seen in Charts 4 and 5, we also can observe that gold has been outperforming both housing and oil since the GFC as well. This is perhaps where gold’s original use shines as not only a hedge for US inflation specifically but global fiat currency debasement. In this regard, we can observe that gold did particularly well in the immediate aftermath of the GFC, when all major issuers of fiat currency raced to expand their respective money supplies and shore up their banking systems with various forms of QE and guarantees.

For example, while housing surpassed its prior peak levels about 10 years post GFC, if we look at the price of US housing in terms of gold, it has never recovered its prior high. Gold has thus worked well as a hedge against rising housing costs.

Oil is far more volatile than housing and saw an even bigger bull market in the beginning of the 2000s, in both dollar and gold terms. At first this was largely gold weakness, but then from the mid-2000s both gold and oil took off. However, from 2008 until now oil has been unable to regain its prior outperformance versus gold and has been steadily declining on a relative basis ever since.

We would be remiss not to mention that there have been periods over the medium term (i.e. one to three years) when gold underperforms other real assets (including TIPS at times) and during such periods lags outright inflation too. However more recently, as seen in Chart 6, it looks like gold has turned the corner and is now clearly outperforming on a rolling three-year basis. Many major commodities rose strongly in price from the early 2000s into 2008, but in the decade since gold has produced more steady returns and/or at least fewer sharp drawdowns versus oil for example. Meanwhile gold only really lagged housing prices during the late 1990s and for a brief period over the prior decade.

Conclusion

Gold might be a better hedge than TIPS for those households disproportionately affected by the more inflationary components of the CPI or which are anticipating the impact of sharp rises in their effective cost of living during the coming years (for demographic or other reasons). TIPS have, by definition, followed the headline CPI. Therefore, they have reliably and fairly compensated those households with low exposure to such sectors as education, childcare and healthcare. Meanwhile the price of gold has kept up with the higher rates of price inflation seen in these sectors, and quite reliably over long time horizons.

In any case, with the Fed signalling that it is determined to drive CPI to above 2% over the coming years, as we demonstrated, both gold and TIPS can provide protection for rising inflation (but the timing and level of protection may vary for both). Therefore, investors need to evaluate their overall portfolio exposures to what is likely to be a challenging environment for wealth preservation ahead.