With the price of gold touching Rs 19,220 per 10 gram, the precious metal just got a little further out of reach. It has had an unabated run since the global financial crisis. High global debt levels, inflation and the strong performance of gold compared with other asset classes have persuaded investors to take to the metal in a big way.
There has also been an increasing awareness of gold's role in portfolio management, considering its low volatility and lack of correlation with other asset classes. For instance, its correlation with the BSE Sensex is 0.04, or next to nil. In the last three years, gold has returned 27 per cent on an annualised basis compared with the six per cent delivered by the BSE Sensex. According to Ruchir Parekh, Fund Manager with AIG World Gold Fund, the surge in the demand for gold, particularly for investment, in the last couple of years has sent prices soaring.
The numbers alone tell the story. If we look at global data for the second quarter of 2010, the demand for gold rose by 36 per cent to 1,050 tonnes. This was largely due to investments, which more than doubled to 534.4 tonnes compared with 245.4 tonnes in the second quarter of 2009. The maximum growth came through Exchange Traded Funds, or ETFs, which grew 414 per cent to 291.3 tonnes. The demand in India, so far, has been very similar to the global pattern, largely in the form of investments through ETFs and purchase of bars and coins from banks, says Parekh.
Moreover, despite the high price, jewellery consumption in India rose 291 per cent to 147.5 tonnes in the first quarter of 2010. However, "a low base of comparison partly explains this statistic," says Will Shum, Senior Research Analyst at Fundsupermart.com.
In the coming days, the demand from emerging markets such as India and China will determine prices. According to Parekh, strong economic growth and the festival season will accelerate demand for gold in these markets.
In the last couple of years, the demand for this valuable metal has remained stagnant at about 3,500 tonnes per annum, while the global supply is approximately 2,500 tonnes. With not many mines being discovered in the past few years and central banks not selling, the demand-supply dynamic is expected to remain favourable for gold prices. In fact, central banks have been buying gold to diversify their reserve holding away from the dollar. Gold's negative correlation with the dollar makes it an effective hedge against currency fluctuations. Although gold prices have been moving in tandem with the dollar in the recent rally, analysts say it could be a temporary diversion. Parekh is negative on the prospects for the dollar due to high unemployment rates and quantitative easing in the United States economy. To rectify its balance sheet, the US government will have to consider debasing its currency, which only makes gold more valuable, says Parekh.
Currently, in New York, gold options for December are being traded at around $1,500 per troy ounce (equivalent to Rs 22,030 per 10 gram), which shows the expectation of demand for the precious metal. In June, prices rose above $1,250 per troy oz as investors remained concerned about the European bailout package and the fate of its economy. If continuing fears of a European debt crisis or a double-dip recession hold up, the probability of gold prices surpassing $1,300 per troy oz cannot be ruled out, says Shum. A price of $1,150 per troy oz, a correction of 10 per cent from current levels, could be a good entry point for short-term investors, he adds.
Should you invest in gold at the current level? Gold has repeatedly proven its worth as an investment. Take the recent subprime crisis, October 2007 to March 2009, when gold delivered 16 per cent compared to a negative 59 per cent delivered by the MSCI (Morgan Stanley Capital International) World Index. The same is true even for the dotcom bust of March 2000 to October 2002, when gold delivered 14 per cent compared to the negative 51 per cent returned by the MSCI World Index.
In uncertain times like now, investors are recommended to hedge their portfolios making some allocation for gold, says Parekh. Analysts typically recommend an allocation of 10-15 per cent for gold in a portfolio. However, with the price of gold at $1,255 per troy oz, the expected return may not be attractive even if we assume the price will hit the bullish forecast of $1,450 per troy oz in one year, says Shum.
"If you are willing to take on more risk, then equity funds that invest in gold mining companies could be a better bet," says Parekh. These companies are dependent on gold as the underlying asset and the price rise reflects in their bottom line, he adds. These funds have outperformed gold as well as the Indian markets by a significant margin in the past year (see The Fund Way). In fact, these stocks share a 90 per cent correlation with the price of gold, but the beta of the stock is 2-3 times that of gold. But such investments will have to be channelised through global funds as there are no listed companies in India offering such an investment.
However, the interest in gold as investment might start waning if the US Federal Reserve raises interest rates. This will lead to investors embracing the dollar again. So, keep your eyes skinned for the Fed's policy moves.
Of course, a US rate hike is not likely to happen in the near future, considering the recovering economy. Earnings for most countries have seen a good growth, while in several markets, such as India and China, it has been at record highs this year and many others (Hong Kong, US) are likely to see record high earnings in 2011 or 2012. Once risk tolerance increases, investors could reconsider gold's fundamentals and look for riskier assets such as equities. This could also eventually hold the gold rally.