Is it time to include gold in your portfolio?

There are a number of reasons that gold deserves the prudent investor’s attention.

1) Gold as an inflation hedge

Gold has traditionally been viewed as a ‘currency’ that preserves its value in the midst of inflation1. The differences between fiat (paper) money and gold are summarised below:

Inflation Interest Gains in value when
Fiat money Depreciates in value owing to inflation Earns interest Interest rates are higher than the inflation rate, for then interest earned will more than compensate for the erosion in money’s buying power caused by inflation.
Gold Preserves its value against inflation Does not earn interest The inflation rate is higher than interest rates, for then the gain in gold’s nominal value due to inflation will exceed the opportunity cost of interest foregone.

As gold is priced in U.S. dollars and the U.S. remains the world’s primary financial centre, the direction of the gold price is largely based on the economic and monetary conditions in the U.S. Currently, we are in an environment where the inflation rate exceeds interest rates2, also known as a negative real interest rate environment (where the real interest rate = nominal interest rate less inflation rate). Hence the gold price has appreciated substantially since 2007.

Going forward, we believe that real interest rates will remain low. As the central banks of the developed countries are concerned with deflation, it is likely they will formulate monetary policies that foster inflation. As such, we think that the environment will continue to be positive for the gold price. Any unexpected surge in inflation, which we believe could arise due to the continual monetary expansion globally, is likely to result in the increase of the gold price. Thus gold may well act as a hedge against future inflation.

2) Gold as a safe haven asset

As seen in the table below, in most of the major crises in U.S. history, gold has tended to be a reasonable hedge against the crises. The only exception was in the early 1980s, where both the Dow Jones Industrial Average (“DJIA”) and the gold price both moved downward. This was the result of the US Central Bank raising interest rates sharply from around 5% in 1976 to around 19% in 1982 to curb high inflation. This caused the gold price to plunge (see the rationale under point (1) above).

Gold price vs DJIA

Gold in Portfolio Pic1

Interest rates in U.S. in the 1980s3

Gold in Portfolio Pic2

If the U.S. equity market is now an old bull market and therefore susceptible to a correction, should any unforeseen bad news arise, gold might well help to hedge against a correction. And there are plenty of possible sources of bad news around the globe: conflicts in the Near and Middle East; the outbreak of Ebola in West Africa; the confrontation with Russia over the Ukraine, to name a few.

3) Supply and demand of gold

There are several main uses of gold, as shown in the table below4

: Gold in Portfolio Pic3

Demand for gold as jewellery and purchases by the central banks could increase over time because:

i) China has become the number one jewellery market, nearly trebling in size over the past decade, and now accounts for 30% of global jewellery demand. According to the same survey5, 80% of the consumers plan to maintain or increase their purchases of 24-carat gold jewellery in the next 12 months.

ii) As seen in the chart below, central banks have been increasing their purchases of gold. This trend may well continue, especially for central banks of developing countries like China and Russia6. Gold currently represents only a small proportion of their national foreign exchange reserves (see table below). It is quite possible that central banks will gradually move their reserves out of fiat currency into other assets, for example gold, to pre-empt the depreciation of fiat currency over time.

Gold in Portfolio Pic4

Gold in Portfolio Pic5

Source: http://en.wikipedia.org/wiki/Gold_reserves

Factors that investors should follow include:

  1. Real interest rate
  2. Strength of the USD
  3. Global geopolitical situation
  4. Global monetary policies
  5. Portfolio allocation of global foreign exchange reserves

Risks in gold investment

A significant risk in investment in gold is that interest rates rise much faster than the inflation rate, causing a high real interest rate (the rationale is illustrated in point (1) above). If this scenario happens, the gold price may correct significantly.

Valuation

We take the following factors in consideration to estimate the valuation of gold:

  1. Production cost
  2. The adjusted gold price based on money supply

Production cost

We use the following metric to measure the production cost of gold: “ Production cost (All-In-Sustaining-Cost) + Tax rate” (In USD) Gold in Portfolio Pic6

Note: We use U.S. corporate tax rate because most of the large gold mining companies are based in the U.S. Gold in Portfolio Pic7

Gold is unlikely to be produced if its price is below that required for gold mining companies to be profitable.

The adjusted gold price based on money supply

As seen below, the price of gold has now returned to the level before the Bull Run, which lasted from end-2007 to 2011, when adjusted for the effect of monetary expansion.

Gold in Portfolio Pic8

Source: GoldMoney, Gold versus the money supply

http://www.goldmoney.com/research/research-archive/gold-versus-the-money-supply

Thus, even when we consider a significant risk such as the gold price correcting, it is more likely that the gold price will rise in the current environment. With the U.S. equity market being an old bull too, it is also very likely that gold becomes a good hedge should there be any bad news and lead to a correction in the markets. Demand for gold has not diminished, and the valuation of gold currently is still fair. As such, Unicorn thinks this is a comfortable time for investment in gold.

Sources

1 Gold rate for today:

http://goldratefortoday.org/gold-inflation-hedge/

2 Why real rates must stay low over the next 5 years, Market Realist:

http://marketrealist.com/2014/06/why-real-rates-must-stay-low-next-five-years/

3OpEd: Return to Economic Normalcy:

http://thetysonscorner.com/oped-return-to-economic-normalcy/

4 World Gold Council, gold supply and demand:

http://www.gold.org/supply-and-demand/gold-demand-trends

5 World Gold Council, New report predicts sustained strong gold demand in China in next four years:

http://www.gold.org/news-and-events/press-releases/new-report-predicts-sustained-strong-gold-demand-china-next-four

6 Global Research, China and Russia are acquiring gold, dumping US Dollars:

http://www.globalresearch.ca/central-banks-are-acquiring-gold-dumping-us-dollars/22672

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