26 May 2016
All that glisters – may not be an investment
Should you be hoarding gold?
by Frank O’Nomics
Beware – the gold bugs are back. After a torrid time, and a fall from the heady heights of almost $1900 per oz in 2009 to just $1050 late last year, gold has seen the start of a promising bull run, returning to $1250 per oz in the last 5 months. Gold tends to perform well when real yields are low (and they are currently so low as to be negative in many markets) and, as a typical investment cycle for gold lasts for around 3-5 years, this would suggest that the gold price has further to go. Should we then be adding gold to our portfolios? While there are always good arguments for adding something that increases portfolio diversification, the nature of the global economy and the greater availability of assets that may be a more rational alternative to gold may well mean that the current rally runs out of steam quite quickly.
“Money is gold, everything else is just credit” said J P Morgan in 1912 and, for the 3,000 years that people have been investing in gold, it has worked well as both a currency and a store of value. In rough terms, it took the same amount of gold to buy a case of wine in Roman times as it does today (bearing in mind that Chateau Lafite did not exist 2,000 years ago), which is a lot more than could be said for the spending power of £ or $ over just the last few decades. Appetite for the metal remains on a rising trend, while mining it becomes ever harder – it takes twice as much ore to produce an ounce of gold as it did just a few decades ago. Asian demand is the significant driver of the market, with 1,400 of the 3,000 tonnes mined last year going to China and a further 600 tonnes to India. As the disposable income and savings of the population of these emerging economies develops it seems logical that this demand will increase further. Given this, should we expect a renewed assault on a $2000 gold price?
In the short–term this may be an unreasonable expectation. The price has already rallied 20% from its low, yet physical demand for gold is down 10% year-on-year with jewellery related demand down 19%. The overall increase in demand (21% year-on-year) has largely been the result of buying by exchange traded funds (ETFs) which have seen significant inflows due to worries regarding the global economic landscape. Gold ETFs are a relatively new investment product which has made it easier for investors to gain exposure to gold, but the need for this exposure will have its limits. Slower growth in emerging economies is the reason for the slip in jewellery demand and the current outlook does not suggest an imminent resurgence. A further limiting factor comes in the way that investors typically try to profit from a gold price rally. It makes much more sense to buy gold shares than to buy an ingot or a Krugerrand, given the greater leverage gained by owning the equity. If a typical gold miner faces an all-in extraction cost of say $1000 per oz, then they will make $200 per oz if the price is at $1200. If the price increases by $120, then an owner of the metal will have made 10%, while the margin for the gold miner will have increased by 60%. Therefore, if we are bullish about gold we should buy the miners, but the problem here is that the prices of mining stocks have already seen significant increases. The largest gold miner in the world, Barrick Gold Corp, has seen its stock price triple since August of last year – a period over which the gold price is up around just 5%. On this basis, it would seem that we have either missed the boat for gold stocks, or that equity prices are somewhat ahead of that of the underlying metal and are relying on a further rise in its value.
It is, however, in the longer run that gold as either a store of value or an investment vehicle can be questioned. Firstly, 52% of the demand for gold is for jewellery, with demand from central banks coming a distant second at 18%. From a jewellery point of view, India is the big buyer, but, from a savings point of view, as the market develops there it seems likely that there will be a demand for more sophisticated investments that produce a yield; this may be one factor behind last year’s fall in demand. Central bank demand is largely dictated by China – which keeps all of the gold that it produces. However, there seems to be no move to return to a gold standard to back currencies and, as the world becomes a safer place, the need to keep a store of gold as a hedge against geopolitical uncertainty seems less compelling for both governments and individuals. A number of developed nations have spent some time unwinding their gold reserves, notably the UK under the last Labour government, and there is scope for this to continue – a factor that could provide a significant long-term cap to the gold price. In short, it is dangerous to assume that the increase in demand for gold will continue in the long term.
As for those who cite the correlation between with the performance of gold in an environment of low or negative real yields on the one hand and the constant real buying power of gold over centuries on the other, this argument only works over very long periods and there are now some adequate alternatives that will give protection from inflation. We have been in a long period of declining long-term interest rates, but it is only the period since the start of the financial crisis that has seen gold benefit significantly. If one looks at the 25 year period from April 1981, the gold price did nothing more than move sideways, oscillating within $100 either side of a $400 median, which is a very poor level of protection against inflation, however slight (and in the early 1990’s inflation was very high). Looking at a very long-term chart of the gold price, we would still appear to be correcting the significant price spike that the financial crisis created, a correction that could have much further to go. Amongst alternative defensive assets, inflation-linked government bonds have a coupon and maturity value linked to inflation, and the US version of these (known as TIPS) currently deliver a positive real yield (at least for those bonds with a maturity longer than 10 years).
There is of course nothing wrong with buying your loved ones some expensive gold jewelry, and there may even be some cheap gold share out there if one can find those with mines that have a low all-in extraction cost. Either could prove to be reasonable investments in the very short or very long-term. However, this is a very different proposition to investing your savings for the benefit of your retirement or your children. The range of investment products has developed significantly over the last twenty years or so, and there seems little reason to be relying on a commodity that has little use beyond decoration, just because our ancestors did.
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