King Midas once said “everything I touch turns to gold” and in an environment of continuing market volatility, institutional investors are increasingly wishing they had the Midas touch – according to ETF Securities’ Nigel Phelan. Gold is enjoying a stellar run. A surge in the gold price has helped this precious metal overshadow most other asset classes. Gold retuned just over 29 per cent from 1 June 2008 through to 1 June 2009, versus a loss of 32 per cent in the broader market as represented by the S&P/ASX 200 Index. This recent performance tops a decade of strong returns – the value of an ounce of gold has increased almost four-fold in the past 10 years with the steepest ascent between mid 2007 and March 2009.
Gold has outperformed equities over a one, three, five and 10 year horizon. A range of factors have combined to drive this surge in demand. Investors looking for a safe haven from turbulent market conditions have been a primary driver. Because each bar of gold is uniquely identifiable, it carries no credit risk and is able to be insured. This compares favourably to cash, which is not physically segregated and is often not insured. So in the midst of a global financial crisis where confidence in the world’s banking system has been shaken, gold has been one of the most secure places to invest. Gold has also typically performed well during periods of deflation, which is another reason why investors are flocking to the precious metal.
Most periods of deflation are accompanied by sharp declines in domestic demand and systemic financial sector problems. Governments and central banks are forced to step in aggressively to offset the slowdown in private sector demand and repair the balance sheets of financial institutions. This generally leads to large injections of paper currency into the financial system and sharply higher government debt levels. As the supply of currency rises and concerns about debt levels climb, investors fear paper currency devaluation and look for alternative assets to hold. In addition, concerns about financial institution and even government – solvency and counterparty risk raises demand for alternatives to paper currency.
In an environment like today’s, when all major economies are facing severe recession, potential deflation, systemic financial sector crisis and the risk of currency devaluation (similar to the situation during the Great Depression), gold stands out as the main alternative to paper currencies. Investors are also turning to gold for its diversification benefits. Gold historically has a low correlation to the business cycle, providing a buffer in cyclical downturns. A zero to slightly negative correlation with equities also bolsters its diversification credentials. Further, gold’s low volatility compared to most other commodities helps to reduce overall portfolio risk.