Inflation Hedging & Investments in 2022| Best Performing Assets: Gold vs. BTC

Many investors, analysts, and economists are concerned about the inflation, resulting in fear, volatility, and a lack of trust in the markets. Learn how you can hedge against the inflation and grow your capital.

What is Inflation?

To understand inflation, it is helpful to understand the basics of how the economy works in terms of how central banks control interest rates to promote lending and borrowing.  According to Investopedia, inflation is the decline of purchasing power of a given currency over time. An estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price of a basket of goods and services in an economy over time. Simply put, $20 dollars could buy more ten years ago than it can today due to inflation.

Inflation can be seen as positive or negative depending on the individual and point of view as it can have a largely damaging impact on societies, though certain companies and sectors can reap the rewards of having asset prices increase as this means these companies can increase their profit margins.

Investors with tangible assets also like to see a healthy rate of inflation as their stocked commodities and property will increase in value. Keeping inflationary levels manageable is a delicate balancing act that is controlled by monetary authorities such as central banks who can take necessary precautions to manage the supply and demand of money and credit to keep inflation within permissible limits.

Central banks do this by adjusting interest rates to encourage or discourage borrowing as increasing interest rates can lead to borrowing being too expensive and discouraging people and businesses from wanting to borrow money and therefore limiting the amount of money flowing into an economy.

Lowering interest rates can have the opposite effect as this encourages people and businesses to borrow money which then goes into making purchases and expansions which pours money into the economy.

In addition to raising and lowering interest rates, central banks can also control the money supply in terms of printing more money or ceasing monetary printing to control the money supply in a nation.

Why Does Inflation Happen?

Inflation can occur for many reasons with the main cause being when the money supply increases such as we have seen with major levels of money printing throughout 2021.

The consensus view among economists is that sustained inflation occurs when a nation’s money supply growth outpaces economic growth. But that is not the only cause of inflation. Inflation can also occur when prices rise due to an increase in production costs, raw materials and wages. A surge in demand for products and services can cause inflation as consumers are willing to pay more for a product and can essentially outbid one another leading to suppliers increasing the price as they know consumers are willing to pay more. There are various drivers that can lead to inflation as we will cover below.

Cost-Push Inflation – Cost-push inflation happens when prices increase due to increases in production costs, raw materials and wages. The demand for goods is unchanged, but the supply shrinks due to high production costs. This results in higher prices being pushed on the consumer. The most common form of cost-push inflation is seen in the energy sector with oil and gas prices. Pretty much everybody needs gas and oil to do everything from heating homes and cooking food to fueling cars. Refineries need a certain amount of crude oil to create gasoline and other fuels. Electric power suppliers often use high levels of natural gas to create electricity and when global policies, wars, or natural disasters reduce oil supply, prices increase across the industry as the demand has not changed, but the supply has been reduced.

Demand-Pull Inflation – Demand-pull inflation can be caused by strong demand for a product or service. If demand rises unexpectedly, this sudden surge can result in prices increasing.

This type of inflation is not a cause for concern in short periods of time but a sustained surge in demand can have a ripple effect throughout an economy and raise costs of other goods and services.

An example of this was seen in 2020 as the economy shut down due to the pandemic and many industries had ground to a halt. When the economy was ready to open back up, economic strength was recovering faster than goods and services could meet the demand of the now open and strengthening economy which resulted in a dramatic across the board increase in the costs for goods and services in many cases.

Built-In Inflation – Built-in inflation is related to expectations of inflation. People have come to expect increases in inflation year over year into the future. This expectation plays a role in everything from the costs of goods and services to wages increasing over time.

Increasing the Money Supply – This is the main culprit causing so much concern in 2021-2022. World governments and central banks have never printed money in nearly the same quantities as we experienced during the pandemic, and this is the main catalyst that is causing so many inflationary concerns around the world.

According to an article from techstartups.com around 80% of all US dollars in existence were printed in just 22 months. Many economists and analysts agree that it is absurd to think that you can create 80% of the entire money supply that has ever existed in just 22 months out of thin air without having a significant impact on the economy.

And this was not a tactic used only by the United States, this level of money printing was seen by many nations around the world as a response to lockdowns caused by the pandemic.

Why Money Printing Causes Inflation

When the money supply increases faster than output this results in inflation. Printing money does not change the number of goods and services available in a country, it just means that that households and businesses now have more money to spend. With there being more money, while the number of goods and services remain the same, simple supply and demand economics tells us that if we all have more money and can spend more, but there is the same limited number of goods and services, that this creates a seller’s market where prices can be increased.

This creates a scenario where there are more potential buyers with extra cash willing to pay more. If you have an extra thousand dollars, I have an extra thousand dollars, so do Bob and Alice and there is only one box of macaroni and cheese left on the shelf that we all want to buy with the original price of $1 dollar, that grocery store can now increase the price of the box of macaroni because as we all have an extra thousand bucks kicking around, and we are likely willing to pay more for that box of delicious fake cheesy goodness.

