The gold rush
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As turbulence shook the global financial system, investors looked for life boats amid the storm debris in the final months of 2008. Many investors scrambled into gold, a traditional safe-haven in times of extreme uncertainty.
Investment soared in the glistering metal through securities backed by physical gold, generally known as gold exchange-traded commodities or funds (ETFs), and bars and coins in the fourth quarter. The spending spree continued in the first quarter of this year.
The emergence of gold ETFs since 2003 has made it easier to invest in the yellow metal, particularly for institutions, as they offer tax-efficiency and liquidity. These regulated financial products are expected to track the gold price almost perfectly. Moreover, enthusiasts say that investors are increasingly appreciating gold’s role as a store of wealth and effective diversifier for portfolios. Though its price rose only 2.7% in dollar terms during 2008, according to Gold Fields Mineral Services (GFMS), a leading precious metals consultancy, this compares favourably with losses in equities and other assets in 2008, highlighting gold’s resilience during troubled times. On an annual average basis, the gold price rose 25.4% in 2008.
The jury is still out on whether this upsurge in buying interest in these relatively new vehicles represents a structural market shift. Is investment in gold ETFs here to stay or will investors dump their holdings in favour of equities and other assets as economies start to recover?
The surge in gold investment stands in contrast to a number of opposing trends. During the early years of this decade, many factors worked in favour of gold: these included declining real interest rates, a collapse in the value of the dollar, unstable equity markets, relatively well coordinated central bank sales in Europe, rising geopolitical risk and producer dehedging. Today these forces are working in different directions: some in favour of gold, others against, says Michael Lewis, global head of commodities research at Deutsche Bank.
Lewis says two forces, in particular, have been waging: the strengthening dollar, which has traditionally been negative for the gold price, and the strong inflows into physically-backed gold ETFs. He considers the dollar to be the most important driver of the gold price: “A surge of financial flows into the greenback on the one hand and inflows into gold ETFs on the other, were the major factors that have kept the price of gold within a broad trading range during the crisis,” he says.
GFMS’ authoritative annual gold survey, published in early April, tells a similar story of opposing demand and supply trends within the gold market itself. While investment was strong, jewellery fabrication fell 10% in 2008, while on the supply side, global gold scrap surged 27% to a new high because of higher gold prices and distressed selling.
Jewellery fabrication slumped further in the first quarter of this year as high and volatile prices and the global economic downturn took their toll on consumers’ appetite, while scrap continued to surge.
The survey’s figure for implied net investment soared by 76% to 288 tonnes in 2008, reflecting record inflows into gold ETFs, while its broader category of world investment, which includes the implied element, bar hoarding and all coins, rose by 52% to 927 tonnes last year. In approximate value terms, it says, this represents an 80% jump in the net flow of funds into the yellow metal from all investors to a record $26 billion (£17 billion).
The tussle between these opposing trends has been enough to hold back the investment-driven rise in gold prices from breaching the $1000/oz mark this year, says GFMS.
Net sales by central banks declined last year, as did central bank lending. Mine production too fell to its lowest level for 12 years.
The shift into physical investment in gold occurred in September last year following the collapse of Lehman Brothers. With confidence in the global financial system and economy foundering, retail investors, high net worth individuals and the wealth management industry fled from riskier assets and abandoned the search for yield in favour of gold. Paradoxically, observes GFMS, gold prices struggled over much of October and November as another group of institutional investors, particularly hedge funds, liquidated holdings to raise cash for margin calls and investor redemptions.
However, the gold price rallied sharply from late November, hitting a high of $989/oz on February 20, before slipping back in March and April.
The World Gold Council (WGC), a marketing organisation funded by leading gold mining companies, says investors bought a record 459 tonnes of gold via ETFs in the first quarter. This amount exceeds the total inflow over 2008 and took holdings of ETFs monitored by the WGC to 1648 tonnes. These numbers are broadly in line with those compiled by other bodies, such as Goldessential, an independent research firm based in Belgium and London. The WGC only monitors instruments that are wholly backed by physical, allocated gold – that is, those that have exclusive title to gold bars, each uniquely identifiable.
