Morningstar:

The return of gold

Satyajit Das | 11 Jan 2013Text size |

Satyajit Das is a former banker and author of the titles Extreme Money and Traders, Guns & Money. This is an extract from his recent article titled L'age d'or (The golden age).

In Germany, gold is now available from vending machines in airports and railway stations - "Gold to Go". Shoppers can buy a one-gram wafer of gold or a larger 10-gram bar.

Seeking safety for their savings, individuals have purchased 150 tonnes of gold, mainly in the form of coins. Investors have poured money into special funds known as exchange-traded funds or ETFs, which pool investor monies, to buy over 1000 tonnes of gold.

Having earlier sold off their holding, some central banks are now rebuilding their gold reserves.

Refiners are unable to keep up with demand for gold bars and coins. New gold vaults are being built to accommodate demand for secure storage.

As the global financial crisis continues and the cure of easy money proves as dangerous as the disease, the gold price has increased from around US$250 per troy ounce in 2001 to a peak of around US$1900 in 2011. It now trades at around US$1700 per ounce.

As poet John Milton wrote: "Time will run back and fetch the age of gold."

Since the replacement of the gold standard with the dollar standard, the gold price has fluctuated widely.

In January 1980, the gold price reached a high of US$850 an ounce reflecting high rates of inflation and economic uncertainty.

Subsequently, the recovery of the global economy saw the gold price fall for nearly 20 years, reaching a low of US$253 an ounce (US$8,131 per kilogram) in June 1999.

From 2001, the gold price began to rise due to a mixture of increased demand, especially from emerging nations such as India and China.

In 2007/08, gold received an additional boost from the onset of the global financial crisis. Concern about a banking system collapse drove gold prices higher with gold prices finally passing the 1980 high, reaching $865 an ounce in January 2008.

In late 2009, the gold price renewed its upward momentum, passing US$1200 in December 2009 on its way to over US$1913 an ounce in August 2011. The 500 per cent increase in the gold price since April 2001 prompted gold bugs to speculate about a new age of gold.

In reality, the rise was driven by fear. The depth of the financial crisis, concern about the security of other assets including once risk-free governments bonds and a fragile banking system prompted a flight to gold as a safe haven.

The monetary policies of governments and central banks, emphasising low interest rates and printing money to restart the global economy, also underpinned the gold price.

Germans wanted the return of their deutschemark, now replaced by the euro, pining for when "mark gleich mark - paper or gold, a mark is a mark".

The nightmare of Weimar, the erosion of the value of money, hovered in the background. As governments borrowed ever-larger sums, ordinary citizens feared that even gilt-edged government securities would become worthless.

As a banker asked an old woman in 1918: "Where is the state which guaranteed these securities to you? It is dead."

Means to a golden end

For investors, investing in gold is not without problems. Shares in gold mining companies may not provide the sought-after exposure to gold prices.

The value of mining companies behaves more like shares than the gold price. This reflects the company's operation, which may include exploration.

The mining company may have investments in other commodity operations, which dilutes the exposure to gold. Decisions to hedge the gold price may affect the sensitivity of the company's earnings to the gold price.

There are problems of mergers and acquisitions, purchase and sale of operations, borrowing and sundry issues like mismanagement and fraud.

Most investors prefer direct investment in the precious, yellow metal. This takes the form of trading in instruments like gold futures contracts or direct purchases of gold.

Gold futures and similar contracts require knowledge of derivatives trading. Physical gold is expensive and also difficult to store and insure.

Popular forms of physical gold investment like coins reflect a premium to the actual gold content, adding to the cost.

To overcome the problems of physical investment in gold, some banks offer gold "passbook" accounts, especially for smaller investors.

Operating like a normal bank account, the facility allows investors to buy and sell modest amounts of gold. The bank pools the investors' money and buys and sells gold to match the amounts owed to investors.

Increasingly, investors use gold ETFs, which are an extension of the gold account. The ETF is structured as a mutual fund or unit trust, which is listed and tradeable on a stock exchange.

Investors purchase fractional shares in the ETF, which then invest the money raised in gold. Some ETFs invest in the metal itself. Others synthesise the exposure to gold using instruments linked to the gold price, such as gold futures and derivatives.

Some ETFs allow leverage, borrowing funds to augment the investor's contribution to increase sensitivity to fluctuations in the gold price.

Gold ETFs create new risks. Where the ETF uses derivatives and other financial instruments to obtain exposure to the gold, it is exposed to the risk of default by the financial institutions with which it contracts.

Even where the funds are invested in physical gold, the metal is held via custodians, often financial institutions, exposing them to the failure of these entities.

This is ironic given the fact the investment in gold is specifically motivated by fear of the failure of the financial system.

In 2011, president Hugo Chavez ordered the Venezuelan central bank to repatriate 211 tons of its 365 tonnes of gold reserves (worth around US$11 billion) from US, European, Canadian and Swiss banks, including the Bank of England.

Part of the reason was concern about the developed economies and their banking systems.

Means to a golden end

For investors, investing in gold is not without problems. Shares in gold mining companies may not provide the sought-after exposure to gold prices.

