Gold's Golden Outlook?

Gold has been about the best performing investment this year.

It’s been driven by a combination of collapsing interest rates, concern that monetisation will drive inflation, fear of the collapse of the global financial system and general investor caution.

A re-test of last year’s high of $US1032.7 an ounce looks very likely.

In the short term, a period of volatility is likely in the gold price given that it’s risen so far so fast and everyone seems to be jumping into it (which is negative from a contrarian perspective). The AMP’s Dr Shane Oliver has a look at gold’s prospects.

Through prehistoric to modern times, gold has been a source of fascination for mankind.

Some see it as the only truly safe way to store wealth and that the decision to break the link between gold and paper currencies (i.e. the gold standard under which the price of gold was fixed in paper currencies) was the undoing of the global economic system.

Others see it as a barbarous relic with no intrinsic value apart from that deriving from its appearance and hence its use in jewellery.

Right now though, gold is attracting a lot of interest. So far this year it’s about the best performing ’asset’.

Whereas shares have continued to slide, government bonds have fallen in value as yields have increased, oil and other commodity prices have fallen, and gold is up 10% in US dollars and is up 18% in Australian dollars.

Why all the interest and will it be sustained?

Gold over the long term

The chart below shows the price of gold since 1900.

Up until the early 1970s the US dollar was fixed against gold, albeit subject to periodic devaluations such as in 1934.

From the early 1970s to 1980 gold was in a secular upswing as investors turned to gold for protection against inflation.

However, from 1980 to 1999 the secular trend was down as inflation was brought under control.

This decade though has seen gold enter another secular upswing, much in line with other commodities.

Last March the gold price rose to a record high of $US1032.7 an ounce.

What’s driving gold prices up?

Following last year’s record high the gold price fell by over 30% to around $US700 an ounce as the $US rebounded during the financial panic last October and fear of deflation became dominant.

Since then, despite further weakness in other commodity prices and share markets the price of gold has rebounded, recently rising above $US1000 an ounce.

Several considerations are behind the surging gold price and most suggest the price could go higher over the medium term:

• Firstly, investors are fearful that all the policy stimulus – both fiscal and monetary – being pumped into the global economy will generate inflation.

This would reduce the purchasing power of paper currencies (such as the $US, euro, $A, etc), so gold is in demand as a hedge against such an eventuality.

Our view is that thanks to massive slump in global demand and surging levels of excess capacity, deflation is a greater threat right now than inflation.

However if enough people are worried about inflation then it will certainly benefit gold.

• Secondly, while there are fears about the future of the $US, the outlook for other major currencies is not much better.

Europe’s economy looks worse than the US and European banks are more highly leveraged than US banks, the strong Yen looks unsustainable given the damage it has already caused the Japanese economy and the Renminbi is not really an option as it’s not convertible.

So gold is seen as a good alternative to paper money.

• Thirdly, some fear that fiscal and monetary policy stimulus will be ineffective with the end result being a collapse in the financial system, against which gold is seen as providing a hedge.

• Fourthly, the opportunity cost of holding gold as opposed to cash or government bonds as an alternative store of value has collapsed.

US and Japanese interest rates are effectively zero, with other key regions looking like they will converge on that.

So the yield on cash is rapidly disappearing. Similarly, government bond yields have fallen dramatically and are now averaging 4% or less.

So with cash and bond yields falling towards zero the missed return from holding a non-income producing asset like gold (putting aside the potential yield achieved from rolling gold futures contracts over) is very low.

While gold has had a great run up over the last decade it still remains below its inflation adjusted peak in 1980, when gold was worth $US2306 an ounce in today’s prices.

Finally, it’s interesting to note that there is also something of a secular cycle in the relative performance of gold versus shares.

The next chart shows the relative performance of gold versus the US S&P 500 share price index.

Gold outperformed shares in the depression of the 1930s, underperformed during the post war years, outperformed in the high inflation 1970s and underperformed shares during the equity bull market of the 1980s and 1990s.

On the basis of this chart, gold may be in the early stages of a secular out performance phase versus shares.