Gold is the most sought after precious metal and is primarily used in jewellery making or as a financial asset.
There are also industrial uses for gold including electronics, dentistry and aerospace, but they only represent a minor percentage of the total gold market. Gold reached its all-time high of $1,900/ounce in the third quarter of 2011.
After the start of the financial meltdown in 2008, investors searching for real yield and protecting against tail risk events started pouring into gold exchange traded funds contributing to the rise of gold. Since the end of 2008 the metal gained 57 per cent, but this April it experienced the largest two-day price drop in three decades, plunging down 14 per cent.
Although the gold price managed to recover somewhat, the rebound was not sufficient to maintain an upward momentum. Strengthening of the US dollar, continued ETF outflows and the equity market rally resulted in another sell-off in mid-May down to the $1,350/ounce level. The events of April and May have elicited a renewed debate about the performance outlook for gold.
Advocates of gold cite two factors for investing in this most cherished metal. The most frequently used argument for investing in gold is inflation protection and the fact that central banks continue debasing their currencies by printing money must ultimately lead to inflation. A weaker US dollar makes gold, which is priced in dollars, more affordable for the largest gold buying nations, China and India. The Fed is purchasing $85 billion in assets a month to stimulate the economy. The European Central Bank cut its benchmark interest rate to a record low of 25 basis points and Japan’s monthly debt purchase program is more than $7 trillion yen. All these factors are historically drivers for a higher gold price.
Although this time has been different, even though there is unprecedented monetary easing, inflation has not been a concern, because central banks are fighting against anaemic growth and deflationary pressures. This absence of inflation despite continued loose monetary policy is the main reason why gold bears don’t buy this argument.
Another argument put forward by gold bulls is that gold is a store of value especially in uncertain times. Although we are still living in uncertain financial times and unexpected economic or geopolitical events should result in a gold rally, the probability of economic tail risk events like the financial meltdown or the break-up of the Eurozone have been significantly reduced.
Gold bears point to improving macro-economic data in the US and the fact that tail risks to the global economy are abating. Analysts and hedge funds have become more bearish on gold, significantly reducing their gold net long positions at the end of April. Exchange traded funds shed 16 per cent of gold holdings this year alone.
Acclaimed billionaire investor Warren Buffet joins the anti-gold camp and is not a champion for adding gold to a portfolio. He told reporters that even if the price went down to $800, he would not be a buyer of the precious metal.
Dr. Nouriel Roubini, also known as Dr. Doom, believes that as an investment, gold’s potential return should be compared to other financial assets such as equities, bonds and real estate. On that basis, gold becomes quite unattractive as it is purely a bet on capital gains, unlike other assets which include both a capital gains and income component.
The significant drop in price last month did entice retail buyers, resulting in the highest gold coin sales for the month of April since December 2009.
India and China, the largest purchasers of physical gold, also saw a significant inflow of gold bullion the first quarter of the year. Although demand for physical gold in emerging market giants India and China provides price support, it will not be sufficient to offset ETF investment outflows.
Improvement in the macro economic data in the US, the rally in equity markets, the lack of acceleration in inflation, and the diminished probability of tail risk events will continue to exert downward pressure on the gold price.
Against that backdrop, gold seems quite unattractive. The yellow metal, however, can still play a diversification role in a portfolio, providing a hedge against tail risk events and inflation in some cases. Therefore, from a risk management point of view, it’s worthwhile including a small allocation to gold in your portfolio, but on a relative value basis, one should probably underweight gold.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.