The price of gold soared past $600 per ounce last week, its highest price in 25 years, highlighting the debate between optimists speculating that the $1,000 mark may be in the offing and bears who worry a steep retrenchment is likely.
Gold set an intra-day, 25-year high of $605.60 per ounce on April 11, before easing back later in the week. It set an all-time high of about $680 per ounce in 1980, and some gold bugs think $800, or even $1,000, could be breached in the next couple of years. The yellow metal has delivered a 13% return since the start of 2006 and has risen in value by about 130% over the past five years (see chart below).
The dollar-denominated Amex Gold Bugs share index of companies involved in gold mining is up 12% and 540% respectively over the same periods.
Both gold and gold shares have delivered better returns than the broad stock market over the medium term, given the 30% rise in the MSCI All Countries World index over the past five years. However, many experts view gold investments as risky.
Demand for gold from consumers and investors reached a record $53.6bn (30.5bn) in 2005, according to the World Gold Council. Jewellery comprised roughly 75% of total gold demand, with India the key market. Demand from exchanged traded funds and similar vehicles grew by more than 400% from 39 tonnes in 2003 to 203 tonnes last year. But total gold demand, at 3,754 tonnes, was lower than supply, at 3,859 tonnes. “The push in the past few months is down to investment demand for gold,” says Jill Leyland, an economic adviser to the WGC. “Over the past year or so, there has been a reawakening of interest by longer-term investors, such as pension funds.”
Leyland argues that there will be increased institutional asset allocation to gold, given both high investor interest in commodities generally and gold’s role as a portfolio diversifier. The yellow metal is seen as a hedge against both inflation and deflation, and as a store of value in times of trouble.
She points out that in real terms the average price of gold over the past 35 years is $297 per ounce. The current price in real terms is only just above the latter figure, she says (see chart below).
Graham Birch, manager of the Merrill Lynch Gold & General fund, says that constrained supply also helps to explain the rise in the gold price, aside from the “surge” in investment demand, which he feels is “set to continue”.
“Today’s higher gold price is due to the unbreakable laws of supply and demand,” he says. “Supply from the world’s gold mines has been constrained by years of underinvestment in exploration and development.”
Several other factors are also used to explain the bull run in gold. First, the precious metal’s price is inversely correlated with the movement of the dollar, and there are ongoing concerns that the greenback could slide given America’s current account deficit.
Second, the price of crude oil continues to hover at record nominal levels near $70 per barrel, which for some analysts could lead to higher inflation. However, although inflationary pressures have increased in America, few are worried about a big acceleration in the pace of consumer price rises.
Third, tension in the Middle East – in Iran, Iraq and Palestine – has brought to the fore gold’s perceived role as a store of value in troubled times.
Nonetheless, some independent strategists argue that these factors fail to explain gold’s bull run. They feel both the metal’s price and gold-related shares are in bubble territory. Some argue the past few years’ gold rush was driven in part by slack global liquidity, whereas liquidity conditions have begun to tighten as interest rates rise. GaveKal, a Hong Kong-based investment consultancy, describes gold as “a negative cash flow asset” since “it generates no earnings and one has to pay to store and secure it”.
“Negative cash flow assets live on borrowed time, or borrowed money. When the latter runs out, the former usually runs out as well,” GaveKal says. “Today, investors are again happy to pile into negative cashflow assets such as gold on the premise [they can sell at a] higher price to an exchange traded fund. But this is a highly dangerous trade for the cost of capital is moving above its returns.”
GaveKal fears growth in India and China could also hit the gold price. “If Indian and Chinese individuals can diversify away from domestic assets, then not only will the demand for gold collapse, but a new supply will also be dug out of the back garden by investors wanting to diversify [abroad].”
The consultancy says “gold is a highly speculative investment, which today has little place in a conservative portfolio”, and warns that “investor enthusiasm about gold stocks has reached alarmingly dangerous highs”.
Andrew Smithers, head of economic consultancy Smithers & Co, said in March that “all financial assets are over-priced, including equities, bonds, property and, probably, gold”.
Meanwhile, demand for jewellery has weakened notably following gold’s recent rally. Philip Klapwijk, chairman of GFMS, a precious metals consultancy, says jewellery demand could fall by 500 tonnes in 2006.
But mine production is forecast to increase by 4%. GFMS says investment demand will step in to drive a bull run to historic highs, but others are much more cautious.