Gold unlikely to lose its lustre as a safe haven

Gold is traditionally considered a safe haven asset and it is a much favoured hedge during periods of severe stress.

The deepening of the sovereign debt crisis in Europe, the combination of high debt levels and political wrangling around the Federal debt ceiling – which lead to the downgrade of US debt by Standard and Poors and it is now leading to concerns over the US bond market and US dollar – have been driving investment demand for gold. Fears of persistent inflation, in an environment of low interest rates, have been also contributed to huge inflows into the commodity, which has reached historically high levels.

“Investors look for alternatives. When you have even the slightest hesitation about the credit quality of European and US governments, you find it relatively prudent to diversify away from them. Gold is today one of the few safe havens left in the world,” says Willem Sels, HSBC Private Bank’s UK head of investment strategy.

PREVIOUS PEAKS

Although the price of gold has surged, especially since the sovereign debt crisis began, it remains below its previous peaks, when adjusted for inflation (see chart 1). Moreover, European sovereign debt worries and suspicions around an inflation-led depreciation of the US dollar are not likely to evaporate soon notes Mr Sels.

One further factor that should support the price of gold in the coming months is that the cost of carry, for the nonyielding assets like gold, is likely to remain negligible, as interest rates in the US are likely to remain extremely low.

“We have been constructive on the outlook for the gold price for quite some time, but still feel that it should continue to be included in the investment portfolio, notwithstanding its recent surge,” says Mr Sels.

A strategic allocation to gold is recommended to be around 3 to 5 per cent of a total portfolio. Some clients have gone up to 10 per cent, as a tactical, short-term move.

If there are still wealthy investors that prefer to invest in physical gold, usually for most of them the easiest way to get exposure to gold is through exchange traded funds (ETFs), he says.

“ETFs are a very liquid way of investing in gold and therefore one of our preferred ways. ETFs made gold much more accessible for many people and have created quite a bit of new demand,” says Mr Sels. Because of their liquidity and the possibility they give to invest in small size, ETFs have opened the door to retail investors in particular.

PHYSICAL BACKING

One important characteristic of gold ETFs or ETCs (exchange traded commodities) is that they are physically backed, explains Neil Jamieson, head of UK sales at ETF Securities. This means that in order to create gold bullion securities, there needs to be bullion deposited in a custodian’s vault. “An investor can have a great deal of confidence that the ETC will track the spot price of bullion as traded in the interbank market,” he says.

There are two sources of deviation from the spot price, one is the management fee and the other one is the bid offer spread. The spread on ETCs is typically very tight, as there is a lot of interest in gold and the market is very liquid. Buying gold through ETFs also give investors the piece of mind that the security is backed by investment grade gold. In the case of ETF Securities, this is the gold bullion traded in the London market.

Another way to invest into gold is through equities. Despite the gold price surge, gold equities, which are the shares of companies involved in gold mining, have underperformed the gold price by approximately 13 per cent year to date, explains Bradley George, head of commodities & resources at Investec Asset Management.

“Gold equities have generally provided leverage to the gold price but have had a disappointing year to date,” he explains. “The gold mining companies have de-rated during 2011. Where the gold price has climbed 25 per cent, the HSBC Gold Equity Index has fallen 8.5 per cent (as at 10 August).”

Gold equities’ underperformance was also due in part to the headwinds affecting equity markets in general, but mainly the dislocation between gold equities and the gold price was due to the cost inflation that companies had to bear, due to fuel price increases. As a result, the shares are trading at attractive levels relative to bullion prices.

Expected retreat of the oil price and upward moves in gold, resulting in gold outpacing oil from mid-year onwards, could also improve strong margins for gold equities, believes Mr George. “September is seasonally the strongest period for gold, which we expect to move higher from current levels. We expect more upside via the gold equities than through the gold price, as oil prices stabilise and trade down.”