Why did gold fall with the stock markets?

Australian Financial Review, October 2011

Gold is supposed to be the ultimate safe haven asset: the commodity that keeps its value when all around is falling. Why, then, did it fall through September when global markets were in their worst state since the global financial crisis?

Gold lost more than US$300 per ounce in the second half of September. Having hit an all-time high of US$1,900 an ounce in April, at the time of writing it was at US$1,627. There had been fears of a bubble following gold’s precipitous rise in US dollar terms (a crucial distinction – for Australians, the climb in their own currency wiped out much of those gains) over the last two years; does this represent the popping of the bubble, and time to get out?

Gold professionals think not. Terry Hanlon, president of Dillon Gage Metals, a US commodity dealer, says declines in gold (and also silver and platinum) were a consequence of people taking profits to offset losses they had made in equities. “Investors who needed to raise cash quickly sold liquid assets, like metals, to do so,” he says. Another reason is that oil prices have fallen, reducing concerns about inflation, which is usually a driver of gold prices since gold is seen as an inflation hedge.

Hanlon believes gold will recover its lost ground, since it is still seen as a hedge against economic downturns in the US and elsewhere. He notes that in October 2008, as the world entered the worst of the financial crisis, gold fell 18%, before gaining it all back and moving up 23% in the subsequent two months.

The private banking community is working out how to position its clients. “Our advice is that gold was bound to have a bit of a correction, because it was becoming exponential in terms of its price appreciation in the last few months,” says Arjun Mahendra, managing director for investment strategy for Asia at HSBC. “But our basic advice is to start accumulating below US$1500 for another burst upwards. It remains in demand as central banks are debasing their currencies and facing inflation.”

Fund managers tend to see the balance of risks to the upside as well. Speaking before the sharpest decline, Blackrock’s director Malcolm Smith, who handles much of the manager’s commodity portfolios, told Smart Money there were four things that could end the bull run in gold, and that he didn’t see any of them on the horizon: a rapid reduction in uncertainty in the financial markets, a rise in real interest rates around the world, a reassertion of strength in the US dollar, and a rapid increase in the supply of gold. “None of them seem particularly likely, therefore the gold price seems supported,” he says. “The question on gold is: do you believe the world economy gets better or worse? If you think worse, then gold is potentially quite interesting. There are lots of investment banks pointing to a gold price about $2,000.”

BlackRock gets its gold exposure through mining names, including Australia’s own Newcrest Mining, which he says has “incredibly strong growth potential, with cash cost of production below industry averages.”

For investors who do want to position themselves for a rebound in gold, equities are worth considering. “There are three reasons you would look at a gold equity over gold,” says Smith. “One is operational leverage: a movement in gold can mean a lot more” for a gold stock. Another is growth potential. “A lot of our focus tends to be on companies that have potential for improvement.” The third is dividends. “Many gold companies to not have a track record of dividends, but you’re seeing it start.”

The other side of the argument is that gold was in a bubble and has further to fall to get out of it. “Gold and precious metals as a safe haven are somewhat overplayed,” says Lee Boon Keng, head of the investment solutions group for Asia for the Swiss Bank Julius Baer, again speaking before the sharpest part of the decline. “They have become not safe havens but speculated commodities. Would I put gold as an important part of my portfolio right now? At this price, probably not.” While gold has fallen since his comments to Smart Money, it probably hasn’t fallen enough to change that view.

So, buying opportunity or the start of a fall? The jury is out – but if you believe gold thrives in periods of economic uncertainty, then the outlook is surely good.