According to the WGC, State Street Global Advisors’ SPDR GoldShares is by far the biggest gold-backed ETF, with about 67% of total gold holdings (at April 30, 2009). The two products issued by ETF Securities, Physical Gold (PHAU) and Gold Bullion Securities (GBS), account for around 14% of global holdings tracked. Next in size are the ZKB Gold ETF, issued by Zurich Kantonalbank (9%), Comex Gold Trust (4%) of Barclays iShares and Julius Baer Physical Gold (3%). Small funds include the NewGold Gold Bullion Debentures ETF (2%), marketed by Absa of South Africa and Goldist, backed by Finans Portfoy and traded in Istanbul, which has less than 0.5% of total holdings. The WGC also tracks the recently launched Sharia-compliant Dubai Gold Shares issued by DMCC, though trading activity and inflows are as yet low.
After phenomenal growth since their launch six years ago, combined holdings of gold ETFs represent one of the biggest hoards of the precious metal, collectively exceeding the gold holdings of many individual central banks, notes GFMS. Only the central banks of America, Germany, France and Italy had bigger gold reserves than the total holdings of ETFs at the end of 2008.
In April, however, gold ETF holdings slipped slightly, reflecting profit-taking in three funds: SPDR GoldShares, GBS (LSE listed) and NewGold. Sierra Highcloud of GFMS comments: “There are always short-term movements in the market, from week to week, yet it is the longer-term trends that are most important”.
Daniel Wills, an analyst with ETF Securities, which claims to be a leading innovator in the development of the ETF market, comments: “The credit crisis has been a litmus test for ETFs. The crisis has highlighted the importance of robust, reliable investment vehicles from a liquidity and credit risk perspective. Full collateralisation (and in the case of gold, physical backing of allocated bullion) and the use of multiple market-makers are fast becoming the industry benchmark.” He adds that the ETF market is just beginning to realise its full potential in terms of the variety of product offerings.
Rozanna Wozniak, the investment research manager for the WGC, observes that gold investment has been rising for a number of years, at the expense of jewellery demand, which fell from about 85% of total gold demand in 2001 / 2002 to 58% in 2008 (WGC data). This move has been underpinned by the emergence of gold ETFs over the last five or six years. The influx into gold ETFs over the past year represents more than just a search for a safe-haven: “We are also seeing a reassessment by investors and institutions of their allocations. Funds and investors thought they were diversified, but most of those assets turned out to be heavily correlated.”
This really hit home when oil and commodity prices started falling sharply around August 2008, she says; though the gold price did initially get dragged down, it bounced back towards year end. In contrast, the benchmark commodities index, the S&P GSCI, and the MSCI World index both plunged more than 40% in dollar terms over 2008. “The gold price has been extremely resilient, even to the decline in commodity prices, so investors are starting to realise that gold is more than just a commodity, it’s more than just a luxury consumer item, it’s actually a monetary asset that has thousands of years of history behind it.”
Charles Morris, the manager of HSBC’s $2 billion wealth management product, the HSBC Absolute Return fund, holds a 10% allocation to gold within the portfolio for what he calls a simple reason: “It’s the highest quality asset of all: high returns don’t tend to come from high quality assets – but wealth preservation does”. In turbulent times, he says, for a private wealth portfolio whose objective is both to preserve wealth and to grow wealth, a slice of gold is prudent. “It’s about permanence of long-term value: you could pass a bar of gold through the ages from the ancient Egyptians to the present day and it would still hold its value: its relative value through time is constant.”
Morris holds gold through British ETFs, which offer investors tax efficiency benefits, such as ETF Securities’ PHAU. He views his 10% allocation as not even remotely aggressive: “I believe a standard private portfolio should have 10% in gold”. However, this is not mainstream thinking.
