Fool’s gold?

Stock Watch by Brad Bishop, Butterfield
Bank (Cayman) Limited. 

Humans have long had a love affair with
gold.  For centuries, it has been
cherished by royalty, sought by thieves and desired by central bankers. Aside
from its few modern day practical uses (such as in dentistry and electronics)
the metal continues to be most popular as a jewel and as a store of value. The
price of gold touched an all-time high in October at US $1,381 per troy ounce,
representing a 25 per cent increase in 2010 and nearly a 200 per cent increase
over the past 5 years. 

What explains this dramatic rise in price?
I hear many comments that suggest gold is rising in price because its supply is
scarce. If this were the case, then yes economics 101 would dictate a rise in
price, all other things being equal. Yet, an analysis of recent statistics
compiled by the World Gold Council reveals that the supply of gold is abundant
and growing. Unlike stocks of crude or other natural resources that are
consumed very quickly, estimates show that current gold stocks could exist for
a few centuries given current rates of production and consumption. World
central bank assets alone at 30,000 tonnes could meet industrial demand of
3,000 tonnes per annum for 10 years.  

A closer look at demand statistics shows
that the demand for gold for use in industrial and jewellery applications has
remained somewhat stable (although some regions, such as India and China, have
shown notable increases). So if supply is growing and industrial and jewellery
demand is stable what gives?  

The answer lies in the demand for gold as
an investment. Recent figures highlight this. Total demand for gold (measured
in tonnes) increased by 36 per cent from Q2 2009 to Q2 2010 and much of it was
for investment purposes. Of particular interest is that ETFs (exchange-traded
funds) have been the largest contributor to investment demand growth, showing a
92 per cent increase in 2009, and a 414 per cent increase from Q2 2009 to Q2
2010. However, even with the pickup in investment demand, the numbers show that
total new supply is keeping up with total new demand. This suggests to me that
the increase in price is mostly a function of investor preferences. In other
words, investors are placing a higher value on gold.

Gold, in contrast to many other
investments, does not produce income and is primarily sought after as a store
of value. And unlike paper money, gold is not a liability of any country and is
accepted as a unique asset and medium of exchange the world over. Throughout
modern history, dollar-denominated gold has been inversely related with the
greenback, making it a useful hedge. In October, this negative correlation was
around 0.53, generally in line with its average for the past 15 years. (See
Graph ) 

During periods of high inflation, it
fundamentally makes sense that the price of gold would increase because the
alternatives, fiat currencies, would deteriorate in value quickly when more and
more money chases the same amount of goods and services. But why has gold
continued to rise of late when the US and most developed countries are battling
with extremely low inflation and even fears of deflation?

My hunch is that gold
investors are sceptical that governments will be able to make good on their
increasing debt levels in an environment where GDP growth is expected to be low
for a long time. Think of your personal situation and how very difficult it
would be for you to service increased debt levels if your income was not rising
significantly. So perhaps gold investors have picked up on the idea that the
only way for governments to repay their obligations, absent a growing economy,
is to “inflate their way out” and make repayments with a currency that is worth
less.  

This fear of future inflation has only
gained strength with expectations of further quantitative easing measures by
the Fed. To make matters worse, world currency disputes have intensified and
raised concern that more volatile exchange rates lie ahead. Both of the above
factors have added to the desire for gold as an asset to store wealth.

Thanks to the advent of ETF trackers,
investing in gold has become easier than ever for individual investors. One
such ETF, the SPDR Gold Trust (Bloomberg ticker: GLD), is backed by physical
gold bullion and is the largest such fund in the world. (See Graph 2). Since
its creation in 2004, the fund has grown to hold 1298 tonnes of gold at last
count, making its holding larger than all but five central banks around the
world. It trades just like a stock, has a low expense ratio of 0.40 per cent,
and is nearly perfectly correlated with the physical commodity.   

Should you add a gold tracker to your
portfolio? The answer to this question depends on your unique circumstances and
investment goals and of course your level of confidence in the international
monetary system.

The views expressed above are not
necessarily those of Butterfield Bank (Cayman) Limited. Financial statistics
sourced from Bloomberg. Gold statistics sourced from World Gold Council and
Bloomberg.

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