How much does that protection asset protect you in your currency?
We live in a time of very high inflation in industrialised markets and the fear of runaway inflation and stagflation is rising. So, investors are asking how to protect their portfolios against high inflation or the possibility of a decline in economic growth. There are so many assets that are proposed as solutions to this challenge, ranging from inflation-linked bonds to property to infrastructure to commodities and so forth. And all of these have their specific advantages and disadvantages. But one thing that irks me is that these arguments are typically supported by an analysis of correlations between stocks and the protection asset in US Dollars and then simply translated into other regions and currencies.
Let’s take the example of the asset that always gets mentioned as a safe-haven asset and an inflation protection asset: gold. Back when I lived and worked in Switzerland, we knew that gold was much less of a safe-haven asset in times of crisis than gold was for investors in Europe. The reason for this is that the Swiss Franc is a safe-haven currency that starts to rally in a crisis while the Euro is not. Thus, in a crisis, gold may rally in US Dollars but much less so in Swiss Francs because Swiss Francs appreciate against the US Dollar thus taking away some of the profits gold has in US Dollars. For Swiss investors, it is thus much better to own gold hedged in Swiss Francs in order to take full advantage of the safe-haven properties of gold in Swiss Francs. For a Euro investor, on the other hand, there is no need for hedging gold investments since the Euro has no tendency to appreciate in a crisis and thus the gold rally in US Dollars tends to translate directly into a gold rally in Euro.
Dirk Baur from the University of Western Australia has done a nice little exercise of measuring the correlation of gold with the local stock market in 68 countries. He did that using gold prices in US Dollars and gold prices in local currencies. The chart below shows the correlations between local stock markets and gold in local currencies. Note how Venezuela has the highest positive correlation. This is because of the hyperinflation in that country that leads to a devaluation of the Venezuelan Bolivar and thus a significant appreciation of gold in local currency. Stocks, meanwhile rally hard in times of hyperinflation as well, not because the businesses are doing alright, but simply because the land, buildings, and machines the companies own are all that is left that has some value and these appreciate with inflation.
Correlation of 68 stock markets with gold in local currencies
Source: Baur (2021)
More generally, the chart above shows that for the countries down to Oman or the United States, the protection qualities of gold are significantly reduced since gold tends to have a positive correlation with local stock markets. For countries starting with Oman and the United States down to Israel or Taiwan, gold has essentially a correlation of zero with the local equity market and thus provides pretty good diversification. But if you find yourself in the countries at the bottom of the list which includes pretty much all Eurozone countries, Sweden, Norway, and Australia then you are in luck. Gold has a significantly negative correlation with the local equity market and thus is an excellent protection asset.
Whether you like gold as an inflation hedge or protection against stagflation is not for me to decide, but the point I am making here is that with every asset you invest in you have two decisions to make:
Do I want to invest in that asset?
Do I want to hedge currency risks or not?
In my experience, too many investors stop at the first decision and don’t spend enough time thinking about the second decision.