Outlook reaffirms dual investment role for gold

Recent events have reinforced gold’s traditional role as a safe haven at a time of volatile markets, while trading gold on the ETF markets has surged. But talk of a gold price bubble looks way off the mark.

A measure of investor sentiment towards gold is the news that ­eurozone central banks are net buyers of gold this year for first time since the inception of the euro.

Openly declared gold purchases from global central banks in the first quarter this year is 43% up on this time last year.

Marcus Grubb, managing director of the World Gold Council, says central banks are expected to be net buyers this year and the next. Typical of this trend are the central banks of Mexico, Thailand and Russia.

Buying Power

Banco de Mexico decided to buy 93.3 tonnes of gold in February and March, bringing its total to 100.2 tonnes.

The decision was part of a new policy to diversify its ­foreign ­currency reserves, which had increased from $75bn in Q1 2007 to $120bn in Q1 2011.

Thailand increased its holdings of gold by 9.3 tonnes, bringing its total to 108.9 tonnes. Russia, the eighth largest holder of gold, has been adding ­regularly to its total, buying 22.5 tonnes between January and March.

These purchases have come at a time of soaring prices. Gold has been trading at more than €1,080/oz j0ust short of a record nominal high  while also trading strongly against the dollar, sterling and other currencies.

But, with talk of the euro approaching its ‘Lehman moment’, any talk about gold price bubbles looks misplaced.

Recent events have reinforced gold’s traditional role as a safe haven. “The past few years have seen a ­perfect storm of events, which has been very supportive of the gold price,” says Neil Gregson, co-manager of JP Morgan’s Global Mining Fund.

The weakening dollar, low interest rates, currency volatility, sovereign debt concerns, geopolitical ­tensions and inflationary pressures have all ­combined to make gold an attractive asset.

Gold now trades at $1,500/oz, up from about $300/oz ten years ago. Gold’s role as a currency has been enhanced through the growth of the ETF market, making the ­commodity accessible to a much broader investor base. Total gold ETF holdings now represent about 70% of annual gold mine ­production.

The nature of the asset – gold is gold’ makes it ­particularly suited for trading on the ETF market. The price ­formation for gold is strongly ­influenced by investor activity rather than the ­balance of mine supply and consumption, which typically drives other metal prices. Opinion is divided over whether gold can be used as a currency.

Tom Winnifrith, manager of the FS t1ps Smaller Companies Gold Fund, thinks it can. He remains bullish on gold not because of its role as a key commodity but rather because he sees it taking on the role of a key ­currency.

This in turn is driven by the belief that paper currencies have lost credibility. With the entire Western economy riddled with debt, paper currencies will continue to lose their value, says Winnifrith.

“The value attributable to such paper is derived from the confidence that it is backed by an underlying asset. Across the West, that is not the case.

“With increasingly large amounts of money pumped into the system it is a simple concept that the money in existence will become diluted and be worth less.”

Gold is the real reserve currency where investors can expect to retain their wealth, he says.

Attraction

A weakening US dollar no longer offers real security or store of wealth, while few other currencies offer a credible alternative.

Units such as the renminbi or rupee are yet to be regarded as safe haven currencies, even as Chinese and Indian appetite for US debt wanes.

“Gold is left as the hard asset of choice when looking to protect savings from confiscation through inflation,” says Winnifrith.

Gregson agrees that paper ­currencies have lost credibility thanks to the sovereign debt crisis. But, he says, “gold can’t really be used as a currency.

“As a financial asset, it does act as a store of value that cannot be manipulated by governments for political purposes. It is flexible in that it can be used to buy currencies anywhere round the world.

“Mostly, however, investors view it as a form of ­insurance and safe ­harbour.”

The conditions that might reduce this attraction, says Gregson, include a recovery in the US economy and an end to the threat of inflation.

A stronger economy would mean higher interest rates and a weakening of the drivers of the gold price.

But Winnifrith dismisses suggestions that the US economy is recovering. A wave of poor economic data has put such a possibility on hold.

Even after analysts revised down their forecasts for the month, he says, “what has been said to be a steady US recovery is showing to be nothing of the sort.” As evidence, he points to anaemic economic growth and a jobless recovery.

With unemployment in the world’s largest economy now ­sitting at 9.1% (or 16%, if those who are unemployed but not able to register are also included), all eyes are firmly on the Federal Reserve and what its next plan will be to kick start the economy and create jobs.

In Europe, the sovereign debt crisis is only adding to the reasons for buying gold.

Winnifrith says: “The debt crisis, with the focus currently upon Greece, will at some point spiral out of ­control. Short-term solutions are being chosen as a means of rolling over the issue. But in reality, the ‘­democratic’ government of Greece should put its citizens first, default, return to the drachma and focus upon rebuilding itself.

“The alternatives are at least a 50% haircut for debt holders or a ­restructuring and new, longer ­maturity dates. The best option for the Greek public would be the former, but that would see a chunk of EU countries’ and EU banks’ asset base disappear.”

 

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