Why gold is glittering

VIKAM KHANNA

Associate Editor, the Straits Times

The Straits TimesAfter going nowhere for the better part of the past six years, the price of gold is surging. Since November last year, it has gone from around US$1,200 an ounce to US$1,514 at the end of last week, a rise of more than 26 per cent.

This year alone, it has risen 18 per cent. Gold bugs are bullish, with some even predicting that the price of gold could double from here.

Why is this happening? What might have triggered a change in the mindset of the market that has led investors to suddenly pour money into an asset with a zero yield?

The timing of gold's breakout after six years may hold a clue. The price started climbing last December. That was when the United States Federal Reserve changed tack from tightening monetary policy to an easing bias.

More liquidity is widely viewed as being good for inflation and negative for the US dollar.

Though that relationship doesn't always hold - inflation has not risen and the dollar has not weakened - it emboldened gold investors to turn bullish.

At the very least, the prospect of lower interest rates reduced the opportunity cost of holding gold.

This was reinforced by another development this year: The rise of negative-yielding bonds. With the Bank of Japan and the European Central Bank (ECB) pursuing negative interest rates, more and more sovereign bonds - and even some corporate bonds - started offering negative yields, which meant investors stood to lose money by buying them.

As of now, there is roughly US$17 trillion (S$23 trillion) worth of negative-yielding bonds, most of them concentrated in Europe.

PSYCHOLOGICAL EFFECTS

This has had two psychological effects on the gold market. First, it ensured that the zero yield on gold was higher than the yield on many bonds.

So whereas bonds are traditionally considered safe assets, their negative yields made them less attractive compared with gold, which is also considered a safe asset and which became the preferred choice for many investors.

Second, some investors began to view the massive stock of negative-yielding debt as a potential systemic risk. A lot of it is held by pension funds and other big institutional investors.

When interest rates start to rise - as they surely will in the future - the bond bubble will burst and these big investors will suffer huge capital losses.

That would send ripples through the financial system and devastate not only the bond markets, but also the equity markets. In such a scenario, gold would be the safest bet.

Another problem relates to pension liabilities as well as other debt held by companies as well as governments. The unfunded pension liabilities of US states is estimated at nearly US$6 trillion, while companies' unfunded liabilities run into hundreds of billions of dollars.

How will these liabilities be discharged? Some investors bet that monetisation - essentially creating new money to pay off the liabilities - will have to be part of the answer. This points to a debasement of currencies as well as a rise in inflation, both of which make gold a good investment.

The prospect of a left-of-centre government in the US following the 2020 presidential election adds to these fears.

The leading Democratic candidates such as Ms Elizabeth Warren and Mr Bernie Sanders - who are riding high in opinion polls - have ambitious plans to expand state-funded healthcare and other social services.

Many analysts, and even some of their Democratic opponents, contend that these candidates have no credible strategy to fund their plans, which raises the risk of more money printing and currency debasement.

The recent gold purchases of central banks are also attracting attention.

The World Gold Council reported that, in the first half of this year, central banks bought more gold than in any equivalent period in the past 19 years.

Their motives may vary, ranging from a desire to reduce dependence on the US dollar in their reserve mix, to hedging against geopolitical risks or against the moves by several central banks to weaken their currencies. But, whatever the reasons, gold investors view their actions as a bullish sign. The renewed interest in mergers and acquisitions by mining companies is viewed as another positive signal. In January, Canada's largest gold mining company, Barrick Gold, completed a merger with London-listed Randgold in a US$6 billion deal.

Then, in April, US mining giant Newmont Mining spent US$10 billion to acquire Canada's Goldcorp to become the world's largest gold miner. Analysts expect more mergers and acquisitions among gold-mining companies.

A key reason: A scarcity of easily accessible gold reserves - many of which are in countries with high political risk and/or are subject to strict licensing regulations - which makes buying existing gold-mining assets a more attractive proposition than building new mines.

The M&A wave also signals that the large mining companies are positive on the future demand for gold.

MAINSTREAM EMBRACES GOLD

So too, increasingly, are mainstream investors. Traditionally, gold investors have been considered mavericks - a minority among investment professionals, who are often ignored. Gold also lost its allure as an investment since peaking in August 2011 at just over US$1,900 an ounce and then largely trending down all the way to last year.

So, many investment advisers have tended to recommend portfolios comprising equities and bonds and, lately, alternative investments such as real estate and private equity.

Gold and other precious metals have been recommended, if at all, only to more adventurous investors.

But, of late, several respectable names among mainstream investors, who are not considered gold bugs, have started to recommend gold.

One of them is Mr Ray Dalio, the chief investment officer of the world's largest hedge fund, Bridgewater Associates, who wrote in July that, going forward, the investments that are likely to perform the best "will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold".

Another hedge-fund billionaire, Mr Paul Tudor Jones, has also endorsed gold as an investment.

So has the emerging markets specialist Mark Mobius, who led the Templeton Emerging Markets group for 30 years before starting his own firm, Mobius Capital Partners.

"Gold's long-term prospect is up, up and up," he told Bloomberg TV in August, adding that "the reason why I say that is money supply is up, up and up".

THE DOWNSIDE

Of course, it's possible that things may not play out quite as the gold bulls expect. For one thing, given the continuing strength of the US economy, it's not clear that the Federal Reserve will keep cutting interest rates next year. In fact, after delivering the third rate cut of the year last week, chairman Jerome Powell hinted that the Fed might pause on rate cuts.

"We see the current stance of monetary policy as likely to remain appropriate as long as incoming information about the state of the economy remains broadly consistent with our outlook," he said at his post-meeting news conference.

It is also not a given that the ECB will take rates further into negative territory and press on with quantitative easing.

Its governing board is divided on these issues and new ECB president Christine Lagarde has called for a more activist fiscal policy to help lift the euro zone's economy.

Momentum is also building in Germany for fiscal expansion. All of this suggests that the continuation of easy money policies well into the future cannot be taken for granted, US bond yields could rise and negative-yielding debt in Europe might be close to its peak.

Any positive developments in the trade war between China and the US - not impossible in a US election year - would also be negative for gold, as would weakening consumer demand in two of the world's largest gold-purchasing countries, China and India, both of which are in the throes of an economic slowdown.

To dampen the demand for gold, which is a drain on its foreign-exchange reserves, the Indian government hiked import duties on the precious metal in its July budget.

So, in an investment world that is full of surprises, there are plausible developments ahead that could upset the calculations of the gold bulls.

But, for now, gold as an investment is continuing to glitter.

vikram@sph.com.sg

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