Inflation is at a 30-year high, so why are gold ETFs out of favour?

Gold is viewed as a hedge against inflation. Despite this, investors heavily sold gold ETFs in 2021.  

A small weighting to gold in a diversified portfolio is widely considered to be a sensible approach to help protect capital when stock markers fall sharply.

The yellow metal is also considered as a hedge against inflation. The theory is that as governments and central banks cannot simply print more gold, as they can currencies, gold’s value is preserved.

Given that inflation has hit its highest levels in decades, running at 5.4% in the UK and 7% in the US, it is surprising to see that investors globally have been selling out of gold exchange-traded funds (ETFs). A total of $9.1 billion (£7.5 billion) was pulled out of such funds in 2021, according to World Gold Council data.

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This bucked a wider trend, with the World Gold Council pointing out that overall demand for gold hit its highest level in more than two years in 2021. Gold bar and coin demand rose 31% to an eight-year high, as investors sought out the precious metal for its safe-haven qualities against a backdrop of rising inflation and ongoing economic uncertainty caused by the coronavirus pandemic.

So why have ETF investors been selling?

There are various factors at play. The first is that a year earlier, in 2020, investor money into gold ETFs hit a record high, with an inflow of $47.9 billion. In addition, the gold price had a strong spell of performance. The precious metal started 2020 at about $1,500 per ounce, reaching just over $2,000 by August, representing a new all-time high. From there, the price of gold started to drop, ending 2020 at about $1,800 an ounce.

Give this backdrop, Adrian Ash, head of research at online gold and silver exchange BullionVault, says that demand was likely to soften in 2021.

Ash said: “Investment flows are what drive gold prices higher or lower. That meant 2020’s record-heavy demand actually worked to cap prices in 2021, first because a lot of generalist investors had already bought the precious metal when the Covid-19 crisis struck – and so didn’t feel any need for increased exposure.” 

The second factor is that in the first couple of months of 2021 investors turned more bullish on the back of an improved outlook for the global economy when the viability of vaccines became apparent. This led investors to increase risk, with the market rotating to value shares, which tend to be more economically sensitive. At the same time, bond prices fell (on the back of investors increasing risk) and bond yields moved higher.

Rising bond yields, which make bonds more attractive for new investors seeking income, are a headwind for gold because gold doesn’t pay a yield.

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From June onwards, investors turned more cautious, with concerns over rising levels of inflation coming to the fore. The gold price, however, did not see rise, but fell from just shy of $1,900 at the start of June to around $1,830 at the end of 2021.

Its flat performance negatively impacted sentiment given that gold is considered a hedge against inflation.

“Its failure to rise as the cost of living surged became self-fulfilling,” explained Ash. “Because gold is so often presented as the ultimate inflation hedge, it risks losing all investment appeal if that function fails.”

However, Ash says that contrary to popular belief, gold prices show zero correlation with changes in the cost of living. Instead, the key driver is the impact that inflation has on the bond market.

“What matters to bullion prices is how inflation affects bond yields, and it’s the rise or fall in real rates of interest which gold tends to mirror, slipping when cash or government debt offers an improved real return and gaining when that return decreases relative to inflation,” says Ash.

Therefore, all eyes will be on how the bond market reacts when interest rates rise to combat high inflation. If, as expected, government bond prices fall and yields rise, then this will be a headwind for the gold price. The Federal Reserve in the US is expected to raise rates a couple of times in 2022, while the UK could make its second rise this week.

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On the other hand, if interest rate rises do not have the desired affect and inflation remains at high levels, it is possible that there could be an increase in demand for gold ETFs as government bonds will remain unattractive due to having yields notably below inflation.  

In addition, market pullbacks could mean an increase in demand for gold ETFs. Geopolitical uncertainty has increased, as the Russia-Ukraine stand-off continues.  

Ash adds: “More importantly for long-term asset allocation, gold has a strong history of rising when stock markets fall, sometimes on shock falls (such as 9/11 or the Brexit referendum) but repeatedly across extended periods of time.”

The World Gold Council observes in its latest report that the direction of gold ETFs “will largely depend on which factor is stronger: demand for gold as a hedge, in light of persistent inflation and potential Covid-related market pullbacks, or further reduction in holdings in light of rising nominal interest rates”.

Another view is that some inflation-fearing investors have opted for other hedges, such as cryptocurrencies and inflation-linked ETFs. Both experienced strong demand in 2021.

In December, the iShares Physical Gold ETC (LSE:SGLN) was the ninth most-popular ETF among interactive investor customers. It has been in the top 10 since May 2021.