Is gold becoming tarnished?

Julian Chillingworth, CIO at Rathbone Unit Trust Management, examines whether gold really is the answer to investors’ prayers.

For years now, investors have taken for granted the ability of gold to preserve wealth. In doing so, they have relied heavily on certain correlations: the correlation between gold and inflation; between gold and the dollar; between gold and debt-deflation.

All things considered, gold has become a bit of an all-round investment hero, but the pending bout of quantitative easing is forcing many to re-evaluate its place; its true worth in a portfolio. Indeed, there is a growing consensus that gold no longer offers the (relative) safety it once did.

There are many reasons why gold remains appealing, and not just to the eye: favourable supply/demand ratios; multi-purpose usage, from jewellery to industrials, and low opportunity costs have all benefited gold prices. More recently, the ultra-easy environment coupled with competitive devaluation, have all been primary drivers of the market. However, investors need to be wary: current price appreciation suggests that gold is technically overvalued.

Technical analysts are also pointing to another risk. Allow me to cast your mind back to 1980, when speculative excesses fuelled the market, leading to a parabolic rise in the gold price, followed by an abrupt fall. In these times, the main catalyst for a price reversal is likely to be a reversal in real rates and a spike in bond yields.

When confidence is dented

Furthermore, demand is also being driven by more artificial stimulus. For example, products are now being launched with share classes with a gold hedge, which is another positive for gold, but is perhaps a sign that investors are becoming overly enthusiastic. Demand for jewellery aside (although there is evidence that this is now tailing off) and investors need to be wary of a drop-off in investment flows. Any dent to confidence, would inevitably lead to a sharp fall.

So when should investors sell? ­Currently, yields are supported artificially by central banks, but policy error or an inflation spike could drive that back-up in yields. Indications of a sustained recovery, fuelled by inflation expectations and healthier monetary mechanisms, would also punish bond yields, as would higher credit demand from the private sector.

In some respects, it is fair to say that the gold theory will only come good in an extreme environment: accelerating inflation or deflation. This has obvious implications for longer-term investors. Very low, real rates will continue to underpin the yellow metal for some time yet, but at current price, one must query future upside and speculative froth. When you are contending with mania, what is ‘price’?

The up-trend here suggests fears about the stability of the monetary system, which is ultimately dependent on the direction of the economy.

Uncertainty persists. We prefer, therefore, to stick with big, adaptive corporations with a foothold in the fastest-growing regions in the world, which can survive most monetary and fiscal scenarios. There is little that is adaptive about gold. In short, we prefer the safety of consistent returns over a speculative rollercoaster.