Gold is a monetary metal whose price is determined by inflation, by fluctuations in the US Dollar and stocks, by currency-related crises, interest rate volatility and international tensions, and by increases or decreases in the prices of other commodities. The price of gold reacts to supply and demand changes and can be influenced by consumer spending and overall levels of affluence.
Gold is different from other precious metals such as platinum, palladium and silver because the demand for these precious metals arises principally from their industrial applications. Gold is produced primarily for accumulation; other commodities are produced primarily for consumption. Gold’s value does not arise from its usefulness in industrial or consumable applications. It arises from its use and worldwide acceptance as a store of value. Gold is money.
Indians do buy gold for socio-religious reasons, but in this article we will look at Gold purely from an Investment Asset Class. Take a look at the following summary of the six primary reasons for investors to own gold. They may never be more relevant than they are today.
- As a hedge against inflation.
- As a hedge against a declining dollar.
- As a safe haven in times of geopolitical and financial market instability.
- As a commodity, based on gold’s supply and demand fundamentals.
- As a store of value.
- As a portfolio diversifier.
1. Hedge against inflation
Gold is renowned as a hedge against inflation. The most consistent factor determining the price of gold has been inflation – as inflation goes up, the price of gold goes up along with it.
Today, a number of Global factors are conspiring to create the perfect inflationary storm:
- extremely stimulative monetary policy,
- a major tax cut,
- a long term decline in the dollar,
- a spike in oil prices, and
- a mammoth trade deficit.
Almost across the board, commodity prices are up despite the short-term absence of a weakening dollar which is often viewed as the principal reason for stronger commodity prices.
Oil, Inflation and Gold
Although the prices of gold and oil don’t exactly mirror one another, there is no question that oil prices do affect gold prices. If oil prices rise or fall sharply, investors can expect a corresponding reaction in gold prices, often with a lag. However, recently Oil has considerably eased off from an all time high, where as Gold prices have gained. Primary reasons for this is the global economic slowdown and investors shifting their funds to the “safe heaven” Gold.
2. Gold As A Safe Haven
There are a myriad of problems festering around the world, any one of which could erupt with little warning. Gold has often been called the “crisis commodity” because it tends to outperform other investments during periods of world tensions. The very same factors that cause other investments to suffer cause the price of gold to rise. A bad economy can sink poorly run banks. Bad banks can sink an entire economy. And, perhaps most importantly to the rest of the world, the integration of the global economy has made it possible for banking and economic failures to destabilize the world economy.
As banking crises occur, the public begins to distrust paper assets and turns to gold for a safe haven.
When all else fails, governments rescue themselves with the printing press, making their currency worth less and gold worth more. Gold has always risen the most when confidence in government is at its lowest.
3. Gold – Hedge Against A Declining Dollar
Globally, gold is bought and sold in U.S. dollars, so any decline in the value of the dollar causes the price of gold to rise. The U.S. dollar is the world’s reserve currency – the primary medium for international transactions, the principal store of value for savings, the currency in which the worth of commodities and equities are calculated, and the currency primarily held as reserves by the world’s central banks.
4. Gold – Supply And Demand
First, demand is outpacing supply across the board. Gold production is declining; copper production is declining; the production of lead and other metals is declining. It is very difficult to open new mines when the whole process takes about seven years on average, making it hard to address the supply issue quickly. Gold output in South Africa, the world’s largest gold producer, fell to its lowest level since 1931 this past year as the rand’s gains prompted Harmony Gold Mining Co. and rivals to close mines despite 16 year highs in the gold price.
Growing Demand – China, India and Gold
India is the largest gold-consuming nation in the world. China, on the other hand, has the fastest-growing economy in modern history. Both India and China are in the process of liberalizing laws relating to the import and sale of gold in ways that will facilitate gold purchases on a mammoth scale.
5. Gold – Store Of Value
One major reason investors look to gold as an asset class is because it will always maintain an intrinsic value. Gold will not get lost in an accounting scandal or a market collapse.
…although the gold price may fluctuate, over the very long run gold has consistently reverted to its historic purchasing power parity against other commodities and intermediate products. Historically, gold has proved to be an effective preserver of wealth. It has also proved to be a safe haven in times of economic and social instability. In a period of a long bull run in equities, with low inflation and relative stability in foreign exchange markets, it is tempting for investors to expect continual high rates of return on investments. It sometimes takes a period of falling stock prices and market turmoil to focus the mind on the fact that it may be important to invest part of one’s portfolio in an asset that will, at least, hold its value.”
Economist Stephen Harmston, World Gold Council Report, 1998.
Today is the scenario that the World Gold Council report was referring to in 1998.
6. Gold – Portfolio Diversifier
The most effective way to diversify your portfolio and protect the wealth created in the stock and financial markets is to invest in assets that are negatively correlated with those markets. Gold is the ideal diversifier for a stock portfolio, simply because it is among the most negatively correlated assets to stocks.
Although the price of gold can be volatile in the short-term, gold has maintained its value over the long-term, serving as a hedge against the erosion of the purchasing power of paper money. Gold is an important part of a diversified investment portfolio because its price increases in response to events that erode the value of traditional paper investments like stocks and bonds.
Article Excerpts Courtesy : Blanchard and Company, Inc
Thanks for the great reading, we buy Gold Bullion in a recession. I will pass this on to our Ira clients to read.