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Forever And A Day

Author: Sunil Kumar Singh/Monday, December 1, 2014/Categories: Gold

Forever And A Day

“No one understands gold,” NM Rothschild, the 19th century UK-based business and bullion magnate once said. There are a few analysts though who continue to shut their eyes to Rothschild’s century-old word to the wise and try to play Cassandra by predicting doom for the yellow metal. 

Every time gold slips by Rs 1000-2000 or more, skeptics jump into action. However, such prophecies about the yellow metal have, more often than not, stretched to the point bordering ludicrousness.

You might have often heard or read the slew of oft-repeated cliches that gold as investment has lost its sheen or that the metal has lost its ‘safe haven’ appeal. The voice has got louder this year as the metal has fallen sharply. On Nov 7 alone, gold dropped to a four-year low of $1,132/ounce but recovered to close at $1,177/ounce. In India too, the second biggest gold user after China, gold prices dropped below Rs 26,000 per 10 gm after three years.

So is buying gold a bad investment choice for Indians? For many doubting Thomases, it is. For believers in gold’s inherent strength, however, it is not. Let’s see why...

Get Out of the Time Warp

Gold is facing a triple whammy prompting many to question whether it is still a safe haven— strength in the dollar index driven by strong economic recovery in the US, expectation of a rate hike by the US Fed sometime next year, and Japan’s decision to pump fresh liquidity as a stimulus to the economy. 

The US Federal Reserve has finally pulled the plug on the multi-year stimulus programme, Quantitative Easing, on the back of improvement in the US economic and labour market outlook. This move has firmed up the dollar. Gold is facing another bout of pressure from low crude oil price resulting in low inflation worldwide. Traditionally, people buy gold as a hedge against inflation. But now since inflation is falling, this logic is hardly working. 

So has gold really lost its safe haven appeal? Yes, momentarily, but not forever.

“For now, gold’s safe- haven appeal has been sharply reduced, but it will always remain a feature that could quickly re-emerge given the current fragile state of the world from a geopolitical perspective,” argues Ole Hansen, Head of Commodity Strategy at Saxo Bank, Denmark.

‘Gold producers across the world are,’ Ole adds, ‘increasingly struggling to create  profit from the current low prices and  continued fall in prices could trigger a reduction in supply, which eventually will help stabilise the market. Investors should near-term expect a gold market that will continue to struggle due to the headwinds’.  

That the rise in the interest rates is bearish for gold is also not 100% true, historically. Generally, when interest rates rise, the benchmark 10-year US Treasury yields go up making them more attractive than gold (as the metal yields nothing), prompting investors to take their money off the table from gold and invest in bonds.

But exceptions are the rule in the world of finance. As Nitin Nachnani, Research Analyst, Geofin Comtrade (earlier Geojit Comtrade), puts it, “During the mighty 1970s secular gold bull, which dwarfs today’s so far, gold rallied while interest rates were rising and then in the 1990s, gold slumped even as interest rates were falling. The notion that rising rates are bearish for gold and the opposite that falling rates are bullish for gold fails.”

A lot of gold investors place bets driven by immediate events, which is a myopic view. It’s better not to look at short-term movement of any asset to take a call on its future course. Notwithstanding the unique traits that separate it from other asset classes, gold in some ways behave like other assets too. For instance, it isn’t entirely unaffected by panic and supply-demand dynamics and it responds to macro-economic developments across the world. 

If you’re a gold investor but are apprehensive about the metal’s outlook in the light of its recent drubbing, take heart that no asset class in this world, including invariably the ‘safe haven’ gold, is infallible and it’s typical for it to go through a period of downswing at some point. 

So gold’s, or for that matter, any asset class’s underperformance shouldn’t be surprising! While there is no such thing as a 100% fool-proof model to forecast the price movement of gold, if you look at its historical trend, you’ll see how gold has behaved over the decades. 

Remember that the current bearish trend in gold started in 2013 when the price of gold dipped after 12 years of unremitting bull run starting in 2001. Last year, gold fell by 28% give and take, which was the sharpest fall after 16 years, when in 1997, it crashed by around 22.2% (there was a dip in 2000, but it was a small 6%). Further, it’s only after 1996-97 that gold has dipped for two years in a row (2013 and 2014) (See History Repeats Itself).

