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Saturday, 27th April 2024 |
| The time is now ripe to invest in gold. |
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| With bonds and property offering mixed returns, Mark Hutchinson examines the investment case for gold. |
Since December 2000 gold has risen 34 per cent while the MSCI World Equity Index has fallen 31 per cent. The global economic scenario which initially created investment demand for gold was an environment of deteriorating stock markets and a weakening dollar. Although, this situation has now altered, the emerging economic trend points to continued investment demand for gold.
The theoretical argument for rising gold demand
After the Federal Open Market Committee meeting (FOMC) in August the committee issued a statement outlining their view of the US economy. Amongst other comments, concerning the slowly improving economy, the FOMC observed, '...the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The committee judges that on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the committee believes that policy accommodation can be maintained for a considerable period.'
The message the Fed is trying to convey is that they will continue to operate a stimulative monetary policy of low interest rates to avoid deflation. The Fed and policy makers in the US have indicated previously that they would prefer to fight inflation than deflation and will take whatever steps necessary to avoid the deflation which has crippled the Japanese economy for eight years. In this author's opinion it is likely, due to the vast resources of the Federal Reserve de facto deflation will be avoided, however inflation is likely to remain 'at its already low level' for the foreseeable future.
What is of utmost importance is the speed of the US economic recovery. In a research report dated 8th August, 'Global: The Half Empty Glass', Morgan Stanley economist Stephen Roach outlined why he is sceptical of the staying power of any upturn in the global economy. The National Bureau of Economic Research has set November 2001 as the month when the economy bottomed, and over the first seven quarters of this 'economic recovery' real GDP growth has averaged 2.6 per cent. Over the previous six cyclical upturns, real GDP growth over the first seven quarters averaged 5.4 per cent, quite a difference.
What is even more striking is the job creation statistics. Although it is popular to claim job creation is a lagging indicator, over the last 20 months of the previous six business cycle upturns, private sector jobs increased by on average 2.8 million workers. Over the 20 months since the economy is claimed to have bottomed the US economy has lost 1.2 million jobs. Effectively, this means that the current up swing has missed the mark by 4 million jobs.
The additional main ailments of the US economy are excess consumer debt, an all time low saving rate, excess corporate debt, and now rising public sector debt (the 2003 budget deficit was forecasted in July to be a record $455bn and the 2004 deficit is forecast to be $475bn), a record current account deficit ($544bn per annum requiring foreign capital inflows of $1.5bn per day) and rising long term interest rates (caused by excess debt issuance and foreign investors demanding an increased return to finance the US trade deficit).
Taking all these factors into consideration it is difficult to forecast anything other than the US entering a period of sluggish growth, with low inflation bordering on deflation. Although there has been evidence of a pick up in the pace of economic recovery this is likely to be a short term bounce. Until the excess, consumer, corporate and public sector debt has been reduced and the unsustainable US trade deficit is addressed a return to strong, robust economic growth with job creation seems highly unlikely and the US dollar is likely to weaken further.
In this scenario why gold?
Equities have performed well in 2003, particularly since the (perceived?) conclusion of the Iraq war. However, they are now highly valued against historic levels and are generally only attractive if investors believe we are returning to booming economic growth.
In June 2003, the government bond market was the second bubble to burst. Yields rose from 3.6 per cent to 4.5 per cent, due to the impending increase in government debt issuance and fears about the current account deficit. The historic long-term average is 6 per cent and analysts are forecasting end of year yields of 5.25 per cent.
Property has the potential to be the third bubble to burst. Rising unemployment combined with rich valuations leaves little to attract the investor to the property market until prices correct.
Commodities and precious metals in particular, as hard physical assets are becoming more attractive in this environment. The long-term trend in the US dollar is still down. Although it has recovered slightly against the Euro, this is more due to the failing Euro zone economy, with Germany, France, Italy and the Netherlands entering their second or third quarter of recession, than US resilience. The US dollar needs to weaken further in terms of purchasing power to avoid deflation in the US economy and improve the US current account. In this environment Gold in particular is a good investment as a store of wealth. The chart below shows the performance of the USD Index (an index which compares the performance of the USD to a basket of world currencies) and gold over the last ten years. The two clearly have an inverse relationship and any further weakness in the US dollar will add to investment demand for gold.
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Would a change in investment demand have a large effect on prices?
According to Gold Field Mineral Services, in their 'Q2 2003 Gold Supply and Demand Balance' jewellery and other fabrication demand account for approximately 80 per cent of the world's gold demand. Bar hoarding and producer hedging represents an additional 10 per cent of demand. In 2001 there was net disinvestment supply of 1.5 per cent, and in 2002 there was net investment demand of 2.5 per cent. So far in 2003 there has been net investment demand of 5 per cent. As can be seen from the chart of gold prices a small pick up in investment demand since December 2001 seems to have had a large effect on gold prices. At the end of December 2000 the price of gold stood at $272.95, at the time of going to press it stood at $385.
What about central banks don't they depress the price?
Central banks, the International Monetary Fund and the Bank for International Settlements hold thirty two thousand tonnes of gold reserves, but under the Washington Agreement the 15 signatory central banks (who are the biggest holders of gold reserves) agreed to limit gold bullion sales to 400 tonnes per annum in total. It has been forecasted that as the gold price increases central banks, realising they have been selling at the bottom of the market will be, going forward, less likely to sell their reserves.
How can you invest in gold?
There are several options
1. Buy a gold mining stock. The industry has a total equity market capitalisation of $80 billion. The biggest company by market capitalisation is Newmont Mining $14bn, followed by Barrick Gold $10bn, AngloGold $8bn, and GoldCorp $2.4bn.
2. Individual investors can buy gold on spread betting exchanges.
3. There is a new security listed on the Australian Stock Exchange, Gold Bullion Limited, which is soon to list in the United States. Ten shares of Gold Bullion Limited represent one ounce of gold, so each share costs approximately $38.5.
4. Take physical delivery of gold, although this is difficult to organise, and who really wants to store gold bars at home or in the office.
5. Buy gold over the internet. Several websites offer the investor paper based investments which represent an investment in the physical underlying, although lots of research should be carried out into the reliability of the provider.
Where can I find out more about gold?
The World Gold Council (http://www.gold.org/) is an organisation formed and funded by the world's leading gold mining companies with the aim of stimulating and maximising the demand for, and holding of, gold by consumers, investors, industry, and the official sector. As such, their information should not be viewed as entirely independent but their website is an excellent source of information on the gold industry and gold investing. |
Mark Hutchinson is a lecturer in finance at University College Cork. He previously worked as an equity derivatives trader at HSBC Bank in London.
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| Article appeared in the October 2003 issue.
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