Business Times - 20 Jun 2009
If deflation is your call, stay away from gold - even if you buy it cheap. By Neil Behrmann
(London)
GOLD is a safe haven investment that retains its purchasing power over the long term. The proviso, however, is that the metal must be bought cheap.
This simple, basic fact is illustrated in The Golden Constant, a book that has just been published by the World Gold Council (WGC), which promotes gold on behalf of its producer members.
Before delving into the book's historical data, the natural question of investors is whether they should follow precious metals salespeople and buy gold now. The sales points are global economic and geopolitical uncertainty, potential inflation following considerable monetary ease and China and other central bank and sovereign wealth fund diversification from the US dollar.
Indeed, vast numbers of investors have already placed money in gold. Ironically for them, this is the biggest potential danger for a sharp downturn in prices. The investment and speculative crowd could sell if the price becomes volatile and breaks downward from its recent trading range of US$927-960 an ounce.
Their exposure is massive. Investment in gold exchange traded funds (ETFs) has soared from around 15 million ounces in 2006 to more than 45 million ounces. Hedge funds and managed futures funds held 20 million ounces of net bull futures and options positions on Comex, the New York Exchange, on June 9, while the small speculators held 37 million ounces.
Excluding coins and gold bars held with London, Swiss and other bullion banks, the total investment and speculative holdings of gold amount to around 100 million ounces or around 90 per cent of annual supplies. And this excludes large gold holdings in commodity mutual funds, pension and sovereign wealth funds.
In the meantime, jewellery demand for precious metals and diamonds has slid during the recession. Indeed, high prices and tough economic conditions have encouraged people to either sell or pawn their jewellery. Production of recycled gold scrap has soared to such an extent that it matched mine output in the first quarter of this year, according to the WGC.
This illustrates the extent that the market has become dependent on investors and fickle speculators.
Over the very long term, how has gold performed during the past few hundred years? The Golden Constant was originally written by former University of California professor Roy Jastram and published in the mid-1970s and has been updated by Jill Leyland, an economic consultant of the World Gold Council. It covers gold prices and the cost of living from as far back as 1560 to 2007. The book shows that gold prices, in real inflation-adjusted terms, unsurprisingly tended to increase its purchasing power during inflationary times. Its purchasing power tended to sag during depressions and deflation.
There have been exceptions. Gold rose by 43 per cent in purchasing power in the first four years of the Great Depression between 1930 and 1933 and then shot up when president Franklin D Roosevelt devalued the US dollar and increased the gold price to US$35 an ounce.
From the end of World War II, when consumer prices stabilised and fell back slightly, gold's buying power dropped slightly. These were the times when the gold price was fixed at US$35 an ounce.
When gold, the US dollar, European currencies and the yen began to float freely from the 1970s onwards, gold's nominal and real value began to fluctuate with increasing volatility.
From 1970 to 1980 when global inflation surged and there was a precious metal boom, gold's purchasing power soared by a whopping 700 per cent in US dollars, an annual real compound rate of around 22 per cent!
But from 1980 to the end of 1999, gold's purchasing power shrank by 78 per cent, a truly ghastly period for miners and gold bugs, although there were brief rallies in the interim.
From 2001, when the nominal price bottomed at US$251 an ounce to the end of 2007, gold's buying power rose by 119 per cent, an annual compound rate of 12 per cent. From the end of 2007, when the book's statistics end, gold in nominal terms has mainly traded within a range of US$800-1000 with a peak of $1031 early 2008, so its real price has fluctuated in a 25 per cent range.
Since gold began to float in a free market it has generally been a good hedge against inflation and more recently a safe haven against banking collapse. But such has been the volatility in currency and precious metals markets that investment within the present historically high range has been a guessing game.
Japan has been the only recent test for gold's purchasing power during times of deflation. During the 1970s, gold's purchasing power soared in Yen terms. But a Japanese investor who bought gold in 1980 would have experienced purchasing power shrinkage of 84 per cent in the subsequent decades.
Despite a strong gold market in recent years, the Japanese investor's gold purchasing power would still be down by 55 per cent.
Granted, 1980 was a time when gold hit an all-time high of US$850 an ounce, but even if a Japanese investor had bought gold when the market was weak in the mid 1980s and 1990s, real prices remained depressed until 2006.
So if deflation is your call, stay away from gold - even if you buy it cheap.
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