Yellow fever

Published in The Market, 2012.

Yellow fever
Gold is the ultimate rock in the storm for investors in times of crisis. Recent highs in the gold price has led to intensified speculation that we may be in a bubble, but at the same time, the case for gold remains as solid as ever. We take look at what drives the demand for the yellow stuff.

In times of economic turbulence there is usually one thing we can rely on: gold. When inflation takes a swing at the buying power of our hard-earned cash, and threatens the value of property and other investments, gold has proven highly resilient. And it is not a new phenomenon: during the reign of Babylonian king Nebuchadnezzar 2500 years ago, it is believed an ounce of gold would buy 350 loaves of bread – just as it does today.

The gold price has enjoyed an incredible bull run over the past decade, having seen a value increase of around 600%. Over the course of this year alone, the price has risen by 30%, and the slump experienced earlier this autumn has since been recovered, courtesy of the troubles in the eurozone. Recent economic events are a prime example of the kind of circumstance that fuels the gold price: uncertainty punishes stocks and currencies, so nervous investors run towards a safe haven. But now the big question is: can this price level be sustained?

The currency push
“A key driver for the rise in the gold price is the desire for people invested in currencies to diversify,” says Charlie Long, analyst at Singer Capital Markets. Currencies like the US dollar are traditionally seen as a safe pair of hands, but this is no longer such a clear-cut case as Western economies having a hard time. Consequently their currencies come under pressure, and investors start to look for alternatives. “In hedging your exposure to western paper currencies, gold is seen as a good bet. Bear in mind, gold has been the major currency throughout history, whilst an unbacked US dollar has only been around since 1971,” says Long.

The ongoing surge in the gold price has led to speculation that we could be in the middle of a price bubble, especially in light of the wobbles experienced in recent months. Still, there is no way to tell for sure where the price is headed; alongside talk of over-inflation we also see speculation of new record highs up ahead for gold. Consequently, each investor needs to consider both sides of the argument and use their best judgment.

“There are good arguments that gold will stay strong, or at least that it will not collapse,” says Long. “It seems to me the fundamental reasons for people buying gold will continue for at least the next couple of years.’

Gold under the mattress
The downside to investing in gold is that the asset class has no income, nor does it yield dividends. Another point to note is that while there are industrial uses for gold, demand is primarily driven by the financial markets. This is why gold is different from the other main metals, these being silver, platinum and palladium, where demand mainly comes from the industrial sector. Consequently, these metals have not enjoyed the same uptick as gold, as their price drivers are different.

As a gold investor, one option is to buy bars and stuff them under your mattress, but a better alternative for those keen to own the physical metal will probably be to buy a certificate for gold stored in a vault. Those wanting assurance they can get their hands on their gold in case of an economic meltdown should make sure to get an allocated account, as this would mean owning a specific pot of gold rather than an anonymous share of a general inventory.

A less radical approach is to buy a gold tracker, such as an exchange-traded fund (ETF). This will be designed to mimic the overall performance of gold for its investors. There are a number of gold ETFs to choose from, depending on whether an investor wants to track the commodity price, the futures price, or if you are bearish on gold, go short. A more risky approach is gold spreadbetting or contracts for difference (CDFs), or investors could buy into an investment trust specialising in the metal. Trusts and funds usually own shares in gold miners, which is another key approach to tapping in on the fortunes of the yellow stuff, but first a fair warning: gold mining is risky business.

Up from the ground
“One point most gold miners have been aware of for some time, but has somewhat been ignored by the commodity markets, is that the cost of mining an ounce of gold has been increasing at a similar rate to the growth of the gold price,” said Duncan Hughes, mining analyst at Ambrian Capital, in a report on the sector.

While the price of gold itself is largely driven by demand from the financial market, the value of shares in gold miners will be affected by a whole host of more down to earth concerns. This includes the cost of digging through less pure deposits, competition for workers, rising prices of associated costs such as fuel, plus the overhanging risk that mines come up short of their initial promises. All this means the value of gold shares have not enjoyed the same good fortune as the pure metal, but, says Hughes, if the gold commodity prices keep rising, the mining stocks should start to catch up.

As the fate of gold miners is tied to the performance of the overall market, there are however no guarantees: “If the global economy suffers a more prolonged recession, or if countries start defaulting on their debts, then gold equities will go down alongside other equities,” says Singer’s Long. “But if the gold price stays high, then gold producers will continue to generate huge amounts of cash. This will force analysts to upgrade forecasts and gold shares should rise. How many other sectors are seeing upgrades to forecasts?”

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