Inflation is nothing new and has been experienced in civilizations dating back before the ancient Greek and the Roman empires. Inflation is often cited as one of the main causes that lead to the fall of the Roman empire.

As the Roman empire grew and it was no longer earning from plundering newly conquered territories, the money supply started to dry up. The Roman emperor decided to start reducing the amount of silver in the Denarius (the Roman coins) as there was no longer enough to go around and by the start of the 3^rd century, the silver purity of the coins had been cut to 50%, down from over 90% less than a hundred years earlier.

This devaluation caused coinage acceleration to happen, meaning that people now needed two coins to have the same buying power as just one coin months earlier and this trend continued causing prices to soar as the value of money dropped, and Romans needed to carry hundreds of coins just to have the equal purchasing power as a few coins had just months previous.

Severe levels of inflation were also experienced in Germany after World War One, photos can be seen of people needing to fill up entire carts and wheelbarrows with money just to buy a few groceries and these levels of inflation are currently being experienced in Venezuela, Zimbabwe, Sudan, Syria and more. We are seeing rising levels of inflation in nearly every nation that participated in massive money printing schemes as a response to the pandemic.

Because Inflation can be so damaging to societies and the wealth of many, investors have been seeking ways to hedge against inflation for hundreds of years.

Why are Inflation Hedges Needed?

“Never depend on single income. Make investments to create a second source.”

WARREN BUFFET 

Both institutional and retail investors alike invest in assets to protect their wealth against the devaluation caused by inflation.

Certain types of investments increase in value during normal economic cycles but decline during inflationary cycles. Traditionally, real estate has been considered a good inflation hedge as rental income and the market value of real estate properties tend to maintain or even increase during inflationary periods. As money is being devalued, investors look to ditch their fiat and purchase whatever assets they can.

Another popular choice for inflation hedges comes in the form of purchasing other “safe-haven” currencies such as the Swiss Franc that fluctuates very little and can see more stability, so if the US dollar’s value is expected to drop 7% in a year, many investors will ditch the dollar and use it to buy the Swiss Franc or other currencies.

While many investors choose real estate, high performing stocks, or other nations’ currencies, gold is the main inflation hedge that investors have traditionally flocked to.

One of the ways that gold protects investor wealth is that as inflation erodes the value of the dollar, the cost of every ounce of gold in dollar value will rise so the investor is compensated for inflation with more dollars for each ounce of gold.

Another factor as to why gold has been used as a good hedge against inflation is due to the interesting fact that in the world of investing, many trends are a result of self-fulfilling prophecies and gold is a great example of that.

Because people think gold is an inflation hedge, the demand goes up and as they buy more of it the supply goes down which causes the value of gold to go up which supports their inflation hedge narrative.

So gold has worked as an even better inflationary hedge traditionally, simply because investors pile in as they assume the asset value will rise, and the asset value rises because investors pile in.

Is Gold Still a Satisfactory Inflation Hedge?

Inflation hedges can come in any form. While gold and real estate are the most common, any asset class that can maintain, or increase in value while the value of a currency drops can be used as an inflation hedge and that is where Bitcoin comes in.

 “During inflation, it becomes more important to invest cash. As prices for goods increase during inflationary periods, cash will lose purchasing power and one dollar will buy less than before. Invest your cash to earn a return to minimize the inflationary bite, or possibly earn a return that keeps up with or exceeds the inflation rate” says Pamela Chen, chartered financial analyst at Refresh Investments.

A very interesting trend emerging as investors are starting to realize that gold may no longer be a good inflation hedge. During inflationary cycles, gold has always held the title as the main inflation hedge asset until recently. That narrative has been broken as the asset has been doing very little in terms of price appreciation lately.

Bitcoin  has been the best-performing asset class of the decade

This has been enticing more investors to gain Bitcoin exposure at a quickening rate. Gold has significantly fallen under scrutiny in recent months and years for losing its ability to be an inflation hedge as investors find other areas of the market where they can protect against rising prices and the precious metal has seen little in terms of capital appreciation as investors widely prefer the higher returns of stocks, crypto and other assets. Stats show that gold hasn’t produced a positive return during periods of inflation since the 1970s.

Why do Some View Bitcoin as a Superior Inflation Hedge to Gold?

Let’s look at the main reasons gold was considered an important hedging asset: It lacks credit or default risks, investors know to pile in for safety and diversification and it has a limited supply. How limited? We don’t actually know as there is no way of knowing how much gold is hidden in the depths of the planet and someday we may be mining gold on asteroids or on other planets.

Every reason just stated also applies to Bitcoin but it’s even better as we know without a doubt that the limited supply is 21 million. Further, it is far more portable than gold as a billion dollars worth of Bitcoin can be held on a flash drive. It is easier to transfer value with Bitcoin as we can send hundreds or thousands of dollars worth of Bitcoin to someone across the world almost instantaneously with just a mobile device, imagine trying to transport that much gold to the other side of the world, that would be logistical nightmare! It is easier to store Bitcoin, it is more secure and has the potential of having more utility as a secure network.

