Why Gold is Back in Vogue

So says Hinde Capital (www.hindecapital.com) in a paper* entitled “Why Gold”. Below Lorimer Wilson, editor of www.munKNEE.com, presents further reformatted and edited [..] excerpts from the paper for the sake of clarity and brevity to ensure a fast and easy read. (Please note that this paragraph must be included in any article reposting to avoid copyright infringement.) They go on to say:

There are many reasons why it is advisable to own gold. Four of the main ones are:
– Gold is Insurance
– Gold is Undervalued
– Gold is in Demand
– [Gold Supply is Falling]

Gold is Insurance
The time to purchase insurance is before your house catches on fire. The financial crisis has led to an explosion in government borrowing to pay for bank bailouts and to plug the yawning gap between tax revenues and government expenditures. Unless sustainable growth returns soon – which is unlikely given the huge imbalances that still exist in the global economy – many governments around the world will have debts that they will find increasingly difficult to manage. When a firm or a regular consumer can’t afford to service their debt, they must default, but when a government finds itself in this fix, they have another option open to them: print money. If this sounds too easy a way out, well, [that is because] it is.

The cardinal risk of money printing is the arch enemy of wealth itself: inflation. If too much money starts to chase too few goods, prices have to rise to re-attain equilibrium. The paper money in your wallet – known as ‘fiat’ money – starts to lose its worth faster than you can spend it. Your purchasing power is eroded and your wealth is decimated…

1. Portfolio Diversification
Not only is gold the protector of purchasing power par extraordinaire, it should be held in your portfolio as a means of diversification. Over the long run it is negatively correlated to most other assets and thus smooths out the volatility in your portfolio. In periods when there is a substantial risk that nations will print money to pay back their debts – known as monetizing their debt – gold will prevail as the most reliable store of value. Paper assets in your portfolio will become worthless. Gold is once again being recognised as a monetary asset, something it has been for thousands of years.

Many individuals still do not have gold as part of their portfolio, but every successful family dynasty has always held a portion of their wealth in gold. It is passed down from generation to generation. Gold is an example of an asset that is cheap and undervalued on a long-run basis. You are not a gold bug if you own gold. You just recognise that it should always be part of your portfolio. Any investment class can perform well or poorly. Equities, bonds, property, cash, commodities, agriculture all have their periods in the sun. This is gold’s.

Gold is Undervalued
There are several ways in which gold is undervalued:
1. Gold vs. Global Money Supply
2. Gold vs. Equities
3 Gold Adjusted for Inflation

1. Gold vs. Global Money Supply

“ Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. The U.S. government, however, has a technology called a printing press (or, today its electronic equivalent) that allows it to produce as many dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars… the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” Ben Bernanke, 21st November 2002

If anyone has any lingering doubts about the intentions of central bankers when faced with the risk of deflation, the above quote should dispel them in an instant. This is an explicit admission from the now governor of the Federal Reserve [that] he will debauch the dollar to avoid even the slightest chance of falling prices.

2. Gold vs. Equities
2009 marks the year gold prices substantially began to outperform equity prices both in real and nominal terms. The ratio of gold and the S&P 500 is currently a little over 1. Looked at historically this is incredibly low. The ratio reached 6 in the early 1980s as gold surged. Looked at from this perspective, gold could outperform equities by a long way before it got any where near being overvalued.

In the period 1971-1980 we had the first post-Bretton Woods gold bull market. The end of Bretton Woods marked the end of the dollar’s link to gold, and thus effectively all the countries of the world became unpegged from gold. During the period 1973 to 1980 the gold price moved ahead of the S&P price… rising 600% in inflation adjusted terms [and] in 2008 the gold price moved ahead of the S&P price for the first time since 1973. What does this mean for gold? Well, if the pattern plays out again, a 600% rise in gold would target a price in the region of $6,000. Gold has enormous potential.

3. Gold adjusted for inflation
Gold in inflation adjusted terms is still way off its peak. Looked at in this way, gold reached a peak of $2,400 in early 1980 (adjusting for inflation using U.S. CPI). Gold today is far from the peak it reached 30 years ago and commodities as an asset class are historically very low compared to U.S. equities.

Gold in the first bull market from 1971 to 1980 managed real annualized returns of 41%. So far, from 2001 to the present, gold has managed a much less remarkable 14% annualized return. To us, this shows gold is still out of favour as a monetary asset. However, this is beginning to change. Recent price moves are a testament to this incremental change in attitudes.

MunKNEE.com Editor-in-Chief Lorimer Wilson with the world’s first 100-kg, 99999 pure gold bullion coin with a $1 million face value produced by The Royal Canadian Mint with a current market value of approx. $4,233,000 US

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Gold is in Demand
The demand for gold as a central bank reserve currency will rise to 1970 levels and will overwhelm dwindling supply. Gold supply comes from several sources: mine production, scrap sales and, until recently, central bank sales. Demand for gold comprises jewellery consumption, industrial and dental needs, as well as investment demand.

