A treasure hunt fraught with danger

The price of gold hit record highs, which suggests investors are still seeking safety in the asset class. However, overheating and sell-offs of government reserves could cause prices to fall.

“It does have some of the characteristics of an overheating asset class when you see gold vending machines being installed in the Middle East,” says James Davies, the head of fund research at Chartwell Investment Management and an Adviser Fund Index (AFI) panellist. “The key drivers of the rally have been private investment and speculation.”

Another possible explanation for the upwards trend of gold prices might be an attempt by investors to diversify their portfolio across several defensive asset classes. If this is a long-term trend it might be used as a supportive argument for a sustained rally. This is the line coming from the World Gold Council, a trade organisation which represents mining companies that produce about 60% of the world’s annual corporate gold production.

“In the last decade we have seen two of the worst bear markets in the last 100 years,” says Juan Carlos Artigas, an investment research manager at the World Gold Council. “As one might expect, sensitivity to risk still runs high for investors around the world, and as assets are rebuilt an ability to protect capital irrespective of market conditions is paramount. Considering portfolio diversification is clearly important, but protecting against systemic risk can be an entirely separate matter.”

Research by Artigas suggests that historically gold has provided a buffer for investors during periods of extreme market stress. What there will be concerns about, however, is whether buying in at existing prices might mean that in the short-term downside risks outweigh any potential upside.

One particular risk is that cash-strapped governments see the high gold price as a reason to start selling off gold reserves into the market. If the moves were misjudged in their scale it could put serious downwards pressure on prices.

“We’re not seeing any large government moves in that direction at the moment,” says Davies. “Around the margin you may get some selling of reserves, which could theoretically provide a trigger point, but I can’t see a price crash in the near future.” Despite his optimism, Davies says he has no active allocation to the commodity as he says most of the opportunity in the asset class has passed.

There is, however, one further role that gold might play. If fears over the health of the American economy prove well founded, gold could also take a revealing role in judging sentiment towards the world’s largest economy. For example if gold continues to strengthen but American government borrowing costs start rising it could indicate that treasuries are no longer being considered risk-free investments.