If gold’s resilient nature still leaves you unconvinced, then take this. It is perhaps the only asset having no counter-party risk compared with other financial instruments such as stocks, mutual funds, bonds... you name it. Gold is a unique investment too. It is the only asset that carries the same liquidity at all times at all places across the world. 

It is this trait of the yellow metal as a universal asset that has kept millions of investors enamored for years.

Hedge Against Inflation

Gold, in its raw sense, is primarily used as a luxe product such as jewelry. But it’s much more than just an item of flashy nose stud or necklace that you can squirrel  away and so by confining it to a thing of lust would be to belittle the metal’s intrinsic value. Gold has some unique properties that differentiate it from other commodities and assets — it is less exposed to swings in business cycles, is less volatile, and tends to behave strongly in times of economic duress. Further, gold has an inherent store of value that makes it a hedge against inflation globally. Central banks across the world diversify their forex reserves by accumulating gold to stabilise their countries’ currencies as well as help balance the economy’s trade deficit.  

In case of India, a critical reason why gold continues to lure millions is the limited choice of credible financial instruments and other productive investment avenues that could provide a hedge against inflation. 

Of course, India has a flourishing stock market (in terms of market cap), as many as 45 asset management companies offering mutual funds and exchange-traded funds (ETFs) of diverse types, 24 life insurance companies offering various investment plans such as unit-linked insurance plans (Ulips), post office saving schemes and the whole bunch of traditional investment options, but they are either not as liquid and resilient as gold or are highly volatile instruments, and give returns that are too low to beat the inflation monster. Gold, on the other hand, has stood the test of time and so it stands out as the most trusted investment instrument for investors.

Call it an irony of sorts that even after almost two-and-a-half decades of liberalisation of the Indian economy (remember the slew of structural economic reforms rolled out from 1991 onward), financial markets in India have yet to win the faith of millions of middle and lower-middle class Indians through their product offerings. This coupled with the fact that the equity investment culture in the country is abysmally low, what are the alternative stable and high-yielding investment instruments one is left with apart from gold? 

Gold-Dollar Correlation

For centuries, miners have been digging out gold from the bottom of the earth, storing it, hiding it in some form or the other, and that’s it! 

You could be forgiven for thinking it the end of the gold story. For, gold glitters on the basis of some set fundamentals, though a bit of speculation cannot be ruled out. One of the fundamentals is its negative correlation with the US dollar, at least since 1970. A stronger dollar generally pulls down gold while a weaker dollar is more likely to push up gold prices. This is simply because when dollar strengthens, it attracts more and more investors and traders. On the contrary, during times of economic crisis and when the dollar starts losing its value, banks and investors globally flock to gold to protect their currencies and hedge against the financial crisis.

Adding to it is the fact that a stronger dollar makes dollar-denominated commodities more expensive in terms of non-dollar currencies, though not necessarily in equal percentage, and thus dents its appeal as a hedge. 

Don’t Take A Plunge

That doesn’t mean you start stocking up the yellow metal without any reason. Gold prices are difficult to understand. Take the case of how the price of gold in India is structured. We Indians pay a premium. In other words, gold price in India is artificially inflated due to various taxes and charges such as custom duty, sales tax, value-added tax, etc. 

These taxes add to the vulnerability of gold prices to drop sharply once the government decides to reduce any one of these tax heads. That’s the reason while gold in dollar terms is losing out, it clearly is not falling much in rupee terms. 

“The gold price in India has fallen lesser due to taxes imposed and also the weakness in the currency, however the direction is clear. Gold prices typically do well in low growth, high inflation, ample liquidity scenarios and in other times, gold prices tend to track inflation. We have now moved out of the high inflation, low growth situation, however, liquidity is ample due to slow credit off-take and hence gold may continue to underperform other asset classes the next year also,” cautions Manoj Nagpal, CEO, Outlook Asia Capital, Mumbai.

So far so good! But take doomsayers’ forecasts with a pinch of salt. The more important issue is, however, to determine whether there is a seismic shift in investor sentiment. When buyers start seeing limited upside potential or further fall in any asset from the current level, that’s the point where the slump in the asset sets in.

Whether such trend has set in gold is an interesting aspect to watch in the months to come. Expect more pain for gold as long as the dollar keeps strengthening, but don’t write it off yet!

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