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Is gold the perfect place to be?

It can be a shelter from the storm. At times it can also be a currency and hedge against inflation. Gold has attracted a growing throng of individual investors due to recent financial turmoil; however, one of the trade-offs inherent in its safe-haven status is that it can undergo volatile price swings. Should you invest in gold?

First, gold is always worth something. This is why buying some quantities of it is generally considered a good way of diversifying and hedging an investment portfolio. Investors often buy gold as a hedge against dollar weakness and, conversely, sell gold during times of dollar strength.

But gold is not a normal commodity. The forces of supply and demand, largely driven by the jewellery markets of Asia and the Middle East, are often overwhelmed by the yellow metal's role in investment markets. Thanks to its historic role as the basis for the global monetary system, many people see gold as a currency in its own right. Its proponents regard it as the only true currency, since paper money will always be debased by the financial authorities. In other words, gold cannot be ruined like, say, the Zimbabwean dollar.

"The value can go down but you can't destroy it by artificially creating the stuff," confirms Ian Henderson, natural asset fund manager at JPMorgan Private Bank.

Last year, gold closed at $847.10 per troy ounce, up 3.1% on the year. Compared with a 40% decline in the S&P 500 and a 60% drop in crude oil prices, it was, after all, a return of capital. But analysts believe gold failed to capitalise during market turmoil because for much of the year, it was as much a part of the craze as any other asset. "We weren't necessarily seeing the rush to safety of this safe-haven market that gold has been in the past," says Darin Newsom, DTN senior commodities analyst. Most investors simply wanted out of all commodities.

From both a historical and long-term investment perspective it is difficult to make an air-tight case for investing in gold. That doesn't mean its place in a portfolio is unwarranted. "Right now I think it is an expensive hedge," says Gordon Curtis who, in 2008, produced double-digit returns as portfolio director for CI Family Office in Europe. He acknowledges the allure of gold as a weapon in the arsenal of a diversified portfolio, but questions its limitations as a strategic asset class. "There is a tremendous amount of wealth in certain pockets less concerned with revenue and more concerned with the preservation of wealth."

An expensive hedge it may be, but gold's interest among money managers' clients has probably boiled down to either greed or fear. Of late, the latter has been the case. "Investors have been in pure panic, they think the world is ending," Nicholas Brooks, head of strategy at ETF Securities, says. "When people get into that sort of mentality, one of the first places they go to is gold."

But gold returns can be volatile, especially when inflation is taken into account. "From a monetary perspective gold has not been a great investment for the past 20 years or so because, back in 1982, the price of gold was around where it is today," says Henderson. Inflation has made gold a rather less "defensive" commodity in the 25-year period between 1982 and 2007. "It has been a fallen angel because people have invested in other things which have provided yield."

Gold is perceived to be a haven from more than one economic horror story. John Reade, a commodities analyst at UBS, believes the metal is gaining from risk-aversion among investors fretting over instability in financial systems in the wake of the credit crisis. He has noticed that gold bars are being snapped up in very large volumes by investors. That suggests some investors are so worried about the health of the banks that they would rather hold their cash reserves in solid form.

It has happened before. "Wealthy families in Argentina are hugely into gold," says Curtis. And for good reason. In 2001, Argentina saw a run on its banks, causing a massive flight of capital from the country. The credit crisis has done little to soothe investors' nerves. Tellingly, Crédit Suisse has seen an increase in over-the-counter demand for gold bars and is bullish on gold. "For investors with a long-term horizon, investments that retain their purchasing power, such as gold or inflation-protected bonds, offer attractive entry options," it said in its December forecast.

The latest report by Barclays Capital forecasts gold to at least stabilise in 2009 and supports an uptrend in prices over the forthcoming months. "Amid doubts and uncertainties," the investment bank forecasts the average gold price to ease 6% in 2009 from the estimated average price of $870 seen in 2008. In the long term, however, the metal could sink to $650, probably towards the end of 2010, Barclays says. Others believe the expected crash of the dollar will result in money moving to gold. This can drive gold up and the movement may be 20% on either side of the forecast average price.

But gold has not lost its lustre for Henderson. On balance, he sees scope for healthy returns in the near term. "The price in US dollars was up 23.6% in 2006, 31.8% in 2007 and 3.1% in 2008, so it has actually been an absolutely excellent place to be in this period of financial meltdown. It has done the job in the past and I think there is every reason to believe that it can do it in the future."

Meanwhile, gold naysayers habitually point to the "weak" performance of gold relative to the broader market in the past five years. James West, an independent capital markets entrepreneur, reckons a few key factors will drive up the price of gold. One is the metal's emergence as a mainstream investment. "One of the biggest contributors to gold's unpopularity as a main street investment is that it has been mercilessly derided by mainstream investment media and institutions," he says. West accuses investment banks of discouraging investors from buying gold because there are greater fees to be made by pushing buyers towards other asset classes.

A second factor is China's recent decision to stop buying US debt. China holds more than $1trillion in US bonds and Treasury bills, but with US interest rates near zero, there is less incentive to purchase. West reckons that by eliminating incentives for Chinese banks to acquire US denominated assets, investors there will divert more funds to holding gold as a hedge against their current US dollar holdings, which have been diminishing in value.

Gold has also been boosted in recent years by a new type of buyer – exchange-traded funds (ETFs). These pooled portfolios allow retail investors to take a punt on the metal without the bother of storing bars or risk of buying shares in mining companies. Morgan Stanley reckons ETFs own more than 915 tonnes of gold – more than the European Central Bank. Funds are steadily being launched in new countries, such as Dubai.

This boost to demand is not being matched by a rise in supply. Indeed, world gold production fell by 1% in 2007, while in the first half of 2008 production fell by more than 70 tonnes according to GFMS, the precious metals consultancy. On the demand side, meanwhile, key markets have been weak. Maybe it is time to invest in gold, after all.

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