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. 

ACCESSING GOLD  Many Australian institutional investors have
had limited ability to gain exposure to gold in the past, which has
traditionally been sought using futures contracts. The introduction of Gold
exchange  traded commodities (ETCs) to
the Australian market in 2003 created an investment structure that addresses
many of the barriers to investment, enabling institutional investors to more
readily gain exposure to commodities without trading futures or taking physical  delivery. 
Similar to exchange traded funds (ETFs), ETCs are open-ended and highly
liquid securities listed on the Australian Securities Exchange (ASX) new
quotation platform – AQUA.

They are a cost effective structure with no entry or
exit fees and low management  expense
ratios.  There has been a huge surge in
global demand for all physically-backed Gold ETCs since the third quarter of
2008. Global inflows into ETF Securities’ 
physically backed gold ETCs was A$2.8bn over the last 12 months to April
2009, of which A$2.3 billion was generated since 1 January 2009.  WILL THE GOLD RUSH  CONTINUE? 
Global investors are undoubtedly struck with gold fever. The gold price
has increased from $US250 in 2000 to more than $US1000 in March 2009, although
it has since dropped back to $US950 in May 2009.  But will it last? 

Despite its recent successes, the gold market
faces a number of challenges. Demand for high priced jewellery is down 11 per
cent and industrial demand  for gold has
fallen 9 per cent.  But while there has
been some decline in the key demand drivers, the current economic climate
points to a sustained upward pressure on the gold price. If history is anything
to go by, a period of deflation like we are experiencing  today is often followed by a period of extreme
inflation. The massive monetary stimulus that is currently being injected
across world financial systems should eventually find its way into real
economies and ultimately into prices.

Gold has traditionally been seen as the
perfect insurance hedge against rising inflation. Therefore as inflationary  pressures grow, gold is expected to remain a
strong performer.  Supply side factors
also augur well for higher gold prices. Gold supply is stagnating with only
two-thirds of the annual gold demand met with new mine supply. Production is
also becoming  riskier and more expensive
with lower grade ore being produced from higher energy, labour and exploration
costs. Production levels from one of the world’s largest gold suppliers, South Africa,
is at 86-year lows.  Whatever way you
look at it, it seems King Midas has not lost his golden touch.

 

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