The lure of gold

Gold prices touched all-time highs recently with 10 grams (gms) of the yellow metal going for as much as Rs 15,745. While prices have cooled down a bit, investors continue to pile into traded gold-backed securities or gold exchange traded funds (ETFs) in a big way internationally, and, to a lesser extent, in India. Gold ETFs, which were introduced in the US barely five years ago, now have over $40 billion in assets under management and holding over 1,300 tonnes of the yellow metal.

For a precious metal that neither gives you dividends nor pays an interest and does not compare too well with assets classes (equities and debt) on the returns front, what has changed to warrant investments at such a scale? More importantly, should you invest in this precious metal and what kind of returns can you expect from this? We spoke to commodity experts, wealth managers and investment advisors to get a perspective on demand drivers and prospects for this asset class.

The spikes in gold
Historically, gold prices have reacted sharply to geo-political and economic shocks, inflationary fears, dipping supply and rising demand, a weak dollar and struggling equity markets. Be it the oil shocks of the 1970s or the 1980 invasion of Afghanistan or the reaction to the collapse of investment banks last year—in every case, gold prices touched record highs. In March 2008 for example, gold touched all time highs of $1,023 an ounce (31 grams) following news of the collapse of Bear Stearns. Even in the current year, recessionary conditions and the global equity sell-offs have ensured firm gold prices with the average going at $900 to an ounce.

Gold also seems to be giving the best returns when the inflation rate is at high levels (gold has outperformed equities by a wide margin in the US during high inflationary periods) and thus, is considered to be a good hedge against it. While currently inflation is hardly a concern, large amounts of liquidity injected by governments is likely to find its way into the market and push up inflation. While this could lead to depreciation of currencies (as governments print more money and increase money supply), gold because of its limited supply (can’t increase it suddenly unlike currencies) continues to hold its own and is thus is considered as an effective inflation hedge.

While a weak dollar has been positive for gold and the yellow metal has a negative correlation with the dollar, currently both asset classes are in demand. 

Best among worst
Gold has moved up by 33 per cent since November 1, 2008 and the dollar has been moving up against most currencies including the euro and the rupee. Says Manasee S Gokhale, economist, NCDEX, “With few other options available and as long as other currencies are falling, dollar would continue to strengthen.” Despite the poor fundamentals of the US economy and a yawning fiscal deficit, institutions have been buying dollars, as it is considered the better bet among weak currencies.

The movement of the gold and dollar in the upward direction is due to recessionary conditions and is therefore temporary, believe experts. Says Jayant Manglik, president, Religare Commodities, “The gold-dollar relationship will get back to the trend line. Unprecedented investments by governments should help economies recover by the end of the year.” The frenzy of investment in gold going ahead, he believes, is likely to die down as recovering economies will bring equities into play once again.

However, till that happens, the key reason for gold prices moving up will neither be dollars, external shocks or the falling equity markets, but as an investment option with investors seeking assets which have minimal risk, offer stable returns and have low price volatility.

The gold rush
Jewellery demand in India has always been the key demand driver making up over two-thirds of total global demand for gold. This has, however, changed dramatically over the last one year due to increase in investment demand worldwide. In 2007, jewellery in terms of volumes accounted for 68 per cent of demand while investments had a share of 19 per cent (rest used for industrial and dental purposes). A year on, investment demand has shot up 64 per cent in volume terms, especially in the last two quarters of 2008, (See chart: Gold demand) with investors snapping up a 1,000 tonnes of gold. Share of investments now account for 30 per cent; that of jewellery has fallen to 58 per cent.

In addition to retail consumption of gold coins and bars shooting up, investments in exchange traded funds (ETFs) have also seen a rise. Unlike the situation in India where gold ETFs have a miniscule five tonnes of gold with them, ETFs such as the NYSE-listed SPDR saw its gold holdings jump 14 per cent in one month to nearly 1,000 tonnes (See graph: ETFs in vogue) which is more than what India, the largest consumer of gold, imports in a year. Will this trend continue? Dharmesh Sodah of the trade body World Gold Council believes that while there will be profit-taking, the assets under management of US-based ETFs have been increasing due to the lack of alternative investments making them sticky.

In India, the movement has not been as dramatic. Says Gokhale, “ETFs are a new concept in India and are likely to do well over the next two years once investors can see a record of stable returns.” Demand in the short term, however, is likely to be hit due to the prevailing high prices. Experts expect a rally in April (the Akshya Tritya festival pushes up gold sales) after which gold might stay down. An upward movement post September (start of the wedding season) could be seen with gold likely to touch about $1,100 levels in a year.

While global demand is expected to be steady, supply constraints also favour firm prices.

In short supply
Globally, with no fresh sources of mining available and a drop in gold prices in the 1990s has meant depressed production and mining activity since 2002. Acute power and labour shortages in South Africa (third largest producer) as well as sharp dips in production in Australia (fourth largest) and Indonesia, has translated to drop in supply for the third consecutive year (2008). GFMS, a UK-based precious metals consultant, believes that supply in 2008 has dipped by about 4 per cent to about 2,385 tonnes, the lowest in 13 years. In anticipation of higher prices, producers have dehedged (squared their forward positions) to the tune of 346 tonnes (or 14.5 per cent of world production of 2,385 tonnes) in 2008.
 

GLOBAL INVESTMENT DEMAND
	2007	2008	% chg*	Q4'07	Q1'08	Q2'08	Q3'08	Q4'08
Identifiable Invt	663.7	1090.7	64	141.4	153.7	139.4	398.6	399.0
Net Retail Invt	410.3	769.3	87	61.4	81.0	135.4	248.6	304.2
Bar Hoarding	236.3	378.2	60	30.2	46.6	88.4	116.6	126.6
Official Coin	137.0	197.7	44	22.4	29.5	36.6	63.8	67.9
Medals,Coin	72.6	60.5	-17	8.4	9.7	12.4	21.2	17.2
Oth Retail Invt.	-35.6	132.8	–	0.3	-4.8	-2.0	47.0	92.6
ETFs, similar Prod	253.3	321.4	27	80.0	72.7	4.0	150.0	94.7
Inferred Invt	-37.7	-190.5	–	192.3	104.3	53.0	-354.7	7.0
Total Invt	626.0	900.2	44	333.7	258.0	192.4	43.9	405.9
Total Invt, $ mn	14,727	24,816	69	8,435	7,671	5,544	1,230	10,372

Another key source of supply, government gold holdings, also saw a sharp 42 per cent fall year-on-year as governments sought to maintain their gold stocks amidst an environment of uncertainty. Sales by Central Bank Gold Agreement countries (primarily the EU) which own nearly half of the government-held gold reserves of 30,000 tonnes is controlled by a 500 tonne-a-year sales cap. Thus, analysts believe that despite the rise of scrap (recycled gold) supply on higher prices in 2008 by an estimated 13 per cent and likelihood of the same going up in 2009 as well, the drop in production and lower government sales will ensure that the pressure on supply will remain going ahead.

Price outlook
In light of the current scenario, how will prices move? Experts believe that since gold prices have moved up in the last three months, the near-term could see some