DEZ
Gold to remain a major component in portfolios
BY BABU DAS AUGUSTINE
12 February 2006
DUBAI - The yellow metal has been in the headlines for the past few months with its prices scaling a twenty-five years’ peak. Economists and global investment strategists visiting Dubai recently told Khaleej Times that gold will continue to form a significant component of investment portfolios around the world.
“Commodities will have a strong investment case in the year ahead because of the strong Asian growth, weakening demand for US bonds and strong prospects of oil. Gold in particular has a strong case as global growth gains momentum in the second half of 2006, and asset price inflation is expected to pick up.
This suggests 2006 will be good year for gold, and commodities in general,” said Michael Hartnett, Chief Global Emerging Market Strategist, Merrill Lynch.
London spot gold prices have risen around 20 per cent in the last three months. This indicates persistent bullish sentiment in the market for the metal.
Analysts expect gold's rally is set continue in the medium term due to a host of factors such as growing inflation fears, geopolitical tensions across the globe, weakening dollar, rising oil prices, robust demand for jewellery, increasing investment demand for gold, potential reserve diversification by Asian central banks and a stagnant level of global mine production.
More than an inflation hedge, the investment case of gold is looking brighter as the global interest rate convergence is likely to weaken the US bond yields and drive dollar further south.
This means that investors US assets will have to hedge dollar either through Euro and Asia’s resurgent currencies (Korea, Singapore, Taiwan and China) or gold.
“The medium term weakness of dollar alone makes gold a strong investment case,” said Gerard Lyons, Chief Economist and Group Heard of Research, Standard Chartered.
Central banks in Russia, Argentina and South Africa have already decided to boost their gold reserves. In the context of the declining dollar, a reallocation of reserves by Asian Central Banks, particularly China could mean further increase in demand for gold.
Gold is now considered as a part of a diversified portfolio more than ever by institutional investors.
Recently, Goldman Sachs has included gold as one of its top investment products for 2006. Investment guru Marc Faber has predicted bullishness in the precious metals in the next few years and predicted that the central banks across the globe who had sold gold would buy it back in the near future.
An important distinction between commodities and equities is that unlike stocks, the price of commodities can never go down to zero.
An interesting example would be the share prices of Enron which collapsed from $95 to less than $1 when the company filed for bankruptcy in December 2001. Historically, commodities have never experienced such a massive decline. On the flip side, commodities can go quite high, as high as anyone is willing to pay for them. Gold, historically, went up from $239.70 an ounce to an astounding $850 on 21st January 1980 within a short span of 10 months.
Futures hold a brighter option
For an investor taking exposure in gold futures market has clear advantages compared to buying physical gold. When an investor trades in futures market, he enjoys a distinct advantage in terms of leverage. This means that with a small amount of capital, the investor can control a large value of assets. For example if an investor had bought 1 Kg of gold in the physical market at $16,000/kg in November 2005, he would have made a gain of about 8 per cent by February 2006. But the investor would have incurred costs such as interest, storage fees and insurance charges.
On the other hand if the investor had opted take exposure in gold through gold futures contracts through the Dubai Gold & Commodities Exchange (DGCX) he would have made more than a 500 per cent gain.
Instead of the physical gold, if the investor had bought the April 06 expiry gold futures contract at $15,750.40/kg (price on November 23), he would have required to pay just the initial margin of $480 for trading.
In addition he does not incur interest, storage and insurance costs. In January middle if the investor had decided to sell the contract at $18,192 /kg (price on January 16), he would have made a profit of $2435 on an initial investment of just $480, earning him a return of 509 per cent in less than 2 months of trading. In the event of gold prices falling, investors in futures contracts face the downside risk of losses, however, investors can limit losses by selling the contracts when the prices begin to fall.
Why gold now?
Gold forms a part of any portfolio, as it is not positively correlated to other asset classes like equity, bonds, and real estate on a long-term basis.
The price of Gold and other asset classes tend to move in opposite direction. This augurs extremely well, when the prime consideration is risk reduction in the portfolio. As a rule of thumb, it is believed that an individual’s investment portfolio should contain from 5 per cent to 30 per cent of gold based on life cycle asset allocation and risk reward preferences of the investor.
Portfolios containing gold are considered to be less risky, based on ‘event risk’ philosophy of investment. According to this, in the event of an economic crisis when all asset classes normally fall sharply in unison, the fall in gold however, is not as steep. During the 1987 stock market crash, Gold proved to be the most effective way of raising cash to meet immediate needs. Investors flocked to buy Gold in 1999 due to Y2K fears.
Outlook for 2006 & 2007
Deutsche Bank has raised their annual average gold price forecasts for 2006 and 2007 by 16 per cent and 26 per cent to $570 per ounce and $660 respectively to reflect strong investment demand and sound physical market fundamentals.
Barclays Capital raised its average price forecast for 2006 by 13 per cent to $525 from $465 previously and also saw potential for a spike above $600.
In 2006, it estimated a price of $495, versus its previous forecast of $450. On the same lines, other leading investment banks of the world like Scotia Mocatta, Standard Bank PLC and Goldman Sachs have also forecasted a considerable rise in gold prices.
Investment strategists like Merrill Lynch's Hartnett believes that fading interest rate and growth differentials enjoyed by the US in the past, geopolitical uncertainties and rising oil prices will provide further impetus to gold prices. With increasing fund interest in commodities as an asset class vis-à-vis bonds and equities, gold has definitely become the flavour of the market and is here to stay.
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