The allure of Gold

People tend to get quite emotional when talking about gold as the multi-year rally since 2000 and especially since 2009 has left people divided in two camps of those who love it and those who hate it.

What is undisputed is that gold has historically always had a special role as a unique store of value. (All the gold in the world fits into a 20 metre cube.) Gold can never be created, although many alchemists tried, it can never be destroyed as it is not soluble in nitric acid, unlike silver and base metals. Gold is a symbol of prosperity and good fortune and it has preserved family wealth through generations.
 
In Rome around 0 AD a roman citizen could buy a whole uniform with one ounce of gold. In 2011 a businessman can still buy his “uniform” with one ounce of gold showing how the value of gold has stayed intact throughout the centuries.

Since the financial crisis of 2008 investors have increasingly been looking for alternatives to traditional investments such as bonds and equities. Gold has benefitted greatly from this reallocation as the easy access and the advantages of gold have made it an increasingly popular investment for everyone from the retail investor to the biggest and most advanced hedge funds.
 
Over the last three years total investments in commodities have risen by USD 265 billion to USD 425 billion, according to Barclays Capital. Gold has particularly driven this explosive increase with the yellow metal currently accounting for more than one third of all investments in commodities.

So what has been the driver behind gold’s phenomenal success as an investment? The financial crisis of 2008 shook people’s belief in the financial system as central banks had to flood the market with cash at ultra low rates in order to keep financial institutions afloat. This triggered the commodity Bull Run as investors went looking for tangible assets with limited supply and therefore a higher chance of keeping their value. Around the same time we saw mining companies cease the practice of forward selling production thereby removing a great amount of supply from the market.

The result of these ultra low rates has been a rise in inflation which meant that the return on fixed income assets such as bonds has turned negative as the yield was lower than the inflation rates. Such a scenario is positive for noninterest bearing assets such as gold as the opportunity cost of holding gold becomes zero.

Another important change has been the behaviour of central banks which up until recently had been a net seller of gold for the past two decades. This practice ceased in 2009 and last year they became net buyers as emerging economies like China, Russia and India sought to diversify their national reserves in order to protect them from higher inflation and a potential drop in the value of the dollar.

Traditionally the retail investor has invested in gold through jewellery and gold mining shares while the institutional investor has invested through futures and physical gold bullion. Over the past five years the playing field however has opened up to everyone with the emergence of the increasingly popular Exchange Traded Funds or ETFs.

They are publicly listed investment funds that trade on stock exchanges, just like ordinary stocks. The funds are passively managed in order to accurately mirror the performance of the underlying market. They therefore have a low tracking error and should deliver almost the same return, minus fees, as the market they track. The rise in gold ETFs has brought gold and silver into the portfolios of many new investors.

During June and July we have seen the European debt crisis escalate once again just like it did around the same time last year when the desperate financial state of the Greek economy began to emerge. Since then we have seen other nations like Portugal and Ireland receiving financial assistance while rating agencies have continued to downgrade the credit worthiness of these peripheral and other European countries.

The U.S. economy during the same time has hit a soft patch with the economic growth weakening more than expected, not least due to the rising cost of energy and a ripple effect from the Japanese earthquake and tsunami in March.

So will the relentless rally continue? We believe it will, albeit at a slower pace than what we saw in 2010 when it returned nearly 30 percent, some 10 percent more than the annual average seen over the past 10 years. The factors that have driven precious metals are still with us and should continue to impact prices for the remainder of the year. Any pull back should be met by buyers, either central banks or investors who look at gold as a long term profitable investment.