Investment Update: Gold amid higher inflation and rising bond yields in India

As food and fuel prices in India have risen, inflation has surged: in June, the wholesale price index (WPI) and the consumer price index (CPI) remained elevated at 15.18% and 7.01% respectively.¹  Meanwhile, the 10-year Indian government bond rose by 1% between the end of November 2021 and July 2022. 

In an attempt to control soaring inflation the Reserve Bank of India (RBI) hiked its policy rate by a total of 140bps between May 2022 and August 2022. ² The RBI has stated that it will now focus on withdrawing its accommodative stance to ensure inflation remains within the target range, while supporting growth. ³

Our analysis shows that:  

• gold has historically rallied in periods of high inflation in India  
• higher inflation and rising bond yield could drive investors towards gold   
• the average institutional investor could benefit from an allocation to gold in the scenario of higher inflation and rising rates.
   

Inflation trends in India

Until 2010 India measured inflation by multiple consumer price indices (CPI) and a wholesale price index (WPI) at a national level. ⁴ A consumer price index (CPI-combined) was released in 2011 and adopted by the Reserve Bank of India (RBI) as the inflation target for monetary policy on 1 April 2014. ⁵ Prior to this date, WPI had been a key indicator for the RBI’s inflation target and was widely used by industry and financial sectors in their policies. ⁶  The regular publication of WPI started in 1947 and the index continued as a weekly series until January 2012, since when it has been released monthly. 

Historical inflation between the 1970s and mid-2000s, shows that wholesale and retail prices moved in tandem with the annual changes in wholesale and retail prices, averaging 7.6% and 8% respectively.⁷ But the relationship between wholesale and retail prices diverged after the Global Financial Crisis. Retail inflation started to rise in 2008, mainly due to higher crude oil prices; food inflation rose in 2009 because of a poor monsoon, and the persistence of food inflation contributed to double digit retail inflation in 2009 and 2010. As a result, the gap between average wholesale and retail inflation widened to 3.2% during the 2010s. ⁸

CPI as an inflation measure and adoption of flexible inflation targeting (FIT) by the RBI

The breakdown of the relationship between wholesale and retail inflation following the Global Financial Crisis set the stage for an intense debate about how to find an appropriate inflation anchor for monetary policy in India. This resulted in formation of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (Chairman: Dr Urjit R. Patel) in September 2013. The Committee recommended a move away from WPI and use of CPI as the nominal anchor for monetary policy (Focus 1). The RBI consequently adopted CPI as the key measure for inflation in April 2014. 

The double-digit inflation of 2009 and 2010 led to a review of the multiple indicator framework used for monetary policy decisions and a phased switch to a flexible inflation targeting (FIT) framework.⁹  Following amendments to the Reserve Bank of India Act 1934, the FIT framework was formally adopted in 2016. In August of that year the government announced an inflation target of 4.0%, with 6.0% and 2.0% as the respective upper and lower tolerance levels for the period up to 31 March 2021. Currently, the RBI plans to retain its inflation target at 4% – with the same lower and upper tolerance levels – for a five-year period (April 2021-March 2026).

The higher proportion of food in the Indian CPI basket poses a significant challenge to inflation targeting 

In India, as in other emerging countries, food makes up a much higher proportion of total household expenditure than it does in advanced economies.  The Indian CPI basket contains 45.9% of food items (Table 1). The volatility of food prices renders a substantial part of CPI inflation outside the control of monetary policy. Using core inflation as the inflation target may not give a true indicator of the actual inflation rate due to two factors. First, if we exclude ‘food’ and ‘fuel and light’ components from the CPI basket, we discard 52.7% of the basket. 
 

Table 1: Food has the highest weight in India’s CPI basket

Breakdown of CPI basket by weight across various countries/regions

Source: Ministry of Statistics and Programme Implementation of India, National Bureau of Statistics of China, Bloomberg, Eurostat, US Bureau of Labour Statistics, World Gold Council

Second, shocks to food and fuel inflation have a much larger and more persistent impact on inflation expectations than shocks to non-food/non-fuel inflation. Food inflation is driven by monsoon shocks; shocks to the government’s minimum support prices (MSPs); and shocks to vegetable prices, such as onions. An RBI study found that monsoon shocks have longer effects on inflation than vegetable price shocks, although agriculture products affect food inflation, albeit with a time-lag. A report from the Urjit Patel Committee concluded that a 1% shock to food inflation affects one-year inflation expectations by as much as 0.5% and persists for eight quarters. With this in mind, the CPI headline inflation measure appears the most feasible and appropriate measure for monetary policy as it is the closest proxy of the true cost of living index in India.

But this high spend on food poses a significant challenge. Government interventions, changes in the underlying structure of the economy and shifts in the composition of demand all have the capacity to create a divergence between food and non-food inflation – and potentially cause the FIT regime to be less effective.

The current inflation scenario in India 

India’s headline inflation (CPI) has been on an upward trajectory since October 2021. With rising commodity prices and supply chain disruptions, retail inflation has followed suit, remaining elevated at 7.01% in June 2022, with WPI inflation touching a  high of 15.18% in the same month (Chart 1).
 

The months ahead are expected to impose further pressure. The RBI has already adjusted inflation expectations upwards, setting a forecast of 6.7% for the financial year 2022-23, compared with its earlier projection of 4.5%. ¹¹

Expectations of a further upward trend in inflation persuaded the RBI to increase its policy rate by 0.4% to 4.40% at its monetary policy meeting on 4 May 2022. The RBI decided to start withdrawing its accommodative policies to ensure that inflation remains within the target, while supporting growth. The RBI governor further hiked the policy rate by 50 bps in June followed by a further hike of the policy rate by 50bps in August in an attempt to control rising inflation. Inflation that remains higher than the stated tolerance level could create further uncertainty and drive investors towards gold.
 

