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Gold prices up, but stick to 5-10% allocation

Gold prices up, but stick to 5-10% allocation
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First Published: Tue, Aug 09 2011. 12 38 AM IST
Updated: Tue, Aug 09 2011. 12 38 AM IST
The downgrade of the US’ sovereign debt by Standard and Poor’s to AA+, from the decades-untouched rating of AAA, has given another shot in the arm to already rising gold price—on Monday gold closed at Rs 24,915 per 10g on the Multi Commodity Stock Exchange, up 15.27% since 1 July. This compares to a 9.05% correction in the equity markets and the current one-year fixed deposit rates of 9-9.5%.
And yet the buying euphoria hasn’t died down. In fact, there were reports of panic purchases of gold bars in the market on Monday by mostly small investors. But does such a move fit into your overall asset allocation plan? And if you are one who has missed the bus, is it a good time for you to buy?
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To find the answers to these questions and more, you would first need to consider factors that are impacting gold prices. We spoke to experts to find out where would the prices go from here.
What’s unique to gold?
Gold has been the currency of choice since the Byzantine Empire. Post-1971, after the collapse of the Bretton Woods system, gold price was freed and determined by market forces. Though since then it has never formally been linked to currency, most countries hold gold reserves as a store of value. This is because gold doesn’t perish or decline in value over the years—a bar of gold today has the same characteristics that it had 10 years earlier.
The annual mine supply for gold is a small proportion of the overall outstanding stock and the annual supply remains relatively fixed. According to a report from the World Gold Council mine supply has averaged 2,497 tonnes per year over the last several years. Given that above ground stocks at the end of 2009 totalled 165,600 tonnes, the annual mine supply is 1.5% of the total stock. Says Hitesh Jain, commodity analyst, India Infoline Ltd, “Gold supply has always been constrained even though now there are more investors.”
Unlike most other metals, including silver, gold has relatively low industrial use, which means that economic activity does not affect the demand materially and, therefore, the prices of gold. Gold carries no default risk unlike other financial assets.
Quasi currency or not, all these factors together make gold an attractive investment as a store of long-term value, particularly during uncertain economic environment and a way to protect wealth during high inflation.
What are the factors impacting prices?
Global uncertainty: Primarily, depreciation in the relative value of the US dollar and financial stress in Europe is supporting the rise in gold prices. US’ slow economic recovery has resulted in its currency falling out of favour, which is used as a reserve currency by other countries. With the US dollar’s relative value depreciating, many are beginning to buy gold to keep their reserves from falling in value.
Says Lakshmi Iyer, head (fixed income and products), Kotak Asset Management Co. Ltd, “Uncertainty in global economic conditions over the last two quarters has contributed to rising gold prices. Central banks now don’t want to be overweight on the US dollar. The US sovereign debt downgrade will only add fuel to the fire, resulting in higher gold prices in the immediate (future).”
Experts also feel that the financial and economic issues that governments in the West are faced with are unlikely to be resolved in a hurry. Says Atul Shah, head (commodities), Emkay Commotrade Ltd, the commodity broking arm of Emkay Global Financial Services Ltd, “In the next two-three years any positive signals of recovery in global growth is unlikely.” This means that gold will be favoured over the US dollar and buying from central banks, which were net sellers till 2009, will continue.
There is fear that incremental mine supply is being hoarded by central banks. Experts feel that this can be an issue only when the outlook for gold prices turns negative, which is not the case. Also, incremental supply is a very small part of the overall gold stock and may not cause any large fluctuation in prices.
Inflation: Gold is an attractive alternative investment during inflationary times. In the emerging Asia context, many countries continue to have negative real interest rates which means that the buying power of money is diminished leading investors to buy gold as a store of value. Says Hitesh Jain, commodity analyst, India Infoline Ltd, “Global money supply has been increasing and giving rise to inflation; gold provides a good hedge against currency value erosion on account of inflation.”
According to a study by Oxford Economics titled The impact of inflation and deflation on the case for gold, “It is also possible that while gold’s real price eventually falls back, this takes place not by a fall in the nominal gold price but by a substantial rise in the general price level, which means that the current price proves an accurate warning of high inflation down the road.” Oxford Economics is a global forecasting and research consultancy.
Festive season: More relevant in the Indian context is the approaching festive season, which invariably supports domestic demand and prices of gold. Says Jain, “Apart from the economic backdrop, (prices could possibly remain high as) we are entering festive season when domestic demand remains strong even at high prices.” Traditionally, Indian festive demand for gold does not depend on prices. Also, beginning November till February is the pronounced marriage season in India; once again demand remains elevated despite prices.
What should you expect?
Experts suggest that for the rest of the fiscal all the above factors will support domestic prices of gold and a worsening global economic situation will push investors to buy gold and may even give its price a further kicker.
But the rush to buy gold indicates that its price rise has too many negatives already factored in. Says Iyer, “Many investors have loaded on gold recently, leading to the recent rally. There may be a near-term 4-5% correction in prices and we may even see some range-bound activity.”
Shah adds, “Gold prices are overstretched at present and we could see a correction of less than 5%.”
What should you do?
Gold remains the investment of choice as a safe haven and given the current situation and expectation of a slow global recovery, gold prices are likely to remain elevated for some time to come. However, this doesn’t mean you necessarily buy gold now. Consider the risks and weigh your portfolio needs before buying.
Risks: Gold is a long-term store of value, but not a long-term return generator. Over the last 40 years, gold’s compounded annual growth rate (CAGR) has been 9.5%. In the 10 years between 2001 and 2010, gold prices have witnessed a definite rally with a CAGR of 17.95%. As on 8 August, the year-to-date rise in gold price has been around 19.31%. The rise in CAGR in the last 10 years is a result of a decade-long rally, typical to asset price cycles.
Remember that there are no income-oriented payouts such as dividends or interest, hence the investor is totally dependent on price rise for returns.
High interest rates raise the opportunity cost of holding gold which could hurt gold prices. Says Iyer, “High interest rates can act as a dampener for gold prices, but it is a cycle and currently we could be in a phase which is positive for gold.”
Portfolio allocation: This means that you shouldn’t have a very large portion of your overall portfolio allocated to gold. Says Rajmohan Krishnan, executive vice-president, regional head (north and south), Kotak Wealth Management, the wealth management arm of Kotak Mahindra Group, “Gold is primarily a hedge, we don’t advise any predominant investment. If a client is keen we can increase it a little, but always maintain a 5-10% allocation and that too via gold exchange-traded funds.”
Since Indians have been traditionally investing in gold, most families would have some amount of gold jewellery and other physical gold. Check the value of your physical gold and add on only if required.
Graphic by Yogesh Kumar/Mint
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First Published: Tue, Aug 09 2011. 12 38 AM IST
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