Thursday, March 26, 2009

Gold in the current economic context

Gold is an asset class that is worth considering for inclusion in your investment portfolio.  Since there are not too many assets (as a class) anyway, it merits serious consideration.  In the current times, for more than that one reason as well.  In any case, what are the assets that one can invest in really?

The equity story, and the state of equity in every investor's portfolio today, is too well known to bear any repetition. Highly risky with potential for higher-than-normal returns in the long run.  Of late, prone to cross-border, cross-currency money flows. And highly prone to precipitous collapses.

Debt, the perennial safe fallback option.  Since it offers safe returns, at all times a couple of percentage points above inflation, it carries a lesser yield.  A yield that is steady.  The assumption of above-inflation returns is all set to be challenged in the US debt markets at least where 10-year yields are at a record low (2.5%); inflation is currently running at 0.4%, but not even the most inveterate optimist is betting on low inflation rates in the US in the next few years. This could make the real return negative, or push up the yields, which the government is trying its level best to avoid.  The currently favoured economic stimulation theory does not favour high interest rates. Also, the assumption that debt must be safe since it offers a low and steady yield has been tested severely in the recent past - the several bankruptcies of big-name institutions, and the FMP scare come to mind.  Lower yield, it turns out, does not necessarily imply lower risk in many cases; a double whammy - you don't get enough interest and you lose your principal too! 

Real Estate, the next option.  A real option and one that you must seriously consider.  The problem is, the money involved is usually high and the liquidity or ease of sale is low.  The returns are usually very good in the long run.  If you don't time the cycle right, make that in the very long run.  In recent memory, we've had three crashes - 1994, 2000, and the current one.  Talking of the current crash, we ain't seen the end of it yet - I expect a significant drop from the current levels in the next few months.  If you are thinking of buying property, start doing your research now, but don't commit your money in a hurry.  Interest rates are not likely to rise in the near future - in fact, there may be a fall - so even loans may be easier to obtain then.  If you have invested in a house which is currently under construction, start worrying.

We shall ignore options like Art and other esoteric investments meant only for the cognoscenti in those respective fields.  There are no other investment options.  Insurance, contrary to popular perception, is not an investment.

That leaves us with Gold.  Worth writing with a capital G, as in God.  It has other connections and similarities with God as well - every deity likes to be adorned with it, it's been worshipped down the ages, people have died for it, and its price movements in future are likely to be highly volatile - just like Gods, who can be extremely temperamental and unpredictable.

Gold is something that you hold with you (even ETF's, since someone is holding it for you).  Therefore the credit risk or the default risk is zero. 

Historically, Gold has always yielded a return higher than or equal to inflation.  It is the one commodity that is guaranteed to keep its value.  The way governments across the world are running their printing presses, currencies are set to suffer  massive erosions in value.  The US government has just announced a massive program to buy troubled assets and buy back home loans (yes, the Fed is becoming the biggest housing loan issuer!) that is going to inject a trillion dollars into the economy in the form of more money, a sure recipe for inflation that will follow.  And this is just the beginning.  The Indian government is running a huge deficit of close to 10% of the GDP if you add the deficits of the Centre and the States.  Right now, the government is prevented from monetising this due to the "Fiscal Responsibility and Budget Management" (FRBM Act) - but this can't hold for long.  If they want the interest rates to come down, they have to monetise this deficit, which is another way of manufacturing money out of thin air.  Other governments around the world are facing the same problem.  In order to apply economic stimulus, they have to run the printing presses.  This is bound to lead to inflation; probably higher than what we have been used to.  A major factor that is holding inflation in check is the recent drop in economic activity and in the price of crude after reaching record highs.  Oil is currently at $53, already seeming to be on the way up.  This is not a sustainable rate.  It will rise further, especially as economic activity starts picking up; and the price of other commodities will rise along with that due to the same reason.  All this is likely to erode the value of cash or cash equivalents that you hold.  A scary prospect, since you won't even realise it as it's happeing - as more money enters the system, the value of yours goes down.

Gold has always had a negative correlation to the US dollar.  Whenever the US dollar has appreciated in value, Gold has dropped, and vice versa.  This is because Gold tends to retain its intrinsic value even as currencies fluctuate.  A currency note is nothing but embodiment of trust in the government (governments don't deserve a capital G like Gold); Gold is something that has been considered as having intrinsic worth, over time, across cultures.  A part of the attraction that we have for Gold is genetically embedded!  You can go against history, but how long can you fight what's in your DNA?

The negative correlation that Gold has with the value of the dollar has not held in the last few months.  In the recent past, as the US dollar appreciated, Gold did too.  The explanation that is offered is "flight to safety" - both Gold and the US dollar are currently being seen as safe harbors.

