• The Golden Dilemma- Challenging the rationale for gold investing

    Posted November 3, 2013 By in News With | Comments Off ZDF Gebäude Hamburg

    Financial Analysts Journal, “The Golden Dilemma”.Paper demystifying rationale for gold investing by Claude B. Erb, CFA and Campbell R. Harvey. Published Financial Analysts Journal, Volume 69, Number 4, 2013.

    Aggressive expansion in the monetary base across developed markets against the backdrop of growing government budget deficits and unsustainable long-term debt levels have raised concerns on the strength of the US dollar, Euro, and Japanese yen as reserve currencies. With fears of monetary debasement and heightened inflationary concerns, investors have turned their attention to gold and other real asset classes. With gold, however, having enjoyed a dramatic run-up in prices since 2000, investors’ are questioning what the future may hold. In this paper the authors debunk the traditional rationale for gold investing, but set the stage for potential continued long-run strength in the asset.

    Historically gold has been viewed as an effective inflation hedge. A review of performance for the metal since 1975, when Congress reauthorized direct investment, demonstrates that gold has not been an effective hedge for realized inflation. While longer-term there is evidence of effective hedging powers for the metal (the authors offer an intriguing comparison of pay scales in ancient Rome to today’s US military illustrating the constant value of services as valued in gold ounces), the long-term is likely to extend beyond investors’ investment horizons and perhaps even their lifetimes.

    With rising concerns over the debasement of today’s reserve currencies, the authors then address the effectiveness of gold as a currency hedge. A review of historical context points to fairly consistent inflation-adjusted gold returns across currencies, but little evidence of weakening currencies contributing to stronger real gold returns. The real price of gold is shown to closely parallel the results measured across eight currencies over the period 1975-2012, while the FX rate returns exhibited quite divergent paths relative to each other over the same horizon.

    A third rationale calls for gold as an alternative investment to low real return assets. With real interest rates at record low levels, we have witnessed gold prices reach record levels. Here the paper caution on the risks of confusing correlation with causation. There is little evidence of higher real gold prices being the direct result of low real yields, and in fact, one could as easily argue that real low yields are the result of high gold prices. Using the more extended history of UK inflation adjusted bonds the authors show that longer term correlations for real yields and inflation adjusted gold prices, while still negative, are much lower than what we have experienced in the US, but more importantly, explain less than 9% of the movement in the price of gold.

    Gold as a safe haven asset for times of impending stress has been argued by gold bugs from time immemorial. A safe haven implies stability in prices during times of stress, readily accessible during periods of turmoil, and sufficient liquidity to use as a means of exchange. Gold has been a favored hedge against the ravages of hyperinflation, but careful analysis may challenge the conventional wisdom. Using Brazil as an example, the authors illustrate that while Brazilian prices appreciated by 259% per annum between 1980 and 2000, the purchasing power of gold for local investors lost 71% over the same period, very similar to the loss of gold purchasing power for US based investors over the same time frame. As for liquidity and accessibility, the authors’ quote Marc Faber, “When Timor sacked Aleppo and Damascus in 1400, it didn’t help to have your savings in gold. You lost your life and your gold.”

    The fourth rationale for owning gold is the return to a “de-facto” world gold standard. While return to a gold standard would bring substantial discipline back to the management of government budgets, the authors argue that, in addition to the impracticalities of such a return, a loss of monetary policy to address periodic market imbalances would impose severe burdens on the global economy. Paraphrasing Winston Churchill the paper stresses, “…the gold standard is the worst form of currency, except for all those forms that have been tried.”

    The last argument presented, and where the authors find potential for continued gold strength, is that gold today is “under owned” by institutional investors and central banks. With over 76% of all of the world’s gold supply already above ground and expansion of available gold averaging only 1.5% per annum since 1900 (World Gold Council estimates), increases in demand for the metal could support continued price appreciation. With gold held by investors representing only 2% of the world’s stock, but gold estimated to represent up to 9% of global investment assets, any increase in investor demand, in light of limited amount of “new” gold coming to market, will have significant impact on prices.

    Adding to the argument, Central banks hold a further 2% of the global gold stock, but developing market reserves are substantially underrepresented relative to the US, Japan, and European central banks. As developing economies, and their monetary reserves, continue to expand and growing concerns over the long-term viability of today’s reserve currencies, developing markets are expected to continue to increase their monetary allocations to gold.

    While questioning the traditional rationales for gold investing, The Golden Dilemma still finds support through fundamental supply and demand analysis for the continued role of gold as an asset class in investor portfolios.

    To order article go to http://www.cfapubs.org/doi/sum/10.2469/faj.v69.n4.1


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