1. Demand for Gold from Central Banks
For the first time in many years, central banks have shifted from net sellers to net buyers of gold. Attitudes are changing and the faith held in paper money, and especially the dollar as an international reserve asset, is being eroded. Western banks have stopped selling their gold. Asian countries such as China and India continue to add to their gold reserves, buoying demand for the metal.

Worldwide, the value of non-gold reserve assets held is $7.5 trillion. This decade total international reserve assets have increased 4 times, yet gold holdings have declined dramatically. If 35% of the non-gold reserve assets – $2.6 trillion – were converted into gold holdings, to match the average G7 ratio of gold to reserve assets, then 2.6 billion ounces of gold would need to be purchased (assuming a $1,000 price for gold). Using the current annual rate of production, this is almost 32 years of mine supply. This would have a huge impact on what is a relatively small market (compared to global equity or bond markets).

The secular shift in levels of gold as a percentage of reserve assets held by central banks is startling. It has fallen from almost 60% at the end of the 1970s to around 10% today. This is mainly a function of foreign exchange reserve expansion under a fiat money system. This would have been impossible under a gold-backed currency system.

Today, 10 central banks hold 80% of the world’s official gold reserves. 35 nations hold under 1% of all reserves; poignantly, several of these are some of the largest holders of FX reserves in the world (mainly these are in U.S. dollars, a currency now steadily losing value), e.g. Brazil, China, Korea, Japan and Singapore. Even subtle shifts in reserve allocation among these countries would have profound implications for the price of gold.

2. Investment Demand
As many investors have noticed, gold is performing well. Exchange Traded Funds (ETFs) have opened up access to many markets for a whole battery of investors, including the precious metals and gold sectors and many investors are taking advantage of this new found ease in entering the gold market [to such an extent] that total ETF gold holdings now make this sector the sixth largest holder of gold in the world – from nowhere only a few years ago. Indeed, total ETF holdings amount to 3% of available gold supplies, worth $50 billion. This is small fry compared to the vast potential demand from underexposed central banks. Nevertheless, the proliferation and popularity of ETFs will continue to encourage further inflow to the sector. Indeed, gold held for investment is tiny compared to the total level of financial assets outstanding. The scope for a significant increase in gold investment is huge.

We must point out that we are not advocates of gold ETFs and related products. We believe there is unrealised credit risk, and investors could find themselves not with the exposure they thought they had – when they most need it. Investors will continue to pour into gold as faith in the value of paper money ebbs away. This will remain a powerful support for gold prices.

4. Gold Supply is Falling
In a nutshell, supply has been falling. New mine production has fallen to 80 million ounces (2,400 metric tonnes) a year over the last decade and this is not through lack of investment: there has been a 300% rise in metal exploration expenditures over the same period.

New mine production is marginal when looked at in terms of available supplies. Hence, any pop in demand must be met by sales from existing mines. Demand is such that miners just cannot get gold out of the ground fast enough to replace existing reserves and production. Why has the amount of ‘economically mineable’ gold lessened in recent years? Mainly it is due to geological scarcity, geopolitical sensitivities, environmental hurdles and growing input costs. As demand for gold swells, supply will have difficulty keeping pace and the price of gold will continue to rise to reflect this imbalance.

THE GOLDEN TRUTH
Gold will continue to benefit as confidence in paper currencies ebbs away. Moreover, demand from central banks to investors, coupled with tight supply, will keep gold supported for some time. As governments around the world furiously try to print their way out of the recent financial crisis, they will further knock belief in fiat currencies and, at the same stroke, increase confidence in other assets with intrinsic value. One of these is gold.

Gold is unique. It is not just another commodity: it was once money. It is neither destroyed or consumed, and it has stood the test of time, outlasting political ideologies, governments, nations and empires. Gold will help people protect their purchasing power over the long run. As a store of value over thousands of years, it is peerless.

Demand for gold will continue to outstrip supply. Thus any new demand must purchase gold from current holders. We strongly believe that this transfer cannot occur at or near 2009 prices as the underlying macro-economic environment shows gold is extremely undervalued. Those who wish to own gold will have to pay increasingly higher prices.

Attitudes are changing and gold is incrementally reverting to its status as a monetary asset. Owning gold does not make you a gold bug. You only need to appreciate that all assets have a time when it is appropriate to own them. Now is that time for gold.

*http://www.hindecapital.com/docs/hinde_gold_fund/Why%20Gold%202010-1.pdf

Editor’s Note:
– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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