Since its early-2011 peak, gold has been a disappointing investment. Despite significant bouts of international turmoil and periodic renewed-crisis fears, the salve often provided by the shiny metal has eluded investors. It declined by almost 50% until 2015, and while stabilizing, has posted only modest gains since that time. 

However, in the last couple years, inflation pressures have been “slowly” building, helping to stabilize the price of gold, and an important indicator recently suggests that inflation has reached a point which should prove much more beneficial to the yellow metal. Is gold about to glitter again?

Inflation Surprises Stoke Gold!

Citigroup’s U.S. Inflation Surprise Index (Chart 1) measures the degree to which inflation reports outpace investor expectations. When this index is low, it suggests inflation has been weaker than most expected and when the index is strong, inflation has been hotter than most anticipated. During the last 20 years, the level of this index at each month-end has been importantly related to the performance of gold in the ensuing month. 

Since 1998, when the Inflation Surprise Index has been below zero (i.e., inflation has mostly been lower than expected), in the next month the price of gold has risen at an average annualized rate of 5.8%. However, whenever the Inflation Surprise Index has been above zero (inflation reports have been outpacing investor expectations), the price of gold has produced an average annualized return of 15.5%! Obviously, gold is stoked when investors underestimate inflation risk! 

Nevertheless, the relationship between inflation surprises and the price of gold is a bit more nuanced. The dotted red lines in Chart 1 separate the historic quintiles of the Inflation Surprise Index. As shown in Table 1, the sign of the Surprise Index (whether it is above or below zero) is less important than its overall level. Since 1998, the price of gold has declined, on average, when the Surprise Index was in its lowest two quintiles. Indeed, inflation surprises in the lowest quintile have produced an average annualized gold price decline of 5.02%. 

But, the price of gold tends to rise substantially once inflation surprises reach the 3rd quintile (even though the sign of the Inflation Surprise Index is negative in the 3rd quintile) and performs even better as the Surprise Index rises into its 4th quintile. Surprisingly, the price of gold does not do nearly as well when the Inflation Surprise Index reaches its strongest quintile. On average, gold rises at an annualized pace of 18.65% in the 3rd quintile, and at an eye-catching 25.39% in the 4th quintile, but returns decline to only 8.95% in the top quintile. 

It is easy to understand why gold does so poorly when inflation has been chronically lower than investors expected (i.e., when the Inflation Surprise Index is in quintile 1 or 2), and it is also reasonable that gold soars as inflation begins to outpace expectations and inflation fears begin to build (i.e., when the Surprise Index is in Q3 or Q4). Why might returns diminish, though, when inflation is chronically beating Wall Street expectations (in Q5)?

We are unsure but offer a couple of possible explanations. First, the price of gold may often become extended as it enters Q5. Gold prices, bolstered by optimism derived from being in the sweet spot (i.e., Q3 and Q4), perhaps already reflect concerns about future worsening inflation pressures. That is, while highest quintile surprises continue to boost the price of gold, because of high valuations, its upside-beta to inflation concerns lessens. Second, when inflation surprises become extremely pronounced, many investors may fear a recession is nearing and begin liquidating gold investments.

“Risk” is also noticeably impacted by the level of the Inflation Surprise Index. When the Surprise Index is in the lowest two quintiles, the frequency of monthly declines average 54% compared to only 36.7% when the Surprise Index is in the 3rd or 4th quintile. 

The U.S. Inflation Surprise Index has only been around since 1998. However, as a gold investor, whether you are more concerned about risk or reward, it pays to monitor the level of inflation surprises!

Closing Commentary

The price of gold bottomed at the end of 2015 when the Inflation Surprise Index last exited its lowest quintile (see Chart 1) and has since oscillated mostly between quintiles 2 & 3. Since the beginning of this year, the Surprise Index has stayed within quintiles 3 & 4—that is, the sweet spot for gold! Just at the end of May, it declined to the lower end of quintile 3, which may bode well for the price of gold in ensuing months. That is, the Surprise Index could increase by 25 points before exiting gold’s sweet spot! 
 
Since the economy has returned to full employment, at a minimum, inflation fears appear likely to persist until the next recession. Consequently, should the Inflation Surprise Index hover in quintiles 3 & 4 in the next year, 20%+ returns represent a reasonable forecast (with negative monthly outcomes only about one-third of the time). 

Maybe it’s time for a little yellow metal in your equity portfolio?