In uncertain times, gold has always been used by investors to hedge against (or counter) unforeseen disasters, including economical, political, social and currency-based crises. Being one of the few investments that is not simultaneously an asset and someone else’s liability, investors have been attracted by the simplicity of its basic rule – a store of wealth that is physical, portable and easily devisable.

Historically, gold and money were synonymous: paper notes were freely convertible into preset fixed quantities of gold  (the Gold Standard). So pure Gold was essentially immune from inflation, a condition of rising prices and falling purchasing power. However, with the last vestiges of the gold standard disappearing in 1971, giving way to fiat currency (money declared by a government to be legal tender), gold has been allowed to float freely and find its own price level.

For a period of time after the abolishment of the Gold Standard, government gold sales had a tempering effect on gold prices as governments liquidated their “excess” gold bullion which they held in their coffers. But by late 1970s, gold sales had reached its peak and prices took off reaching a high of $870 per ounce in 1980, due in part also to the international crisis arising from the Soviet invasion of Afghanistan and the Islamic Revolution in Iran.

From the peak in 1980, gold investors suffered a punishing 20 years when gold bullion prices declined to around $250 per ounce in 1999. While the U.S. stock market's benchmark, the S&P 500, chalked up 16.4% annual returns from 1980 to 2001, gold's annual return over the same period was a loss of about 2.5%!

However, since bottoming out in 2001, gold has turned in a shining performance rising again to its recent peak of $1,033 per ounce in March 2008. No points for guessing the crisis factor that served as a catalyst for its turnaround in 2001!

Where gold languished as a neglected asset class in the past, its recent surge reflects the restoration of gold as a significant component of financial assets worldwide. The fear of future inflation and ongoing financial uncertainty, accompanied with the individual’s desire to preserve wealth has also been the driving factors behind its recent appeal.

Supply and Demand

Demand from retail investment in the form of bars and coins (Germany and Switzerland being the top two markets) and precious metals funds, including the popular exchange-traded funds (ETFs) have been major sources of growth for gold. However on the back of the recession and reduced consumer spending, jewellery demand and Industrial demand (particularly for production of electronics goods such as laptops and mobile phones, and dental /medical uses) have seen declines, with only China being a notable exception.

According to the World Gold Council, total demand in India, traditionally the world’s largest gold market particularly for jewellery, declined significantly on the back of the deterioration of the domestic economy and record rupee prices. Among the other factors that has seen declining interest in India of late appears to be the monsoon season, when fewer weddings tend to take place.

As is commonly known, gold jewellery is the most common gift during religious events in India and forms an essential part of the dowry basket. Some analysts however see demand picking up by August and last until the end of the year as a series of festivals and auspicious days for weddings compel people to buy gold.

On the other side of the equation, supply characteristics, in the form of mine production, secondary recovery of gold and central bank sales are key in influencing the price of gold.

Other Factors

Now whether future investment behaviour is motivated by wealth preservation (driven by uncertainty) rather than capital appreciation (driven by growth) remains to be seen.

According to the latest World Bank estimates, the global economy will decline this year (2009) by close to 3 percent, a revision from a previous estimate of 1.7 percent.  While recovery is seen in 2010, the extent/pace is still relatively uncertain. 

Global inflation is another key factor driving gold prices. Recently, the US government's consumer price index, its broadest inflation gauge, rose 0.1 percent in May 2009, against expectations for a 0.3 percent increase. This is a rather soft reading of inflation in the world’s largest economy. However, tracking it’s future progress could be quite telling.

Of late there has also been quite a bit of chatter on whether the US dollar will continue to be the supreme global reserve currency going forward. A reserve currency is a currency which is held by international governments and institutions and used to pay off their international debt obligations. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc.

While the US Dollar has its clear supporters like some Asian countries and recently Russia, gold seems to track an inverse relationship with the US dollar.

While a strong US dollar sentiment puts a dampener on gold prices, a current declining US dollar index, a six-currency gauge of the US dollar’s value, provides support to gold prices.

The price of Oil, a key inflation indicator, and some other commodities also seem to affect the price of gold.

How to Invest or Trade in Gold?

So do you have a view on the future price of gold? Evaluating gold as an asset class unto itself leads us to the choice: Do we want to invest/trade directly or indirectly in gold?

These days investors have various investment vehicles (or means) though which they can invest or trade in gold. Investing directly would involve the purchase of physical gold in the form of bars and coins. For traders who are not inclined to gain custody and store physical gold, indirect investments may be the way to go. This would involve investing in shares of gold mining companies for instance or gold Exchange-traded Funds (ETFs), which operate somewhat like a unit trust. It would be important to note though that investing indirectly in mining companies for instance dilutes the "purity" of the asset class and exposes investors to operational and execution risks, among other issues. Also, such investments tend to be based on a bullish only (or positive) view on the future price of gold.

Now for individuals who would rather trade on the price movements of gold, there is the option of using products such as Margin Spot Gold, Gold Futures contracts or even Gold CFDs. These individuals tend to form opinions on the future direction of the price of gold, be it up or down, and use such products to trade and profit from. This works on the concept of buying low (first) and selling high (if they think the price is going up) or inversely selling high (first) and buying low (if they think the price is going down).
---
Sunil Khemlani
StoneBridge Securities (NZ) Limited
Tel: 09 308 0787 Email: sunil.khemlani@stonebridgegroup.co.nz
StoneBridge Group is an Australian-owned trading house (accredited with the ASX and NZX exchanges) providing advisory and execution services on Foreign Exchange, Commodities, Futures & Options, Shares & CFDs.
“This publication has been prepared on behalf of and issued by StoneBridge Securities (NZ) Limited (“StoneBridge”). This is not an offer to deal in any financial product and is not specific advice for any particular investor.  StoneBridge believes that any information or advice (including any recommendation) contained in this publication is accurate when issued but does not warrant its accuracy or reliability, and is not liable for the future performance of transactions or for any loss or damage arising in connection with this publication. A full Disclosure Statement in accordance with the Securities Markets Act 1988 is available free of charge on request. ”