Wozniak says that though more institutions are starting to consider gold as a diversifier, the amount of funds invested in gold as a proportion of total funds available for investment, despite the popularity of ETFs, is still tiny. ETFs are likely to assist the shift: they offer a simple means of gaining exposure to commodities or gold without investors having to take on the risk of going through the futures market. Investors are tending to shy away from more complicated structures and the more speculative areas of the gold market, instead favouring the lower risk and greater transparency of physically-backed, allocated gold ETFs, which have no default or counterparty risk, she adds.
How much of a portfolio should an institution be allocating to gold? The WGC has carried out two studies jointly with New Frontier Advisors, an American institutional research and investment advisory firm, to assess the optimal size and allocation to gold for institutions. The first, published in 2006, concluded that an allocation of gold could be expected to provide strategic benefits to a long-term institutional portfolio: 1-2% for low-risk portfolios and 2-4% for balanced portfolios. Last year, Wozniak repeated the study from the perspective of a British institution: it showed the optimal allocation of gold for a typical UK-based pension fund to be 4.5-10% of a portfolio.
Dan Smith, a metals analyst at Standard Chartered, observes that over the past five years more pension funds have started investing in commodities as a long-term play to improve risk-adjusted returns, typically allocating around 3% or less. Two pension funds at the forefront of this move have been Calpers, the California Public Employees’ Retirement System (Calpers) and PGGM, the Dutch pension fund.
Clark McKinley, information officer at Calpers, says that though Calpers does not directly invest in gold, it has slightly less than $500m (at current market value) invested in commodities, mainly in allocations to passive investments that track the S&P GSCI Commodity index, with some variations. Gold accounts for 3% of this index.
Walter de Wet, a commodities analyst at Standard Bank, expects the trend of diversification into commodities by institutional investors to continue. However, he says: “Gold will only get a small slice of that – the preferred investment remains energy”.
The test will come once equities start performing well again as the global economy recovers. Though a proportion of ETF holdings is likely to represent more permanent allocations to gold, speculative holdings are likely to look elsewhere for returns. As de Wet comments: “No asset ever outperforms all other assets forever”.
Morris of HSBC is among those who would hold on to their allocation to gold: “If we see the world taking off we are much more likely to buy Chinese shares,” he says. “I think clients like it – it helps them sleep at night knowing they have some gold bullion in their portfolio.”
If the tide turns and money starts flowing out of gold ETFs, the effect on the gold price may be mitigated by relatively new sources of demand, for example, from emerging country central banks. In April, China reported that it had almost doubled its gold reserves to more than 1000 tonnes by buying domestically produced metal. Russia too has added to its gold reserves: the latest IMF’s International Finance Statistics show Russia’s gold holdings increased by 51 tonnes over six months. Analysts generally expect China and Russia to continue to diversify their reserves away from the dollar: both, along with Japan, have huge foreign exchange reserves, the vast majority held in dollars.
In contrast, central banks that are signatories to the second Central Bank Gold Agreement (CBGA), principally European, have continued to reduce their gold reserves. CBGA members are permitted to sell a maximum of 2500 tonnes over a five-year period. In the year to September 26, 2008, total sales from the group reached only 358 tonnes, below the yearly 500 tonne-quota and the lowest ever level reported since the signing of the first CBGA in 1999, says GFMS. Total sales over the five-year period are likely to fall well short of the total 2500 quota too. The third CBGA – the current one expires on September 26 – may include the IMF’s planned sales of 403 tonnes of gold, though this requires legislation from member countries, including America.
The trend of lower sales by CBGA members reflects a more positive view of gold since 2005: previously they viewed it as a low-yielding asset and sold off their holdings massively during the 1990s and early 2000s. Nevertheless, says GFMS, many of the group are still heavily weighted in gold and net sales are likely to continue, though overall volumes should drop considerably. However, it expects countries outside the CBGA to remain net buyers for some time. The GFMS survey also notes that the less transparent and politically less sensitive sovereign wealth funds could emerge as important buyers, particularly if concerns about the future value of the dollar and security of American government debt obligations were to grow.
