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Gold Has All The Glitter

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Indian demand for gold has seen a shift lately. While jewellery has been the primary source of demand in India, introduction of investment options especially ETF (exchange traded fund) and gold-linked mutual funds have increased investment opportunities. While gold price in dollar terms has corrected substantially from its peak, prices in India are still high due to a weaker rupee. Thus, gold is expected to remain price sensitive.

The demand-supply scenario globally for gold has also changed in the last few years and China's role has risen significantly. China's production has been on the rise for a few years and is expected to rise further. Simultaneously, China's consumption has also increased significantly and the country is now challenging India for the title of the world's biggest gold consumer.

Central banks have been net buyers since 2009 as gold is seen as an alternative investment. India and China are among the few nations who have raised reserves in the last few years. China has one of  the biggest forex reserves and speculation remains high that it may diversify. While it is unlikely to dump US treasuries despite the weakening outlook for the US economy, it may consider buying gold at lower prices. Meanwhile, Mexico, Russia and Thailand have raised gold reserves in the last year.

For over three years — since gold rose above its nominal high of $950 per ounce in February 2008 to reach $1900 per ounce in September 2011 — there has been much talk about gold being a bubble. I find it difficult to agree for the following reasons:

  • Huge deleveraging in the US will lead to another phase of declining US Dollar.

  • As historical data proves, paper assets (financial assets) have excelled when economic growth has been strong. When growth has faltered or the outlook has been less certain, hard assets have performed better.

  • Record low interest rates have moved gold and Treasury Inflation-Protected Securities (TIPS) higher in 2011. While the correlation between gold and TIPS declined earlier in the year, the recent rise suggests investors are more willing to pay for inflation protection.

  • World gold production has not been able to keep pace with the rise in demand.

  • The US M2 money supply has been strong while the US consumer price index (urban consumers) remains subdued — the correlation between the total US M2 and gold has exceeded 0.90 since November 2004.

  • Similarly, China's M2 money supply has risen by 20 per cent, Switzerland's by 25 per cent, Russia's by 30 per cent, and the world's by 8-9 per cent. Japan's M2 is expected to move higher after recent events. In order to fight economic and debt issues, paper currency has been printed at historically high levels.

  • Rising debt levels across the globe have also been driving gold prices higher.

Thus, based on the above price behaviour of gold, it cannot be referred to as a bubble.

All the reasons for gold's price action till date, as analysed, continue to exist. There are further reasons as to why gold will continue to do well:

  • As a percentage of assets, gold ownership remains negligible vis-à-vis equities and bonds. Ownership of gold is likely to be less than 2 per cent of global investable assets. This is in marked contrast to the end of gold's last bull market when gold and gold stocks accounted for over 20 per cent of global assets.

  • Click here to view enlarged image

    Gold remains poorly analysed and under-appreciated. This will change in the coming months and years when the importance of gold as an investment and currency diversification and as a store of wealth is appreciated again.

Gold has also done well during every crisis:

  1. Jan 1973-Dec 1974: Equity markets plunged due to a 5-month Arab oil-embargo following the Yom Kippur War. Gold prices appreciated by 182 per cent (absolute returns in USD).

  2. Jun 1979-Sep 1979: A combination of factors such as the Iranian Islamic revolution, the Iran hostage crisis, the invasion of Afghanistan by the Soviet Union, Iraq's invasion of Iran leading to an eight-year war resulted in the BSE Sensex falling by 5 per cent but gold gave a 40 per cent (in USD) return.

  3. Second half of 1982: Gold prices appreciated by 44 per cent (absolute returns in USD) compared to Sensex returns of only 11 per cent.

  4. Oct 1987-Jan 1988: Stock markets crashed worldwide on Black Monday;Dow Jones Industrial Average (DJIA) and Sensex returned negatively, but gold returned positively.

  5. Jan 2001-Mar 2003: Dotcom bubble bursts, September 11 terrorist attacks, US-led invasion of Afghanistan, Enron scandal, mounting concerns over corporate governance, US-led invasion of Iraq; DJIA and Sensex plunged by 25 per cent while gold delivered 25 per cent returns.

  6. Jun 2007-Mar 2009: Global financial crisis; DJIA fell more than 50 per cent, Sensex was down by 45 per cent, while gold delivered over 40 per cent positive returns.

The next 6-12 months have a high probability of Europe and the US slipping, and this could lead to a serious loss of faith in paper currency. Logically, the shift will be fast and the price behaviour then could be seen as a parabolic upside.

In fact, if the world is able to overcome all uncertainties and growth gets back on track — a low probability — because of the excessive M2 money supply due to central banks printing money; there will be huge inflationary risks. Gold is again the best hedge.

Gold will continue to march ahead and can give absolute positive returns in the region of 15 to 20 per cent at least in the next 12-15 months.

I recommend at least 10-15 per cent of one's portfolio be allocated to gold. It is difficult to time the purchase of any investment — I would be comfortable buying gold below $1,600 per ounce. Gold could remain weak in the short to medium term as long as the Euro remains under pressure and thus the dollar continues to be strong. Once the euro issue is out of the way, the fiscal issues of the US government, anaemic private investment, and consumption growth concerns would again take centre stage, leading to weakening of the US dollar (weak  dollar is positively correlated with gold price). So in the medium to long-term, I am positive on gold.

There are various methods that allow investors to either buy gold, or gain exposure to gold price movements. From physical purchase to buying gold online, from ETFs and complex financial products to mining stocks, the most appropriate gold investments will depend upon the investor's specific requirements. Though, while purchasing physical gold, one has to be very careful of the purity, ETFs are a reliable and  flexible option.

Disclaimer: The views expressed are personal and do not reflect the views of Kotak Mahindra Bank Ltd.

(This story was published in Businessworld Issue Dated 23-01-2012)