Gold has traditionally been considered as a "safe harbor" or "flight to safety" investment.  In times of impending war or crisis people always rush to buy Gold.  Ironically in the last few months, the same reason, "flight to safety", has been offered for flight to the US dollar.  As economies collapsed around them, people flew to invest in US Treasury Bills!  Considering that the US is at the epicentre of the current crisis, this defies rational explanation.  Anything that seems that irrational is bound to reverse soon.

The appreciation in the US dollar that we have seen in the recent past is not likely to last.  The US currency is all set to suffer a devaluation in the months to come.  As the Fed conjures more and more money out of thin air, the value of the currency will start dropping. As the government is pump-priming the economy, not all sectors are going to respond with equal alacrity.  Financial services, business services and consultancy, and real estate will be slow to respond.  They will be continue to shed jobs for some time to come.  This means jobs have to be created in the manufacturing sector.  Whatever is manufactured, needs to be exported (also, though the consumption abilities of the US population are not to be underestimated).  This requires the dollar to lose value.

The US population has now started saving. In the last few years, the savings rate was negative, as the population was being encouraged to consume more through easy money policies.  However, compared to countries like India, the savings rate is very low.  The US government has huge debt on its books.  These are dollars that it owes to others, including sovereign nations who park their money in US government bonds.  As the dollar depreciates due to reasons already noted above, there would be selling pressure on these bonds.  There will also be pressure to take the money out of the country, further depreciating the currency.

As the dollar depreciates, the price of Gold will go up.  In Indian rupees, that may be partly offset by any appreciation of the rupee against the dollar.  However, if the dollar starts depreciating steeply, the demand for Gold may pick up which may serve to increase the price further.  The "flight to safety", this time, from dollar to Gold.

The outlook for the US economy in the near future is not very good.  It looks like this recession will take some time to correct itself.  In the meanwhile, if the Indian economy starts looking up, there would be some investments flowing back to India as well.  This would push up the stock markets and also result in appreciation of the rupee.  However, I do not see this happening right away - in my view, the latest rally in the Sensex that we have witnessed is still a bear market rally - I think the market is due for one more correction.  Hence, investing in stocks is fraught with uncertainty right now.

The last few months have seen a lot of talk around Gold.  It suddenly seems to be very popular.  Prices have reached record highs and there is talk of prices going up even further.  High-net-worth individuals are rediscovering it with a passion.  Swiss banks are announcing provisions of special vaults to store peoples' gold by the ton.  ETF's have gained in popularity in the recent past; Gold ETF's, more so.  These ETF's have started buying Gold since people have started buying more and more of their units.  There has been a perceptible drop in retail demand around the world due to the rise in prices; people are preferring to recycle the existing Gold that they have.  The drop in retail demand is likely to be a temporary phenomenon.  What is of greater concern, however, is the number of ETF's and high-net-worth individuals who are joining the party.  While they are helping to drive the prices up as of now, they also tend to have a herd mentality.  If they start selling, a lot of them will sell together. This development points to Gold becoming a more volatile commodity in future, than it ever has been.  Something for the ordinary investor to be wary about.

So where does all this lead us?  Is Gold going to go up or go down?  In the near future?  In the long run?  Should one invest in Gold at current prices?

It's time Gold formed a part of every investment portfolio.  As with any other asset class, I would suggest that it should be a percentage allocation, and not an all-or-nothing bet.  Given the current uncertainty in the world, Gold is the best protection - especially against the worst possible scenarios.  Quite apart from looking at Gold as an investment, I would also look at it as a proxy for cash.  It is likely to hold its value - against any currency, as the currency depreciates, Gold will rise in price.  However, the volatility factor is new to the equation.  Due to reasons mentioned above, we are likely to see Gold prices becoming highly volatile.  As with most other investments today, you need to have a strong heart to indulge in it.  A periodic cardiac check-up is a good idea.

Equities are currently a bit uncertain - but if you are convinced it has reached bottom (let me know when you decide this point has occurred - if you are right, I will hail you as a guru) you should invest significantly in equities at that point.  Real estate currently seems to be certain.  It is certain to drop.  Whether you are invested in cash, gold, debt, or equities, it's a good idea to keep an eye on the real estate market and pick up a property (or two) when the prices hit new lows.  All this of course assumes you have the money.  If you don't, anyway you have nothing to worry!

As to what form of investment is to be preferred, I would suggest ETF's.  Gold biscuits are also a good option.  If you don't intend to hold it for a long time, don't go for biscuits, since the buy-sell spreads there are higher.  If you do buy biscuits, buy them from a jeweller, not from a bank. Banks charge higher margins, and they don't buy them back from you.  Ornaments are good for adornment; they are not such a good idea for investment.

Silver is another good option.  I am quite bullish on silver as a long-term investment.  The only problem is, there are no silver ETF's in the Indian market, and it's a very bulky commodity to store.  If you have a large hidden vault in your loft, you could consider buying it.

Happy Investing!