The case for gold

Australian Financial Review, August 2008

Even by the choppy standards of world stock markets, the gold price has had a roller-coaster time of it lately. In March gold hit a landmark high of US$1,000 an ounce, with many commentators calling for it to climb as much as 50% more. But at the time of writing it was at $786, having fallen more than 20% (the dictionary definition of a bear market), most of it in the space of a single week at the start of August.

So what’s happening? After all, the base case for gold is very strong indeed. Aaron Smith, managing director of the managed futures fund provider Superfund Financial in Singapore, puts it like this: all of the gold existing in the world today is equivalent to a cube approximately 15 metres long, wide and deep. It’s valued at US$4.5 trillion; the US national debt alone is almost 15 times that amount. There’s really not all that much of it. And there isn’t a great deal more being found – people are digging iron ore mines, nickel mines and copper mines, but there’s no boom in new viable gold mine discoveries. Supply is therefore limited.

On the other side, gold is in demand. It is held by central banks all over the world. It is of course highly popular for jewellery, particularly in Asia, where the growing affluence of countries like India and China – where hundreds of millions of people are entering the middle class and getting disposable income for the first time – underpinning demand. And finally, gold tends to do well when the US dollar is weak, when stock markets are under pressure, and when oil is high. All of these factors are in place. It’s for this reason that Smith at Superfund says his medium term forecast for gold is “about US$1500”.

One of the reasons for the recent correction is that the US dollar has got a bit stronger, oil has fallen, and commodities generally (and the stocks of companies who deal in them) are coming off their highs. There has also clearly been a period of liquidation – pension funds and money managers around the world reducing their exposure to commodities generally and gold particularly. Even so, the vigour of the fall has been striking. “For those who have ridden the bull market in precious metals over the years, sharp price reversals and ongoing volatility have always typified market action,” said Fat Prophets, the investment commentators with a specialism in commodities, in a recent note to investors. “However, we were surprised somewhat by the latest sharp falls in crude and precious metals.”

So what does this mean for investors: are gold’s days in the sun over, like pretty much every other investment these days? Or is this a perfect buying opportunity before the next upward trend?

Fat Prophets said: “We do not believe that the bull market in gold and gold stocks is over. We do however believe that the correction is likely to be more protracted and endure for longer now that the US dollar has displayed some strength.” A look at the gold price over the years shows that spikes and reversals are commonplace. “Throughout history, gold has been a hedge in inflationary and deflationary times. We continue to believe its value as a hedge will be maintained.”

HSBC economist James Steel in New York has a similar view. “On the occasions when bullion prices have retreated, the declines have usually, though not always, coincided with efforts by the authorities to resolve the credit crunch,” he says. “As such, there have been a number of false positives with gold declining on each fresh attempt by the authorities to stymie the credit crunch, only to rally back as the credit crisis morphs into another form, remaining a drag on the financial markets.”

David Baker, of gold specialist fund managers Baker Steel, adds: “If we were sitting here saying there’s lots of new gold supply coming on stream, I’d see reasons for the gold price to be depressed. But mining companies are struggling to find new deposits or to meet production targets. It still looks ridiculously cheap compared to oil.”

Buying into gold is in some measure a bet on the US economy still being in bad shape – and in particular the messiness of its banking sector. That $1000 an ounce price came round about the time that Bear Stearns had to be bailed out and wedged into JP Morgan. Shocks in the financial markets tend to trigger an upward run in gold, which for 4000 years now has been considered a safe haven in difficult times. Correspondingly, if you think the US is past the worst and on its way back up again, or that the US dollar is going to strengthen, or that the commodities boom is over, then you might want to think twice about buying in to gold even at these levels.

For Australians who want to buy in to gold, there are a few options. One is to buy the physical metal itself. This can be done at Gold Corporation, better known as the Perth Mint, set up in 1899 as a branch of Britain’s Royal Mint back in the day when gold sovereigns were everyday legal tender. Today it issues legal tender gold coins and bars, and offers depository services which allow people to invest in gold without having to physically keep it anywhere themselves. Gold comes in allocated and unallocated forms. With allocated gold, you purchase a specific physical coin or bar from the Mint, which places it in a vault, Goldfinger-style. Unallocated gold involves you purchasing an interest in a pool of precious metal held by the Mint. It’s 100% backed by real gold, but you can’t go and identify your own individual bit of bullion.

The Mint also offers certificate programmes representing interests in gold, and an exchange-traded fund listed on the Australian Securities Exchange. This involves you buying a share like any other, which is intended to track the gold spot price. This is probably the easiest way for most investors to get exposure to the gold price directly, as you can sell in and out in minutes like any ASX share.

Then there are shares of companies that are involved in the gold mining industry. Examples in Australia include Lihir Gold and Newcrest. “It’s a different risk,” says Baker. “Physical gold is the lowest risk. There’s not much chance of getting much growth out of physical – if you buy a bar of gold it doesn’t get any bigger over time – but if you buy a share, that mine can get bigger, or find more discoveries. But the tradeoff is there are more risks.” Those risks include the rising cost of gold production, a failure to find more gold, problems with hedging and derivative strategies, and all the woes that can from time to time afflict any arm of the mining industry.

Baker Steel runs a number of mutual funds in the gold and precious metals industry, including one, the Genus Dynamic Gold Fund, which invests primarily in gold and precious metal equities.  Baker Steel is also the manager for the Select Gold Fund, offered in Australia by Select Asset Management, with a minimum initial investment of A$25,000 and a 1.89% management fee. To give an example of how choppy these funds can be, $100,000 invested in this fund in October 2003 would have been worth about $90,000 by April 2005, then $200,000 a few months later in April 2006, about $140,000 by July 31 – and presumably a fair bit less when the August numbers come out.

Another managed investment product available in Australia is the listed investment company, Global Mining Investments. This uses the investment management expertise of the renowned London-based natural resources team that used to be Merrill Lynch Investment Management and is now BlackRock Investment Management. It’s not just a gold fund, but rather resources generally, but this team has long championed the supply/demand fundamentals of gold and the equities that are linked to it. The fund was launched in April 2004 at $1 per share, and by July 31 its net tangible assets (the value of what it owns) was double that at $1.99; however its share price, at $1.60, was much lower than the NTA at the time of writing (August 18). BlackRock itself has an international gold fund available, including on the Syngery platform.

For anyone making an investment in gold itself, it’s important to realise that the currency plays a major role. The recent crash in gold prices has come in US dollar terms – but that’s partly because the US dollar has strengthened so much. If you, sitting in Australia, held that gold investment, then in Aussie dollar terms it would not have fallen so heavily since the US dollar has strengthened against the Aussie. The reverse is also true: it’s all well and good gold going up 10% in value in US dollar terms, but if the greenback has fallen by the same amount against the Aussie dollar then you haven’t actually come out any better off.