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Gold market fundamentals

Katharine Pulvermacher is Manager of Investment Research at the Head Office of the World Gold Council. Her background is economics and econometrics.

In the February issue of Families in Business, Katharine Pulvermacher explained that gold, as a portfolio diversifier, can help families protect their wealth. In this issue, she takes a closer look at the fundamentals of the gold market

When buying insurance, the family business owner expects to pay a premium. But an insurance policy is only worth something – other than relative peace of mind – when he or she makes a claim.  An investment in gold, on the other hand, maintains its value over time. It is one of the best long-term hedges against inflation due to its liquidity.

In fact, gold market fundamentals are looking better than they have for 25 years. That is partly because there is a shortage of raw gold supply coming out of the mines. Figure 1 shows that while mine production rose from 2,162 to 2,604 tonnes a year from 1991 to 2001, total demand rose from 3,129 to 3,868 tonnes over the same period (data source: GFMS Annual Gold Survey). In other words, the gap between demand and supply has widened considerably over the past ten years.

This trend is set to intensify, according to independent mining research published in March this year by Beacon Group Advisors. In Global Gold Production Outlook 2001-2010, Don MacLean and Don Blyth find that gold supply from mining is likely to drop over the next ten years. They anticipate that this will come in the form of a gradual decline in production over the coming four to five years, followed by a "precipitous drop". They conclude that "global production looks set to enter a long-term decline starting this year" on current market prices.

The shortage of gold from mining activity is compounded by the reluctance of the world's central banks to let go of the huge amounts of gold resting in their vaults. Because central bankers are not renowned for their sentimentality, the family business investor can be sure that they hold gold over the long-term for sound investment reasons:

Gold provides the country with economic security so that the government has a liquid asset to draw upon in times of market crisis.

Gold is not subject to any unforeseen currency exchange controls and is available in times of need. Alan Greenspan, chairman of the US Federal Reserve, recently said: "Gold still represents the ultimate form of payment in the world. Germany in 1944 could only buy materials during the war with gold. Gold is always accepted."

Central banks retain gold reserves to provide confidence to the public that the country's currency is underwritten by a secure asset. Of course, gold is no longer exchangeable for currency notes on a one-to-one basis as it was in the days of the Gold Standard, but the public like to know that the currency has gold as a 'back-up'. For example, the European Central Bank chose to hold 15% of its centralised reserves in gold when it launched the euro in 1999.

Gold is seen as a good portfolio diversifier because returns are negatively correlated to virtually every other financial asset and it can be leant out to raise income for the bank if it chooses to do so.

In 1999, Europe's central banks formalised their long-term strategy to hold a substantial amount of gold in their reserves when 15 countries signed the Washington Agreement formalising their commitment to retain the commodity as an "important element of global monetary reserves".

While supply is constrained, demand for gold is at a high. According to the most recent figures, family business owners joined other private investors in pushing demand for gold investments 8% higher in the last quarter of 2001 to 110 tonnes. Even though jewellery sales have been affected by the global economic slowdown and the reluctance of some tourists to travel, for 2001 as a whole gold demand was 3,235 tonnes, just 2% below that for the record year of 2000 (data source: Gold Demand Trends, World Gold Council). That means that the demand for gold has been strong both during the economic boom and in today's uncertain market. When sales of jewellery are strong in the good times, interest in other gold investments eases; conversely, sales of jewellery slow in an economic downturn and investors rush back into gold investments. Gold demand fluctuates between sectors and countries.

It is easy to see why gold is proving to be an attractive addition to the family business investment portfolio and why it looks like a solid option as a longer-term investment asset. And if the world's senior central bankers are keen to hold on to their gold reserves, it should, at the very least, give the family office pause for thought.

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