Higher inflation and rising bond yields weaken the appeal of bonds as a portfolio diversifier 

Aligned with rising bond yields across the globe, the Indian 10-year government bond yield has been on an upward trajectory since December 2021. Yield on the 10-year bond has increased due to a combination of global factors (rising inflation, a hike in US interest rates, higher crude oil prices and the invasion in Ukraine) and domestic factors (rising inflation and the RBI’s rate hike) with the bond yield recording an increase of 1% between the end of November 2021 and June 2022. 

Historical data shows that the correlation between equities and bonds remained mostly positive from 2008 to 2012, when the average inflation in India was close to double digits at 9.7%.¹²  The current rise in the bond yield is accompanied by higher inflation and we are increasingly seeing instances of a positive equity-bond correlation (Chart 2). Bonds are expected to generate poor returns going forward and with a positive correlation between equities and bonds, they could also lose much of their diversification and risk-hedging attributes.

Our own research indicates that a hypothetical 60:40 US portfolio over the period from 2022 to 2031 will have a Sharpe ratio of just 0.41.¹³ To bump up the Sharpe ratio to 0.51 – which prevailed during the negative correlation era of equities-bonds from 1997 to 2021 – the equity allocation needs to be raised to 70%. But a higher equity allocation could expose the portfolio to stock market pullbacks. In such a scenario the portfolio would benefit from an allocation to gold due to its asymmetric correlation to equities – close to zero when equities perform well but significantly negative when they don’t. 

Gold as an inflation hedge 

Various studies have examined gold’s role as an inflation hedge. Ghosh, Levin, Macmillan and Wright (2002) used the monthly gold price and US CPI (1976-1999) inflation to look at co-integration between the two. They established that gold could be used as an inflation hedge in the long term.¹⁴  A paper published by Lucey, Sharma and Vigne (2016) found that gold’s relationship with CPI has indeed been inconsistent and time-varying and, as a result, it has been – since 1971 – insignificant on the whole.¹⁵  Another study by Aye, Chang and Gupta (2015) analysed long-term US data from 1833 to 2013 and found an interrupted co-integration relationship between gold and inflation, implying that although gold may act as an inflation hedge in the long term, the relationship can be interrupted by structural changes in the gold market. 

Our own research indicates that gold has a higher correlation with the broader measure of money supply – particularly M2 – than with CPI. ¹⁶ Gold is a global asset and a hedge not just against the price of goods and services but also against the erosion of purchasing power in general – such as property, collectibles or financial assets, none of which appear in CPI indices. In addition, a sizeable proportion of gold demand is driven by consumers and this impacts prices over time. Money supply, therefore, is closely linked to nominal GDP growth, and is a reflection of this important consumption dynamic as well as inflation, thus giving a closer correlation with the gold price.

Singh and Joshi (2018) analysed the gold price (in Indian rupees) and CPI inflation in India for the period 1979 to 2017 and concluded that gold and CPI inflation were co-integrated; although they exhibited a long-term relationship there was no causality in the short term.¹⁷  In India gold is perceived as a hedge against inflation: studies have shown that a 1% increase in inflation leads to a 2.6% rise in short-term demand for gold.¹⁸ 

By way of example, over the past 41 years gold has delivered an average annual return of 10% in rupees, clearly outperforming CPI inflation, which grew by an average of 7.3% over the same period. 

Gold’s performance has also been particularly strong in periods of high inflation, increasing by 12% on average when inflation rose above 6% (Chart 3). ¹⁹ 

Gold’s role in a higher interest rate environment 

Interest rate hikes are driven by rising inflation. In the short term, higher rates are a headwind for gold but in the current environment they remain historically low – in real terms mostly negative across developed markets. Our own analysis suggests that US real rates would need to move above 2.5% to have a meaningful long-term impact on gold. Historical data shows that gold has offered attractive returns during India’s monetary-tightening cycles. In five rate-hiking cycles since 2004 gold in Indian rupees averaged an annualised return of 19.5%, outperforming other major assets (Table 2).

Table 2: Gold in Indian rupees performed well during hiking cycles*

*All returns are annualised growth rates based on monthly data using a total return index of BSE Sensex for stocks, a total return index of blended NSE and BSE 10-yr India government bond index for bonds and the Indian domestic gold spot price using Indian Bullion and Jewellers Association price before 21 October 2005 and MCX Gold Spot price after 21 October 2005 for gold.

Source: Bloomberg, World Gold Council

Our analysis also shows that the risk-adjusted return of an average institutional investor’s portfolio could benefit from allocating a portion of its assets to gold during these cycles; for instance, ~5-10% allocation to gold would have resulted in higher risk-adjusted returns during the previous hiking cycle from April 2018 to August 2018 (Chart 4).

Conclusion

Central banks around the world have responded to rising inflation. The US, UK and Canada have raised interest rates, while  the US Federal Reserve and European Central Bank (ECB) have rolled back their emergency pandemic support for the economy. But if the RBI like other central banks follows suit - this could result in large market swings and potentially result in economic slowdown.

Against this backdrop, gold may offer investors a source of return and effective diversification. We have shown that in historical periods of higher rates and high inflation gold has generated attractive returns relative to stocks and bonds and has improved risk-adjusted returns for Indian investors.