Why the world has faith in gold

Gold remains in a primary bull market since the last decade. History has shown that commodity prices move in cycles of 16-17 years which might mean there is four-five more years of the gold bull market to capture. Corrections in gold prices of around 30% are a normal occurrence and have been observed in the past.

Ritesh Jain
Mon, Sep 10 2012. 09 46 PM IST
Live Mint

Gold as an asset class is in vogue again with prices reaching a new high in rupee terms. With rising prices, the usual pitch from so called experts too has risen as to how gold is in an “ultimate bubble” phase and is all set to go bust. Frankly, it is nothing new. In 2010, George Soros, one of world’s most accomplished investors, dumped his gold holdings at around $1,200 per ounce but interestingly, he recently surprised the markets by deciding to reinvest into gold at $1,600 per ounce. Pimco, the world’s largest bond fund manager, also added gold allocation in its commodity fund as prices dipped lower around $1,500 per ounce. They are not the only ones to have turned buyers from being sellers. Central banks across the world including Russia, China and other emerging nations have become net buyers after a long time. According to a recent report from World Gold Council, June quarter recorded official sector (central bank sector) gold purchase was more than double compared with the purchases made in the same period last year. If you consider the fact that gold represents only around 1% of total global investment assets, it seems crazy to be not invested in the asset. It is thus important to understand what is driving gold prices before drawing conclusions on the future course of prices.

To start with one has to understand that strictly speaking gold has no value as it is a non-income generating asset. With no cash flows associated with gold it is always at a disadvantage to other income generating assets including real estate. Till few years back it was not widely accepted as an asset class because either fixed income or equity alternatively used to do well. Investor perceptions have, however, undergone a change in the recent past. In this era of negative real interest rates, investors are looking out for assets to protect their investments. While Indians have been among the largest savers, the trend is fast changing as deposit rates have remained below inflation (CPI) for some time now, rendering the real interest rate negative. The combination of low capital gains and low returns in equities on account of a “stagflationary” environment has further reduced investment options. Gold thrives well in this environment, especially given its enviable track record of 11 straight years of positive returns.

Gold continues to remain in a primary bull market since the last decade. History has shown that commodity prices move in cycles of 16-17 years which might mean four-five more years of gold bull market yet to capture. One also should not forget that corrections in bull markets of around 30% are a normal occurrence and have been observed in the past. Investors need to be aware that the last leg of any bull market is often the most profitable and the most volatile. Hence, one should periodically use corrections as opportunities and gain from investing in gold.

Indian investors, however, continue to remain puzzled that though globally gold prices are almost 10% below its all-time highs, the prices in rupee terms are at all-time highs. A large part of this can be attributed to fiscal mis-management in the country, which is reflected in 20% depreciation (yearly) of rupee. The recent doubling of import duty on gold has also led to investors paying higher for gold in rupee terms.

On the positive side, Indian investors are now exposed to more efficient investment options in gold. Other than most travelled route of physical gold or jewellery, mutual funds offer exposure to gold in different fund types such as hybrid funds, exchange-traded funds and fund of funds. Though we have seen demand from India dampening this year, we believe higher inflation would help retain demand in the long run. In India, inflation has played a crucial role in gold’s popularity as an inflation hedge. In addition, globally gold has become more a proxy of the political stupidity and hence a crisis hedge.

One would still ponder on the question: how high is high enough for gold? It is very difficult to answer that question given the fact that it doesn’t have a fundamental value attached to it. We believe that it isn’t the gold prices that are moving up; it is the value of currencies that is depreciating which is pushing gold prices higher. Gold prices act as good proxy to lack of confidence in the fiat currencies. The crisis which started with companies being under financial stress has now moved on to countries. Gold acts as a hedge for investors in such times. If one believed that the future is bright, businesses will pick up and the real interest rates will turn positive, would one still buy gold? The answer would be no. But in the current market environment where the US, the world’s largest economy, is running at more than 100% debt-to-GDP ratio and Europe is struggling to keep its union up and running, we can be reasonably comfortable in believing that good times are farther than they appear. Till then, have faith in gold!

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