Bitcoin is also not tied to the risks of any one economy or currency, nor is it controlled by a small group of companies or shareholders such as stocks are and therefore has a lower third-party exposure risk. As stated earlier as well, the best inflation hedge is the one that will increase the most in value during inflationary cycles and it has become quite evident that no other asset class outperforms cryptocurrencies in the past decade.

Can Bitcoin Become the “Ultimate” Inflation Hedge?

This is a tricky question to unpack and analysts, economists and investors across the board argue on both sides of the narrative. On one hand, we know Bitcoin has incredible returns. Who cares if inflation rises to 12% per year if you hold Bitcoin as it increases 500% a year?

As Bitcoin adoption increases many theorize that Bitcoin can become the world’s reserve currency and that we will all be using Bitcoin to transact with, rendering national currencies redundant.

Another factor is that because Bitcoin has a fixed supply, governments cannot simply print more Bitcoin as they do with fiat currency meaning that Bitcoin value cannot be inflated away into oblivion.

The same self-fulfilling prophecy that lent to gold being a great inflation hedge and safe haven in the past can also be attributed to Bitcoin. As Bitcoin’s reputation as an inflation hedge and risk-off asset for crypto holders grows, more institutional and retail investors will enter the space which will of course drive the value of Bitcoin skywards.

However, Bitcoin has been shown to be a very poor inflation hedge in the back half of 2021 and one of the largest narratives against Bitcoin as an inflation hedge is its volatility and the fact that it regularly sees dips of 30% and more. As the market cap of Bitcoin increases, volatility will likely lower in the asset but as it stands now, anything that can drop so significantly in such a short period of time cannot be considered by many as being “safe,” and these losses only amplify the damage caused by inflation.

The inflow of institutional money also has a good and bad side for Bitcoin and that comes in the form of correlation to other asset classes which is a bummer. The flow of institutional money into Bitcoin is great as that is what is needed to significantly increase the price of Bitcoin but what isn’t positive is the more institutional money that flows into Bitcoin, the more Bitcoin starts to act like every other asset class that institutions invest into. When Bitcoin was only held by retail investors it appeared to be brilliantly uncorrelated to other asset classes such as gold, stocks and real estate and this was perfect because a negative correlation means that there is always a safe place to park money when other assets drop and Bitcoin was negatively correlated to many assets which is what started its narrative as a hedge in the first place.

As stocks and real estate crashed, Bitcoin was seen as the life raft that could perform well amidst a crashing market. Unfortunately, with the flow of institutional money, Bitcoin is now traded very similar to the stock markets as the same behavioral fears, biases and speculation that fuel stock markets and gold markets are now present in Bitcoin as the same institutional investors are invested in each asset.

As a result, we have seen a depressingly positive correlation. Two years ago, it didn’t matter if the stock market tanked or gold dropped, Bitcoin was on its own trajectory doing its own thing, but now we see when the stock markets drop, Bitcoin drops harder as institutions sell off their riskiest assets during volatility first which means Bitcoin sells off and drops more significantly.

The inverse is also true, as markets do well, so does Bitcoin as investor confidence grows resulting in the two markets moving more and more in tandem, reducing Bitcoin’s reputation as being the ultimate inflation hedge.

Bitcoin has also never been tested before in a truly inflationary market so it is too early to know for sure whether or not Bitcoin will prove to be a significant inflation hedge. Many institutions are betting big on Bitcoin in that regard, while others are avidly against it as the whole point of an inflation hedge is to perform to the upside, at least the same amount, if not more, as currency is being devalued to the downside. So if inflation is expected to drop a currency’s value of 7% in a year, many feel that it doesn’t make sense to hold an asset that can drop 7% in a day.

Closing Thoughts

While it is too early to tell if Bitcoin can become the ultimate inflation hedge, many investors still believe that Bitcoin is the ultimate store of value. Bitcoin is already being used as an inflation hedge by many institutional firms and legendary investors such as Paul Tudor Jones, and Bloomberg economists Björn van Roye and Tom Orlik concluded that Bitcoin’s reputation as an inflation hedge is believed by many and that confidence and belief is what drove much of Bitcoin’s positive price moves as investors were preparing for increasing inflation.

According to Messari senior research analyst Mason Nystrom, all that needs to happen for Bitcoin to be more widely considered as a hedging tool in times of high inflation is more adoption, which will eventually happen in response to increased regulatory clarity and ease of accessibility.

The more capital that flows into Bitcoin, the less volatile it will become as it is more difficult to move an asset price the higher the market capitalization. Nystrom goes on to explain that Bitcoin is a good inflation hedge now, it is just a matter of investors looking at it with a long enough time horizon.

Holding any asset that can go up hundreds of percent over a long enough time frame is always a good call, assuming investors are patient enough and don’t panic sell with each drop.

While Bitcoin is not the best place to park money for a short-term store of capital or inflation hedge, and it is discouraging to see how correlated Bitcoin is becoming to traditional markets, nothing beats the positive returns that Bitcoin has experienced in the long term.