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Gold – which way now?

Richard Willsher is a freelance journalist specialising in finance.

If you need a reasonably risk-averse option for your investment portfolio then gold may be the answer. But how will it function in terms of yield, and as part of the current economic climate? Richard Willsher examines what the future holds for gold

Two men meet at a crossroad. One asks directions from the other who tells him which way he should go but adds, "I wouldn't start from here though." This might be an analogy for investing in gold right now.

As we go to press the middle spot price for gold is hovering at around the US$550 an ounce level. Over the last year this has risen 28%, hitting a 25-year high in January of $579. In early 1980 it was reaching up to the $700 mark while in 1999 the price slumped to a low of $252. These facts draw two obvious questions: how much higher can the current rally go and for longer term investors, can gold still be considered a stable store of value and a long-term hedge for returns?

The second of these questions may be easier to answer than the first. Investors from the largest central banks in the world down to individual private investors believe in gold as a reservoir of value and a safe haven. According the World Gold Council 67.5% of the total foreign reserves of the US are held in gold, as are 52.4% of Germany's, 59% of France's and Italy's. Some countries are keener than others. The UK for example has only 10% of its reserves in gold, Chancellor Brown having made a policy decision to sell. Russia, Australia and South Africa have even less because they are producers and are therefore already more exposed to gold risk than other economies. They hold their reserves in other forms.
Private individuals may invest in bullion or, more likely, in jewellery, especially in emerging markets and areas of the world which are unstable – or where a store of value is a good to thing to have in reserve should the unexpected occur. "There are some very risk averse investors who are not concerned about how much money they make," explains Katharine Pulvermacher, managing director of investment research and marketing at the World Gold Council. "Their concern is, when all else fails, this is something they can fall back on. To them, having gold stashed away seems like a good option."
So there are large amounts of gold already acting as stores of value around the world and this, according to gold market experts, is unlikely to change. Tracking the value of gold over time, Pulvermacher notes that gold has held up pretty well. "In real terms, $500 an ounce today is actually far below what it would have been in the mid 1970s. If you build in the effect of inflation… there is an argument that the price is still below the long-term mean if it was going to give a real return of zero." She goes on to add that if you look at the supply and demand fundamentals, there is burgeoning demand against constrained supply and consequently value will at least be contained and will, more likely, increase.

Not everyone agrees with this. Tim Bond, head of global asset allocation at Barclays Capital, says, "If I thought 1970s style hyperinflation was round the corner I think there would be a case for buying gold or other precious metals but I don't think that's the situation.We've got a steady upward pressure on fairly scarce raw materials and there are others which are more attractive. The stories behind gold seem flimsy to me. I think it is a bit of a mania…"

Barclay Capital's Bond does recognise the momentum that has been generated in commodity investment over the last few years. Referring to what many are calling the 'supercycle' he points out that with the exception of agricultural commodities, just about everything else in commodities has been going up in value. He adds, "You have probably seen the bulk of the price gains that you are likely to see but there is no denying that the situation is quite different to what it was ten years ago. Massive increase in demand, with a combination of scarcity and political instability and environmental constraints and new material is quite hard to find. We are believers in the supercycle having turned but not that it is the right time to plunge into the market. The easiest part of the game is now over though we are seeing interest from very large investors; that is another factor."

He goes on to say that pension funds have been out of the commodity markets for some time and are now returning. This is one of the significant drivers that is encouraging gold bulls to see further gains in the current price of gold.

Price and fundamentals
A survey among 25 analysts and gold market players drawn from around the world, published in the London Bullion Market Association's Alchemist magazine, shows the majority see further increases likely. Fifteen commentators put the top-level prediction at over $600 an ounce during 2006 and, with only a couple of exceptions, none put the lower level prediction much below $500. Moreover, there is clear consensus among these and others who study the gold market as to what the main drivers are and are likely to continue to be.

By far the largest demand for gold is from the jewellery sector, which dwarfs industrial and dental uses and that from investors. The greatest demand for gold for jewellery comes from India, with China playing an increasingly significant role.

However the most rapidly growing demand is from investors. Exchange traded funds (ETFs) track the gold price and are backed by gold. Despite having been launched in 2003 they accounted for around 200 tonnes of gold demand in 2005. As an indication of return levels, the CF Ruffer Baker Steel Gold Fund has shown a 67% return over the last year and Merrill Lynch's Gold & General Fund was up 50%. The steadily growing surge of wholesale investor money is likely to force demand for ETFs. The drive behind these products is for portfolio diversification, as well as for return. Experts differ on whether central banks will be future buyers or sellers. Some argue that the governments of countries like China may bolster their foreign reserves with gold. Others argue that countries like Germany, will be sellers. The consensus seems to be that central banks will be net buyers, representing a demand on the market.

The future?
So, is gold a good hedge against the behaviour of other asset classes and is it in a continuing upward trend? The answer to the first seems to be 'yes', at the very least because it's always been so. Investors who buy it, especially in the physical form of jewellery, bars or coin, know that they own it, they can touch it and it does what it says on the tin. That is valid if you ignore the potential threat to value from inflation and the fact that other asset classes, such as bonds and cash, produce income which physical gold will not. Also, holders have the problems and costs of storage and security to contend with.
Is a price of over $500 an ounce the right level to buy in at? For sure, buying gold a year or two ago would have been a better bet. Can gold be a good investment in yield terms? The answer again has to be 'yes' on an historical basis though timing is everything. If the 'wall of money' theory holds good, the market may yet be ramped by incoming funds fulfilling their advisors' profit prophecies, at least until the bubble bursts. It may correlate well against lower performing asset classes such as government bonds.
So how much of a portfolio should be in gold? Ibbotson Associates, which studied the portfolio diversification benefits of gold for Bullion Marketing Services, concluded that "investors can potentially improve the risk-to-reward ratio in conservative, moderate and aggressive portfolios by including precious metals bullion with allocations of 7.1%, 12.5% and 15.7% respectively". Meanwhile at the lower end, UBS Wealth Management is currently recommending a 5-15% allocation in commodities as an asset class, which includes energy-related, depending of risk profile, of which 10% may be in gold. Other Swiss banks are suggesting 15-20% allocation into metals of which gold is likely to be the largest constituent. Clearly there is a significant spread of views.

It is said that if all economists were laid end to end they would not reach a conclusion; perhaps the same is true of gold analysts, both bulls and bears. Or perhaps the cycle has already turned too far to be sure of what the future holds for gold. It might, as the man said, be better not to start from here.

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