Briefing on Gold

Investment Briefings

Introduction

Gold fulfils the conditions of a perfect “medium of exchange” (or money). It cannot be created or destroyed by human whim, it has few alternative industrial uses, which might affect its value and it has a very low weight to value ratio (and so is easily transportable). Throughout history it has been universally accepted by humans as possessing intrinsic value, being universally understood to demonstrate wealth and power.

It is different from other financial investments (like bonds, equities and real estate) which can be valued by a calculation of the discounted stream of future cash flows. These assets can be valued by human logic; gold however is valued more by human emotions, be it for its ability to demonstrate and display wealth, to protect against political uncertainty or to act as a hedge to paper currencies being devalued. To some investors such as Warren Buffett, the lack of an income stream means that gold is not really an investment, but to others, gold is considered the ultimate investment, since all financial securities are merely paper claims on cash flows, which can be overridden in extreme circumstances, by governments or by force.

Economic Background

There are today approximately 5 billion ounces of gold in the world (and 7 billion people); supply from gold-mine production averages about 80 million ounces per year, so supply of gold grows only by about 1.5% per annum. With supply relatively fixed it is changes in demand for gold that are the key to understanding changes in the price of gold.

Since owning gold produces no income, and indeed may incur a storage charge, the opportunity cost of owning gold is that of earning interest on paper currency instead. Thus gold has historically been strongly correlated with the level and direction of real interest rates. When paper currency can earn a high real interest return, the demand for gold tends to be low, and when the real interest return is low then the demand for gold tends to be high. The real interest rate in the Western world peaked in the early 1980s when the US Federal Reserve decided to stop inflation (even at the cost of recession and unemployment) and pushed up interest rates to almost 20%. Since 2000, interest rates have been kept low (now at essentially zero) while inflation has remained steady so that real interest rates have fallen sharply and are now negative. Current central-bank policy is concerned with maintaining very low interest rates even at the cost of this leading to higher inflation and so the real interest rate seems set to stay very low and possibly move lower in the future.

Gold Today

The global financial crash of 2008 and the subsequent economic policies have generally contributed to greater desire among many investors to include gold as part of their overall portfolios. The crash demonstrated that the entire financial system is massively interconnected – governments realised the danger and were able to backstop the system, before confidence in the entire banking system was destroyed. It did though make many realise just how dependent their wealth was on a functioning banking system and that the creditworthiness of banks does need to be considered. Lower confidence in the international banking system translates quickly into a greater desire to hold “money” outside of that banking system.

Since then, the policies adopted by the central banks in the West following the crash (specifically Quantitative Easing in very substantial amounts), have caused investors to realise that the supply of paper currencies can be expanded significantly and at will. Control of the supply of money is no longer a key tenet of central banking but instead can be discarded easily to pursue other economic objectives. The actions of the Federal Reserve, in particular in promising open-ended QE until the economy is much stronger, are a clear reversal of the Fed’s priorities from 1980 onwards. The search for a currency whose supply cannot be increased so easily, quickly leads to investment in gold.

In the Eurozone, the problems of sovereign debts and the consequential series of bailouts have begun to undermine confidence that the Euro will survive as a stable currency. This has caused much European (and in particular German) investor money to find its way to banks in Switzerland and converted into Swiss Francs and gold.

The Arab Spring and its consequent potential for radical, political change in the Middle East have caused many wealthy Arabs to reconsider the allocation of their wealth and contingency plans should they feel the need to move to a different part of the world. Holding more of their wealth in gold, which is easily transportable, is a straightforward decision for many.

The Future for Gold

China and India, due to their sheer size and rapid economic growth, are fast becoming much more important fractions of the global economy, and both have long histories and associations with gold ownership. In India, buying gold has long been the default investment strategy for every section of society – as incomes and wealth build, so too will Indian demand for gold.

Until just a few years ago, individual Chinese were not allowed to own gold, but throughout history the Chinese have revered gold. This hiatus extends to the national level, where gold forms less than 2% of its central-bank foreign-exchange reserves. This contrasts with 76% for the USA and 74% for Germany. China is relatively light in gold reserves (and relatively heavily exposed to US Dollars) when compared with most other countries in the world, and they have made very public their concerns with the QE policies adopted by the Federal Reserve. China (both nationally and individually) looks likely to be a major source of demand for gold for many years into the future.

In a world where all paper currencies are being actively printed, it is not surprising that investors are seeking a currency where supply is strictly controlled – in recent years gold has become that default currency, and looks set to maintain that status for some time.

Gold Mining Equities

Before the introduction of exchange-traded products on gold bullion, it was difficult for individual investors to own gold directly, other than in the form of coins and jewellery. The natural alternative was to own shares of gold-mining companies, the assets of which were, in effect, their discovered (and undiscovered) bullion reserves in the ground. In addition, the nature of the profit and loss account meant that their earnings were operationally geared to the gold price giving scope for share price volatility in both directions. These shares were in relatively limited supply and became very expensive in relation to their assets and earnings. In the first decade of this century, the rising gold price would normally have seen the shares outperforming the underlying bullion price. However, this did not occur as investors used the exchange-traded physical gold products to get their desired exposure to gold. Instead gold-mining shares underwent a steady de-rating as their scarcity value diminished. Their valuations are now in line with those of other equities, and once again offer an exposure with higher returns (and risk) than bullion for those investors bullish of gold.

Conclusion

Most of the feasible scenarios that might arise from the combination of Western Central Bank printing, enforced austerity throughout peripheral Europe, continued Middle East tensions both within and between countries, and the rise of China and their lack of gold holdings relative to the other major powers, lead to conclusions that the demand for gold will increase, a commodity which remains limited in supply. This underpins a long term bullish perspective on the gold price, even after a 10-year bull market. The most negative scenario for the gold price is that the world’s problems resolve themselves slowly and peacefully over time, and growth and interest rates return to their pre-crisis levels.