Is it time for gold to shine again?

13th February 2014

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Gold bugs have had a good start to 2o14, unlike those invested in stock markets. Edmund Shing looks at significant changes in supply and demand.

While the FTSE 100 index has lost 1% over the year to date, in contrast gold futures have gained over 7% in US dollar terms. Billionaire hedge fund manager John Paulson’s Gold Fund gained some 18% over the month of January, according to Institutional Investor Alpha.

This rally should of course be put in the context of the substantial slide that the gold price has suffered since October 2012, when it sat close to $1800/ounce. Today, even after rising since December of last year, the gold price is still only $1292/oz (Figure 1). Were the gold price to continue to rise back to its October 2012 level, there could still be another 38% to gain!

1. The Gold Price Breaks Out of its 2013 Downtrend

Source: Bloomberg

Now that is easy to say; but what could the drivers be for a continued gold rally? And is there a better way to play this trend than simply through the yellow metal itself?

Uncertainty and Strong Chindian Demand Are Key Drivers

There are two key drivers that can be easily identified for gold; one is uncertainty in financial markets, and the second is the growth in demand for physical gold from Chinese and Indian consumers.

1. Uncertainty is coming back!

Since January of last year, there have been three times when stock market volatility has spiked sharply, reflecting increasing worry over the global economic picture – in May 2013, in August and then in January this year.

Each time that these worries have surfaced, the VXV US stock market implied volatility index has shot up as fund managers seek to protect their stock portfolios by buying put protection in the options market. Subsequently (with a lag of about one month), the gold price has then also surged as investors look for safe havens such as gold bullion to put their money into, to shelter from the turbulence in financial markets – as the green arrows in the chart below highlight (Figure 2).

2. Gold Rallies Each Time Stock Market Volatility Flares Up

Source: Bloomberg

Interestingly, on the previous two occasions in 2013, once stock market volatility started to recede, the gold price would then resume its downwards trajectory. But not this time… Has something changed to support further gains in the gold price?

2. Physical Gold Demand from Chinese and Indian Consumers Has Kicked In

We should also note that there is a fundamental reason for gold prices to keep rising this time; aside from pure investment demand (which is very fickle), there is also demand for the physical metal for jewellery. The biggest consumers of gold jewellery in the world reside in the twin emerging market powerhouses of China and India. Figure 3 is a clear illustration of how Chinese and Indian consumer demand dominates global consumer demand for gold, over 60% of global consumer demand emanating from this population of 2.5bn people.

3. China and India Love Gold!

Source: The World Gold Council

Looking at 2013 over previous years, we can surmise that, as of the third quarter of last year (the latest data available), total consumer demand for the yellow stuff is rising substantially (Figure 4), in part of course due to the fact that it is a lot cheaper today than it has been since late 2010.

4. And Total Consumer Demand for Gold is Rising

Source: The World Gold Council

Looking at jewellery demand by country on a year-on-year comparison is revealing: demand in Hong Kong and China have both jumped by over 37-40% for the first 9 months of 2013 compared with the same period a year earlier; in India, the growth rate is a substantial +13% on the same basis.

Now for students of economics, we should not forget its first rule, that of a balance between supply and demand driving prices up (when demand exceeds supply) and down (vice-versa). So far, we have established that physical consumer demand has gone up a lot. But what about global supply of gold?

Well, for the first 9 months of 2013, gold supply actually fell by 4% compared with January-September 2012. So there we have it: evidence that physical demand is going up, while supply is going down. Should we then be so surprised that gold prices are actually rising?

For real gold bugs who want to dig into these industry statistics, have a look at the World Gold Council’s Gold Demand Trends Q3 2013 report.

A Historical Aside: Since 1970, Gold has Beaten the S&P 500 index, as well as US Inflation!

Before I end on the “What should you do?” section of this article, allow me to indulge my personal passion for long-run historical data. Did you know that, since 1970, gold has actually outperformed the US S&P 500 stock market index by quite a distance!

So yes, there may be long period when the gold price is flat or goes down, but over the long haul, it has proved a surprisingly decent investment, as long as you are invested during those periods when it enjoys a strong bull market.

For the record, over this 43-year span, gold has returned an average of 8.5% per year (and remember, that is without any investment yield), while US large-cap stocks have delivered 7.0% and inflation ran at an average of 4.2% per year (Figure 5).

5. Since 1970, Gold has beaten US Stocks, Inflation handsomely

Source: Author, Bloomberg

What is the Best Way to Play this Golden Story in Funds, Stocks?

There are a myriad of ways that you can board this gold investment train.

1. Physical Gold Bullion, Coins

The first is the most obvious: buying gold coins or bars. Bear in mind however, that while they are shiny and pretty, you do tend to pay a premium as a retail investor for the most commonly-traded coins such as UK gold sovereigns or South African Krugerrands – an indication of current gold coin prices can be found on www.goldline.co.uk. Not only that, but then you will need to invest in a very good safe or pay for a bank safety deposit box in order to store them!

A second way to invest in gold bullion is via gold bullion ETFs, which invest in physical gold bars and take care of the storage in a bank vault. Perhaps less exciting than buying your own coins, but a lot less hassle too… One that is listed in London and denominated in sterling is the ETFS Gold Bullion Securities ETF (GBSS.L).

2. Gold Mining Funds, Stocks

The second way, that I prefer personally, is via investment exposure to gold mining stocks. This results in more volatility to your gold-related investment, but also gives a large element of leverage to movements in the underlying gold price.

To illustrate the effect of this leverage to the gold price, between August 2011 and December 2013, the gold price fell some 37%. Over the same period, the Gold Miners ETF in the US (GDX) fell nearly twice as much, some 69% (Figure 6)!

6. When the Gold Price Fell 37%, the Gold Miners ETF Fell 69%

Source: Author, Bloomberg

Now the easiest way is via funds, either ETFs or investment trusts such as:

a. The ETFX DAXglobal Gold Mining Fund (AUCP.L). This ETF tracks an index of gold mining companies and is denominated in sterling. Its biggest holdings currently include the companies: Goldcorp Inc., Barrick Gold and Newmont Mining.

b. The BlackRock World Mining Trust (BRWM.L). This long-standing investment trust, run by the world’s largest fund management company, invests in global mining companies (so not just gold miners) and is well-diversified. Its largest holdings: Rio Tinto, BHP-Billiton and Glencore Xstrata (all of which are listed on the London Stock Exchange and are memberrs of the FTSE 100 index). The investment trust currently trades at a very small premium to net asset value.

Then finally, for those who are keen to take much more investment risk and who are not so concerned by diversification, can opt to buy individual gold or other precious metals mining company shares. While most of these companies are listed in Canada, the US or Australia, there are some listed in London. These include:

African Barrick Gold (ABG.L),

Aquarius Platinum (AQP.L) and

Randgold Resources (RRS.L).

The grand-daddy of these UK-listed precious metals mining companies is:

Anglo-American (AAL.L), which these days is more of a diversified global miner like Rio Tinto or BHP-Billiton, but still retains significant exposure to gold, platinum and diamonds.

As always, I urge you to do your own research, particularly with these individual stocks, as they can be very volatile!

Personal disclaimer: I own shares in Anglo-American plc

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