Evelyne Winters, a senior analyst of Goldessential, observes that though ETFs hold more than three times the CBGA’s yearly sales quota of 500 tonnes, no comparable regulation exists to control ETF redemptions. Though the chances of such extreme events may be negligible, mass redemptions or sudden insolvency or bankruptcy of an ETF would have serious consequences for the gold market. Moreover, she is concerned that if gold suffered a severe correction, ETF sales might accelerate, triggering a snowball effect in the market, given the poor
regulation.
Looking ahead, the question for gold investors is whether investment flows this year will prove powerful enough to overcome the drag effect on the gold price of counter currents.
The WGC, in its Gold Investment Digest for the first quarter, noted that a prominent theme for investors was the outlook for price stability: opinion appeared divided between those concerned about the prospect of inflation and a smaller number worried about deflation.
Charles Gibson, an analyst with Edison Investment Research, says there are lessons to learn from the 1970s, a decade where structural trade deficits, burgeoning budget deficits and bank failures were prominent too. As then, the authorities are reacting to debt deflation with a stimulative monetary policy: “History suggests they will probably overdo it”. In the 1970s, the result was a runaway wage-price spiral and a second peak in inflation later in the decade. As a result, gold rose from $35/oz to $850/oz in 1980 – a 24-fold increase in value. Though he does not expect such a dramatic increase in the current era, he forecasts that a repeat of the same cycle would see gold averaging more than $1000/oz over the next 21 years, with a short-term peak of $1,567/oz as investors again seek a hedge against inflation.
Gibson’s analysis, detailed in a recent report, assumes the continuation of very low and/or negative real American interest rates and a relatively well-supported oil price. In particular, he argues that negative real interest rates disrupts the mechanism by which the bullion banks lease gold from central banks, leading to a squeeze on supply from producer hedging.
Could the slump in jewellery demand hold back the gold price? It could do, says Gibson, but during similar periods in the past, the increase in investment demand has always outpaced the decline in jewellery. In fact, he suspects that if inflation is seen as a problem, investors will rush into jewellery as much as they have piled into gold ETFs, bars and coins. “Gold is sailing and the wind is behind it,” he says.
Michael Lewis of Deutsche Bank takes a more neutral view on the outlook for the gold price: “Gold is probably the most richly priced commodity in the world at the moment: in real terms, it’s trading at around 65% above its long-run historical average.” This represents a significant premium to many other commodities.
For the gold ETFs, the main threat would be dollar strength, he says. However, any change in the outlook for the gold price over the short term would be more likely to be to the upside, linked to further weakness in the dollar.
However, Lewis views the risk of inflation to be low, at least for the next couple of years, because of the large
output gap in America and the likelihood of weak economic growth persisting in 2010 and 2011. Only when the global economy starts to recover strongly are inflationary risks likely to emerge. Instead, the global economy is likely to remain in a disinflationary environment: this is a relatively benign scenario for gold as it keeps real interest rates low and allows gold to compete aggressively for risk capital. “What gold really needs to worry about is deflation,” he adds, as real interest rates would rise. However, he expects the global economy to avoid this outcome.
In contrast, Wozniak argues that persistent deflation could underpin the gold price as it would enhance the yellow metal’s safe haven status.
Dan Smith is fairly bullish about the gold outlook: he expects investor inflows to remain strong for long-term reasons and the dollar to weaken significantly before the end of 2009. Though Standard Chartered expects economies to suffer deflation in the short term, Smith does not expect
this to have much impact on the gold price.
GFMS comes down firmly on the side of the bulls. It argues the $26 billion that entered the gold market last year – a relatively small amount of money compared to the regular flows into mainstream asset classes – could be dwarfed by the flows into the yellow metal this year if gold’s appeal widens substantially because of investors’ growing concern at western governments’ and central banks’ willingness to attempt an inflationary solution to the current global economic crisis.
Sierra Highcloud of GFMS comments: “There are many blips and corrections in every bull cycle, yet we believe that over the course of this year prices will, overall, remain well supported, if not move to fresh all-time highs”.
The bull market may have further to go – but investors may be in for a choppy ride.
