Volatile markets prompt gold rush

Demand for gold has soared as investors seek safety and, coupled with no increase in supply, its value will continue to rise and provide some stability in a volatile environment.

The rise in the gold price has been rarely out of the financial news. After so many years of the price languishing in the doldrums, a whole generation of investors has no knowledge of its unique investment characteristics.

Many reasons are put forward to explain the price of gold; from its use as an inflation hedge to its “safe haven” status in times of crisis. The rise in the gold price from a low of $260 (£130) in 1999 is a result of several of these factors coinciding.

Many of these factors are closely correlated and this article aims to demonstrate how they have combined to produce the current rally in the gold price.

First, we need to examine the fundamentals of the supply/demand picture for gold. The precious metal is special because most of the gold ever mined in the world is still in existence. On the supply side, the production of gold has remained stable between 2001 and 2006.
During the many years of the gold bear market there was little incentive for companies to increase production or explore for new finds.

Now with the price rising, the laws of economics state that supply should rise to meet demand. However, mining is not easy. Even when a new gold deposit is discovered, developing the site and building the infrastructure takes time.

Environmental concerns also add a further layer of complication and time delay. A period of 10 years between discovery and commercial production is realistic.

Therefore the lack of immediate supply is likely to help the price. Jewellery accounts for about 70% of demand, with investment (20%) and industry (10%) making up the balance. Gold for jewellery purposes is particularly strong in India and the Middle East.

A more recent source of demand is the new investment vehicles being launched on stockmarkets, such as exchange traded funds (ETFs). These provide investors with exposure to the gold price without having to physically hold the gold.

However, the ETFs themselves do have to buy gold to match the funds invested in the vehicle. Should investor demand increase, so will demand for physical gold itself.

With some commentators talking of a commodity super-cycle lasting 20 years, and the oil price reaching $100 a barrel, the spectre of inflation may return. The Western consumer is used to cheap goods manufactured in emerging markets. The costs in such countries will not remain low indefinitely, and when they rise this may provide another impetus to inflation.

Gold has traditionally been viewed as a hedge against inflation. A research note called “Short run and long run determinants of gold” by Eric Levin and Robert Wright has found there is a long-term relationship between the price of gold and the American consumer price level.

Although over shorter time periods the relationship may deviate, over the longer term it does revert with the gold price and American inflation moving in tandem.

With the depreciation of the dollar, to bring the American current account deficit into balance, American inflation may rise as imports become more expensive. There is much debate as to whether dollar depreciation will raise imported inflation by much – the reasons why are detailed and beyond the scope of this article – but the sentiment may help provide further support to the gold price.

Also relevant has been the accumulation of dollars by many central banks as a result of financing the deficit. With the dollar devaluing, by diversifying into other assets including gold, foreign currency reserves will be protected.

If an investor is not convinced by the fundamental investment merits of gold, it also provides excellent diversification benefits to a portfolio.

As explained above, some of the forces that determine the gold price differ from say the stockmarket and other commodities, both of which are more influenced by the business cycle.

The correlation be-tween gold and various other assets denominated in sterling is shown in the table above. There is almost no correlation between the gold price and the FTSE 100. Gold also tends to have a lower volatility than the equity market.

Finally, gold is often viewed as a “safe haven” in times of political and financial crises. The subprime housing crisis is an example of investors fleeing to government bonds and gold as fears grew that the crisis may grow to a full-blown credit crunch.

Geopolitical factors also affect the markets. Tensions in the Middle East remain and there continues to be a lack of stability in Iraq, further driving the flight to safety.

In conclusion, if an investor believes the present drivers of the gold price look set to continue, then gold should continue to rise in price and may provide a good return in a more volatile investment world.