The value of mining companies behaves more like shares than the gold price. This reflects the company's operation, which may include exploration.

The mining company may have investments in other commodity operations, which dilutes the exposure to gold. Decisions to hedge the gold price may affect the sensitivity of the company's earnings to the gold price.

There are problems of mergers and acquisitions, purchase and sale of operations, borrowing and sundry issues like mismanagement and fraud.

Most investors prefer direct investment in the precious, yellow metal. This takes the form of trading in instruments like gold futures contracts or direct purchases of gold.

Gold futures and similar contracts require knowledge of derivatives trading. Physical gold is expensive and also difficult to store and insure.

Popular forms of physical gold investment like coins reflect a premium to the actual gold content, adding to the cost.

To overcome the problems of physical investment in gold, some banks offer gold "passbook" accounts, especially for smaller investors.

Operating like a normal bank account, the facility allows investors to buy and sell modest amounts of gold. The bank pools the investors' money and buys and sells gold to match the amounts owed to investors.

Increasingly, investors use gold ETFs, which are an extension of the gold account. The ETF is structured as a mutual fund or unit trust, which is listed and tradeable on a stock exchange.

Investors purchase fractional shares in the ETF, which then invest the money raised in gold. Some ETFs invest in the metal itself. Others synthesise the exposure to gold using instruments linked to the gold price, such as gold futures and derivatives.

Some ETFs allow leverage, borrowing funds to augment the investor's contribution to increase sensitivity to fluctuations in the gold price.

Gold ETFs create new risks. Where the ETF uses derivatives and other financial instruments to obtain exposure to the gold, it is exposed to the risk of default by the financial institutions with which it contracts.

Even where the funds are invested in physical gold, the metal is held via custodians, often financial institutions, exposing them to the failure of these entities.

This is ironic given the fact the investment in gold is specifically motivated by fear of the failure of the financial system.

In 2011, president Hugo Chavez ordered the Venezuelan central bank to repatriate 211 tons of its 365 tonnes of gold reserves (worth around US$11 billion) from US, European, Canadian and Swiss banks, including the Bank of England.

Part of the reason was concern about the developed economies and their banking systems.

Investors also worry about the risk of confiscation of gold holdings. In reality, any government can confiscate anything - gold, savings, property - they want to in times of economic emergency.

In 1933, US president Roosevelt issued Executive Order 6102, prohibiting the private holding of gold and requiring US citizens to turn over their gold bullion or face a US$10,000 fine (equivalent to around $170,000 today) or 10 years imprisonment.

In response, opportunistic coin dealers encouraged investors to buy expensive "numismatic" or "collectible" coins, taking advantage of an exemption in the 1933 order that protected these assets from government seizure.

Seeking to reassure investors, some ETFs have installed fibre-optic-cable-linked cameras in their gold vaults. Investors can monitor their holdings via the internet.

Of course, this clever marketing gimmick does not protect the investor from the failure of a custodian or financial counterparty, as well as confiscation risk.

Golden brown bottoms

The investment case for gold is mixed. Gold's tactical value over specific periods is significant.

The period from 1999 to 2001 is referred to the "Brown Bottom" of a 20-year bear market during which gold prices declined.

The reference is to the ill-fated decision by Gordon Brown, then UK chancellor of the exchequer and subsequent prime minister, to sell half of the UK's gold reserves via auction over 1999 and 2002.

At the time, the UK's gold reserves were worth US$6.5 billion, constituting around half of the UK's foreign currency reserves.

The decision to sell around 400 tonnes of gold at the low point in the price cycle cost the UK taxpayer up to 10 billion pounds or around 600 pounds per UK family (depending on the gold price used).

Commentators have compared this to the cost of 3.3 billion pounds to UK taxpayers on Black Wednesday 1992, when the UK was forced to withdraw from the European Exchange Rate Mechanism after a failed attempt by the Treasury and Bank of England to defend the pound.

Any investor who purchased the gold sold by the financially astute UK chancellor would have made a substantial profit.

But gold is not itself a great store of value, at least over long time periods.

Gold bugs excitedly speculate about gold prices reaching US$2300. But even at that price, gold would merely match its January 1980 peak price after adjusting for inflation. In other words, the holder had earned nothing on the investment over almost 30 years!

The gold price, adjusted for inflation, is the same as the price in the middle ages.

Dylan Grice of Societe Generale summed up the case for gold as a store of value in the following terms: "A 15th century gold bug who had stored all his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90 per cent over the next 500 years."

The gold price can also be very volatile. In late 2011, after reaching record levels, the gold price fell nearly 20 per cent very quickly.

Warren Buffett observed that if stock investors are driven by optimism about prospects, then "what motivates most gold purchasers is their belief that the ranks of the fearful will grow".

Harry "Rabbit" Angstrom, the central character in John Updike's 1970s novels about American suburban life, spends US$11,000 on the purchase of 30 gold Kruggerrands (a South African minted gold coin). Rabbit explains the purchase to his wife: "The beauty of gold is, it loves bad news."

In economic chaos, war or collapse, gold reappears, reasserting its grip on humanity.