Will solid gold hedge go on growing?

An authoritative forecast suggesting that the price of gold could surge to $2,500 an ounce over the next five years reinforces the view that investing in a bar or two is a good buffer against inflation.

Gold could surge to $2,500 an ounce over the next five years as investors pile into the traditional safe haven from inflation. So says Daniel Brebner of UBS, which last week told clients to increase their gold holdings, largely as a bet against the devaluation of paper currencies as governments around the world crank up the printing presses.

Some of Merrill Lynch’s analysts, including Francisco Blanch and MaryAnn Bartels, have set a technical target for gold over the next three years of $1,500-$1,600 an ounce.

“Given the broad uncertainties in the current macro ­climate we believe investors should look to gold, with its historic tendency to act as a hedge,” says Brebner. He adds that the downside risk is relatively low, predicting that gold is unlikely to fall below $500. The metal was this week trading at about $900 an ounce, so if the bank is right and gold surges, investors will almost treble rather than double their money.

But the biggest surprise for investors is how little the gold price has reacted to the flood of perilous economic news over the past year. In March last year it briefly topped $1,000, then promptly fell back. Indeed, as Lehman collapsed and banks around the world were nationalised, gold continued to fall in price, dropping below $750 in November. British investors have done relatively well out of investing in gold – but only because sterling fell so much against the dollar.

Marcus Grubb, the head of research at the World Gold Council, says the price has been held back by hedge fund deleveraging. In their desperation to raise cash, hedge funds are selling assets that are most easily liquidated – and that means gold. In the third quarter of 2008, about 300 tonnes was sold off. Given that annual gold production is about 2,400 tonnes, it was quite a downward pressure on prices. But Grubb expects that process will work itself out soon, and that gold’s fundamental attractions will reassert themselves.

Central banks – which hold 29,000 of the 162,000 tonnes of gold mined since antiquity – have largely halted the sale of reserves and are keen to keep what they have to back increasingly fragile currencies. Sales by central banks fell 42% last year, and a new central bank gold agreement expected in September is unlikely to reverse the trend.
Meanwhile, global production of gold has fallen by about 3%-4% a year since 2001, with many big South African mines close to exhaustion.

It may come as a surprise how little gold there is in the world. All the gold mined since antiquity could be melted into a cube and it would fit under the dome of St Paul’s Cathedral. Not that Britain has much of it. After the Bank of England’s ill-inspired sell-off in the late 1990s our reserves are just 1.5% of total central bank reserves globally.

Calculating the remaining reserves lying underground is difficult; as the gold price rises, it encourages miners to go deeper and further, rather like Canadian tar sands become attractive as the oil price rises. The cost of mining gold in South African mines two miles underground is currently about $600 an ounce. But it is China that is now the world’s biggest gold producer, although nearly all its output goes to meet domestic demand.

On the demand side, the most important factor is the Indian consumer. India is the world’s biggest consumer of gold and demand from the subcontinent has soared as the economy has expanded. The economy has slowed over the past year, but demand – largely for jewellery – is still ahead of last year.

“It’s a currency, it’s a commodity and it’s a luxury consumer item. It is very diverse in demand terms,” says Grubb. It also correlates closely with inflation. If you believe that a rise in inflation is inevitable given the spectacular increase in government spending, then gold is the place to be. It tends to do well when yields on equities are low. Gold yields nothing, of course, but given how few companies will be paying dividends this year and how poor returns are on cash, gold’s zero yield is not so challenging. And its default risk is zero too.

It could be a little troubling for investors that gold has been in a bull market for eight years – although in 2008 it slowed, giving dollar investors a gain of just 6%.

More exciting is the fact that it has become so much easier to invest in gold directly through exchange traded funds (ETFs). Grubb says demand for gold ETFs has exploded over the past year – particularly among German and Swiss investors – offsetting the sell pressure from hedge funds.

When Lehman collapsed there were widespread concerns over synthetic products such as ETFs, and some halted trading. But Grubb says all its ETFs are in “100% physical gold”.
Not that ETF investors need worry about taking physical delivery of gold – it’s stored in an HSBC vault whose location is probably best not published.

The charge on a gold ETF such as that operated by ETFSecurities.com is 0.39%, and there is no stamp duty, so it is a relatively cheap asset to acquire. Investors can buy a single security, equivalent to one tenth of an ounce (about $90).

But some warn that investors fleeing into gold are being lulled into a false sense of security. Demand for gold jewellery fell in America and Britain late last year, and Indian demand is strongly affected by price – many dealers melt down scrap when the price rises above $1,000.
Saxo Bank, which specialises in gold and silver trading, said last week: “As real physical demand is falling in most precious metals, it becomes hard to support a rationale that underpins a fundamentally bullish market … we retain our short-to-medium target for gold of $780.”

Personally, I think that’s too bearish. So many people now believe that inflation is a real risk that they will be keen to hedge by buying gold. As a diversification play it is also very attractive, especially when virtually all other diversification plays have disappointed.

The downside risk is if sterling recovers. The $1,000 level also appears to be a price barrier that is difficult to breach. But if gold stays firmly above $1,000 for some time, that UBS forecast of $2,500 will not look so outlandish after all.

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