Gold still has role to play despite losing its lustre

The rally in the price of gold during the financial crisis, when it reached its record high in 2011 of more than $1,900 (€1,392) an ounce, or in any major unforeseen event or calamity – such as during the recent Syrian crisis – clearly highlight the safe haven characteristics of this precious metal.

At just below $1,300 an ounce, spot gold is down 22 per cent this year, after a big drop in April and then June, after the chairman of the US Federal Reserve hinted about tapering the US bond buying programme. The US averted a default in October after agreeing a last minute deal but the risk related to the Fed’s exit strategy, although tapering has been delayed, remains and could lead to another spike in gold prices.

So what are the expectations for the gold price today? And what exposure do private banks recommend clients should have to this precious metal and commodities in general?

In the years following the financial crisis, the close correlation between commodities and other risky assets has renewed debate about the role of commodities as a portfolio  diversifier, explains Aditya Monappa, head of asset allocation and portfolio construction, wealth management, at Standard Chartered Bank in Singapore. However, there was an eventual reversion to the mean after crises in the past and correlation between commodities and equity has returned to more normal levels since the start of 2013.

“While we underweight the commodity asset class on a tactical basis, we continue to view it as providing risk diversification and acting as an inflation hedge within the portfolio,” says Mr Monappa.

In particular, Standard Chartered is underweight on gold, believing it is still in a downtrend. Clients with a balanced risk profile are recommended to hold a gold position of around 2 per cent in their overall portfolio.

In the UK, Coutts significantly scaled back allocations to gold from 8 per cent at the start of 2013 to 3 per cent today, depending on client mandates.

“At the beginning of the year, there was a reduced requirement for gold as a safe haven,” says Niamh Wylie, portfolio manager at Coutts. “Inflation concerns had abated, the US economy was picking up, equity markets were roaring ahead and we felt there were better opportunities in equities, and reallocated to equities, mainly European and UK.” Stocks also offer a superior protection against moderate levels of inflation, while gold works better as a hedge against extreme inflationary and deflationary scenarios.

Currently, Coutts is neutral on the outlook for gold, although some gold positions have been retained to act as a “shock absorber” against unforeseen calamities.

The UK bank owns a number of physically backed gold ETFs and active gold mining funds, such as those managed by BlackRock.

ETFs have given investors new sources of access to gold and replicate the spot price much more effectively and efficiently than gold equity. Actively managed funds are subject to the equity beta and are exposed to the issues of the gold mining sector, such as costs, currency effects due to dollar movements, and hedging.

However, gold mining companies are now beginning to return cash to shareholders and gold shares “are incredibly cheap,” as their P/Es have fallen substantially, says Ms Wylie.

Physical relationship

From 2009 the relationship between gold equities and gold bullion broke down, as the cost base of the industry went up in line with the gold price, but today that correlation has returned to be strong, states Richard Davis, portfolio manager, natural resources equity team at BlackRock. Equities year to date show a beta of 1.8 to gold bullion. “Gold bugs will realise that if the gold price does go up, they will get a better bang for their buck by investing in the gold equity as opposed to the underlying metal itself,” he says.

Physical gold protects against weakness in the major currencies. In India, for example, which is being hit harder than most by the flight of foreign capital from emerging markets after the Fed began talking about tapering its quantitative easing – the rupee fell to all-time lows, declining as much as 20 per cent against the US dollar this year. The Indian rupee gold price reached its peak two months ago.

“Currently we are seeing a big shift in the demand for physical gold from Europe and US to Asia, in particular India and China,” says Daniel Marburger, director, Jewellers Trade Services, a large bullion dealer in Europe. “People in those countries are afraid the value of paper money will decrease, and that’s why they are buying gold.”

In India, the government raised the tax on bullion imports three times to 10 per cent, to curb demand of the precious metal to reduce its trade deficit and support a weak rupee. “But despite the rise in import taxes, strong demand for gold continues,” notes Mr Marburger, explaining new sales or gold bars, coins or jewellers are expected in India during the upcoming wedding season, when it is a tradition to give gold gifts to spouses.

If emerging markets and the Bric nations head for slower growth, as supported by the recent International Monetary Fund’s decision to cut its growth forecast for the developing economies, there may be similar currency issues in other countries, says Mr Marburger.

Also, while in the Western world people have been liquidating their holdings, taking profits or cutting losses, in Asia people are taking advantage of that price reduction to buy cheaper assets. Retail gold demand from China has increased greatly, in particular for jewellery. And yet, capita consumption of gold in China is still much lower than other parts of the world but it is expected to grow as the middle class and disposable income grow. “Increased retail demand will never push prices to $2,000 or $3,000,” says  BlackRock’s Mr Davis, “but it has important implications to where the floor price in gold might be, and that floor price may be rising.”

Meanwhile, central banks are filling their vaults with cheaper gold to diversify their portfolios. According to the World Gold Council, central banks were net buyers of gold for the tenth consecutive quarter, buying 71 tonnes, which reinforced the trend that began in Q1 2011. The London Bullion Market Association (LBMA) forecasts the gold price will rise to more than $1,400 by November 2014.

