Still positive on gold despite new record price
We remain positive on the outlook for gold, despite it hitting a new record this month. Relative to other assets, gold has historically traded at even higher levels in periods of elevated perceptions of risk. In our ‘2010 Investment Outlook’ we forecasted structurally higher risk premia amid an environment of increased macro-economic volatility, and events this year have reinforced this view. With gold providing a useful hedge against many of the risks in the current environment, we believe it will rise still higher this year.
As gold is a hedge against risk, it will trade on the basis of the particular risks that concern investors. These issues can quickly change or disappear. So during the financial crisis, we saw gold rise as bank shares fell. But when bank shares rallied after government sponsored bailouts, gold continued to rise as investors’ concerns shifted to doubts about the solvency of governments. That is not to say that gold rises in response to all risks, is a perfect hedge or is without risks of its own.
While the lack of consistent correlations with other assets can be an attractive attribute, it also compounds the problem of valuation. Gold defies standard valuation methods. Most methods of value rely on cash flow, but gold produces no cash return and so is impossible to value on this basis.
We believe that in order to forecast the outlook for the gold price, it is necessary to make a judgement on the level of perceived risk that will prevail in financial markets. As noted above, our judgement at the turn of the year was that risks would persist in the aftermath of the financial crisis, and this has been reinforced by recent events.
We have taken a series of benchmarks against which to assess the price of gold. These benchmarks allow us to see the long-term average, and the ranges around that average, at which gold has traded in different periods of risk appetite.
Our start point is 1973 when the US dollar finally abandoned the gold standard and traded freely of the gold price. We have a slightly later start point for the comparison with oil, post-dating the end of fixed-price contracts. Standard deviation bands provide ranges which cover around two-thirds of trading and so offer useful measures of when the relative price has moved a statistically significant distance from the average.
The benchmarks that we have chosen are inflation, oil, house prices and equity prices. Clearly gold is not affected by inflation, so we should look at the real, or inflation-adjusted, price in dollars. Oil is the key global commodity and so is the obvious benchmark when looking at gold in comparison to other commodities.
The economic relationship with house prices and equities is more tenuous. These other assets are investment capital assets that can produce returns that grow in real terms. Even though we are only looking at capital values, rather than the accumulated returns, we assume that the ratio between them and gold is significant. Our argument is that, given gold is regarded as a store of value, investors look to swap part of their capital gains into gold to hedge their accumulated wealth. House prices are seen as a store of value and a hedge against inflation, especially UK house prices. We have used a UK house-price benchmark, adjusted for currency movements, for comparison. Finally, we looked at global equities in dollar terms.
In our first graph, we have taken the current dollar price of gold and looked at its price history adjusted for inflation. This gives an average price of $665 per ounce, with one standard deviation from the average at close to $930. The peak is in excess of $2,000, expressed in current prices. The current gold price of just over $1200 is more than one standard deviation above the long-term real average, but short of its peak ratio by this benchmark.
For the comparison with oil, we have taken the current dollar price of gold and oil and plotted past movements in terms of gold as a ratio of oil. In the same way that the inflation graph shows an inflation-adjusted history of the real price of gold, this graph shows an ‘oil-adjusted’ gold price. The current gold price is slightly above the long-term average ratio against this benchmark.
However, care must be taken when looking at the prices produced by these benchmarks as they are expressed in terms of the current price and ratio. These calculations, by holding one of two moving components in the relationship constant (e.g. oil prices) assume that past peaks are a result of moves higher in gold. The ratio could change as a result of oil falling rather than gold rising, etc.
For the comparison with house prices, we have taken the current dollar price of gold and plotted past movements in terms of gold as a ratio of UK house prices, adjusted for currency movements. In the same way that the inflation graph shows an inflation-adjusted history of the real price of gold, so this graph shows gold in terms of UK house prices. The current gold price is at the long-term average ratio against this benchmark.
For the comparison with equity prices, we made similar calculations to the above examples, with the resultant graph showing gold in terms of equity prices. Again, the current gold price is just slightly above the long-term average ratio against this benchmark.
Our view is that gold is attractive given our belief that investors’ perception of risk will remain high. When looking at gold in real terms it is short of previous peak levels and its ratio against other real assets is still close to the long-term average. We believe gold could also remain in demand as the ultimate currency, given the possibility that the depreciation of the euro, dollar and/or sterling could be used as a policy option in helping to ease the process of fiscal adjustment by their respective governments.
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