If demand is important, supply shocks for gold are not as important as for other commodities, explains Michael Lewis, head of commodities research at Deutsche Bank. This is because annual production of gold accounts for less than 2 per cent, which
is about 2,200 tonnes globally, of total inventories.

“Gold price can rise or decrease irrespective of the marginal cost of production, and the impact of supply shocks on gold price is not as extreme as it would be in oil, copper or corn,” says Mr Lewis. If producers stopped producing gold, the world would run out of gold in about 30 years, versus, say, 50 days for oil and oil products.

Key drivers of gold price are the real interest rate, the exchange rate and the equity market environment, he explains.

“There is quite a compelling story over the next three to five years in terms of dollar strength and as a result we believe the US dollar is at the start of a multi-year uptrend,” he says, explaining that when the dollar is at very weak levels like today, it takes quite long time to gather momentum.

The rise of interest rates, temporarily put on hold by the US Fed’s decision to delay tapering, will go in favour of the dollar, which is also supported by foreign buying of US equities. On the trade side, where 55 per cent of the trade deficit in the US is
petroleum, it is supported by the dramatic drop in US requirements of OPEC oil, as much is produced internally. Deutsche Bank estimates the dollar fair value should be at 1.19 to 1.20 against the euro, versus 1.35 today.

The equity risk premium has fallen significantly, in particular from October last year. It is now at a level close to its 10 year average and it could fall further. The quite rapid correction upwards of long-term real interest rates, since the end of last year, from being negative, will substantially reduce the ability of gold to generate positive returns, says Mr Lewis.

According to Deustche Bank’s analysis, the fair value of gold ranges anywhere between $1,100 to $1,500 an ounce, depending on what physical or financial asset gold is referenced against.

In an environment of dollar strength, bullish equities and possibly higher real interest rates, over the next couple of years investors should explore other parts of the precious metal complex, he says, although the appeal of holding gold in a portfolio from a strategic point of view remains. For example, there are still hazards for the US economy, which remains vulnerable to the Fed’s exit scenario.

The platinum and palladium markets, for instance, have better supply/demand dynamics and fundamentals, although the volatility of these commodities would be slightly higher than gold.

In general, commodities are going to struggle to attract investors’ money, says Mr Lewis, as in an environment of a very powerful dollar cycle ahead, equity returns start to outperform commodity returns. But this will also mean the correlation of commodities to equities and other asset classes could start to come down, as it is happening today.

Commodities are expected to revert back to the physical fundamentals, with many markets performing on physical drivers, on inventories and on supply and demand.

In contrast with precious metals, base metals are much more affected by global growth rather than by dollar movements, which means winners and losers might emerge. A relative value strategy, of going long one market and short another, played through futures, could be interesting.

But investors outside of the commodity complex, “the tourists” typically confine themselves to crude oil, corn, copper or gold. “That may well be changing and investors would need to broaden the space they are looking at within commodities, because there will be opportunities, but it is going to be a more diversified performance now.”

Supply and demand

While in the short term there are some headwinds in the commodity markets, which to some extent are already priced in, longer term the outlook is reasonably positive, due to a combination of quite strong demand and constrained supply growth in some commodities, says BlackRock’s Mr Davis.

Right across the entire commodity spectrum, for the last decade there have been very few big projects being built and fewer large projects being discovered, compared to the 1970s and 1980s when huge deposits of copper and oil fields were found.

Industrial commodities are closely linked to global GDP and the evolution of the Chinese economy will be very important in the future. China is today a big consumer of all the construction commodities for building infrastructure, and the country’s per capita consumption of some of the metals and industrial commodities is on a par with that in the Western world. But China’s per capita use of consumption commodities, such as oil, and gas in particular, is much lower and is expected to grow significantly.

“That’s a long term trend which is well worth keeping an eye on, and any portfolio should be constructed in order to take into account that trend,” says Mr Davis.  

ETF outflows

Today gold has probably the highest participation of investors of any commodity in the world. About 40 per cent of gold consumption is investor activity, with ETFs today holding about 1,900 tons of gold, versus zero 10 years ago. And the fact that investors fly into ETFs also explains why at times, in some periods of dollar strength, the price of gold rose too, explains Deutsche’s Mr Lewis.

However, gold exchange traded products, including ETFs, saw global record outflows of $19.6bn (€14.4bn) in the second quarter this year, according to ETF Securities, although these have slowed down to $4.2bn in the third quarter. The main reason for that reduction is that the bulk of shorter-term tactical money that went into gold over 2011 and 2012 has now been cleared and gold ETP holdings are now back at 2010 levels, according to the ETF provider.

SPDR Gold, the largest US gold-backed ETF and a pioneer in the space, which saw outflows of $11.55bn in the second quarter, has also seen outflows decrease to $2.55bn in the third quarter.