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Special report 4: Five factors driving gold higher

14 August 2014

Whether it’s a golden wedding anniversary we’ve attended, cheering on an Australian to a gold medal performance at the Olympics, or describing a friend or loved one as having a ‘heart of gold’, Gold is a word that we all instinctively recognize and associate with something of merit or value.

And whilst many of us own some gold jewellery, as a pure investment asset, gold is a little harder to understand.

On the downside, it pays no yield, its volatile (like shares) and its impossible to value by any traditional valuation metrics, as it’s not like a business which has sales figures or profit margins you can analyze.

Certainly these are the characteristics that most financial planners and big fund managers focus on, as they find it too difficult to classify as either a ‘growth’ asset, like shares, or a ‘defensive’ asset, like term deposits.

Indeed, despite matching the performance of listed Australian equities over the past decade or so, and comfortably outperforming term deposits and government bonds over the same period, most fund managers still don’t have any allocation to physical gold whatsoever, and instead keep all of their clients money invested in the afore mentioned financial assets.

But gold has a number of fantastic qualities that investors should consider when they’re putting their portfolios together.

Firstly, over the long run, the return on gold has been over 8% per annum, and in the last 10 years the return has been closer to 10%, even after having a correction in 2013.

Secondly, gold is a highly liquid asset, which is very to buy and sell quickly, in either large or small denominations. Indeed At ABC Bullion we have an array of clients. Some are small retail investors picking up a few grams at a time, or even an ounce of silver at a time, whilst others are SMSF Trustees or High Net Worth investors looking to pick up tens of thousands of dollars or more.

Thirdly, gold is typically uncorrelated to the equity market. What this means is that in environments where the ASX tends to fall, gold tends to rise, and vice-versa.

Indeed, in the 5 worst years for on the stock market since the 1970’s, which we’ve listed below, shares have fallen by just over 24% on average. Gold on the other hand, apart from 1990 where it had a very minor fall, has gone up by on average 38.48%, outperforming the stock market by a staggering 63%.

Clearly, any investors who held a portion of their portfolio in gold would have been well served in this environment, and wouldn’t have suffered the kinds of sleepless nights many investors remember from the GFC.

ASXGOLD

Finally, gold is a proven monetary hedge or monetary insurance, and has an unparalleled track record of preserving wealth in environments where there is either really high inflation (like the 1970’s) or deflation (like the 1930s).

The stability and security that gold offers is one of the major reasons why the US Government, as well as governments of Western Europe and indeed Australia, still hold onto their gold reserves today, as it is considered a ‘strategic reserve asset’.

Indeed, up until 1971, the world was in fact on what was known as the ‘gold standard’, where the money we earned and kept in our bank accounts was in effect backed by gold. As a side note, it’s not a coincidence that the coins in our pockets still look the way they do.

Going forward, gold will continue to provide investors inflationary and deflationary protection, as well as help hedge against falling equity markets and the like.

Indeed, prices may well head substantially higher in the coming years, due to a combination of factors, listed below.

1. Total Supply is Stable.

Every year, the world produces about 2,700 tonnes of gold per annum. This number has barely changed in a decade and going forward, could even fall as gold becomes harder and more expensive to find.

Across the course of human history though, there have been approximately 170,000 tonnes of gold mined, and apart from some that is sitting at the bottom of the ocean, and a small percentage that is utilized in industry, all of that gold is still around today, either in bar, coin or jewellery form.

This is why we say the TOTAL SUPPLY is so stable, because annual supply, at 2,700 tonnes, is only 1.5% of the total supply of 170,000 tonnes. Total Supply only increases fractionally every year, and that rate of change won’t increase going forward, especially with discoveries falling like they have been of late.

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2. Portfolio Reallocations by Investors

At the end of 2013, only 1% of global financial assets were invested in gold, with the rest of it in equity markets like the ASX, government and corporate bonds, bank accounts and property.

In previous periods, the value of gold and gold mining companies, as a percentage of global assets was closer to 20%.

All of the other markets listed above are already at or very close to all time highs, and are offering historically very low yields. That’s a huge risk and should be a huge warning to investors.

Furthermore, in the coming years, as the world is forced to deal, one way or the other, with the challenges of the ageing population, spiraling government debts and central bank money printing, the returns on these other assets are likely to be much lower, if not negative.

This will likely lead many investors to reallocate a portion of their investments towards gold, pushing prices higher.

3. Ultra low interest rates

Over the last 40 years, the key driver of gold prices has been ‘real’ interest rates, which are calculated by taking central bank interest rates (for example in Australia the RBA rate) and subtracting the rate of inflation.

Basic logic explains why this is so. If real interest rates are high, then you have a large opportunity cost in holding gold (which is after all a non yielding asset), so investors tend to sell gold and put their money in a bank term deposit, or even government or corporate bonds.

But in environments where real interests are low, or even negative, then more and more investors realize there is little point leaving their money in the bank, or having all their money in other overvalued assets (like some argue shares and property are today), and they move some of their money into gold, which forces prices up.

This was the central point made by bond fund manager PIMCO in an excellent research they released titled “Demystifying Gold Prices” where they stated that, when it came to what one would pay to own an ounce of gold;

“it would likely vary over time with the level of real yields available in very high quality, nearly “default-free” assets (such as U.S. Treasuries).”

PIMCO

The above chart highlights PIMCO’s point clearly, showing the correlation between increasing real yields and a falling gold price, though they used USD gold and US bond yields in their illustration.

For Australian gold investors, or those thinking of buying gold, the results are similar, and encouraging.

Indeed, if we look at data going all the way back to the 1970’s, we can see that in environments where ‘real’ interest rates were 2% or lower, AUD gold prices have tended to go up by just over 25% each year.

In those same years, equities on average rose only 13%, whilst bonds were up only 7.5%. Gold was clearly the place to be.

All around the world today, including in Australia, real interest rates are either incredibly, if not outright negative. Due to the low levels of economic growth we’re still witnessing and our constantly increasing total debt burdens, they will remain that way for many years to come.

It’s the perfect environment for gold prices to appreciate.

4. Central Bank Buying

To this day, governments and central banks of countries like the USA, Germany, France and Italy still hold between 60 and 75% of their foreign exchange reserves in gold.

This is despite the fact that for about 20 years (from 1990 to 2010), Central Banks were selling a portion of their gold reserves, which helped push prices down. Indeed central banks only turned net buyers of gold a few years ago, marking a major structural shift in the precious metal bull market.

By 2012 they were purchasing over 500 tonnes of the yellow metal a year, a number that eased back to just over 400 tonnes the following year.

According to the World Gold Council, in Q1 of 2014, central banks picked up 122.4 tonnes of gold. We expect that across the course of 2014, central banks will buy between 400 and 500 tonnes a year of gold again, and continue this pace of purchases for the foreseeable future.

In analyzing the activities of central banks, its also important to note too that whilst Western central banks have largely stopped selling gold, it’s the emerging market central banks who are doing most of the buying.

They’re looking to build up their gold reserves to a level similar to that of countries like the USA, Germany, France and Italy.

Central banks turning from net sellers to net buyers is another bullish factor for gold prices.

5. Chinese and Indian consumer demand.

The last major factor that will push gold prices higher in the coming years is the role of both China and India.

Gold has long been seen as the ultimate store of wealth in these countries, as well as a symbol of prestige and importance.

Indeed the two most populous nations on the planet already have an insatiable demand for physical gold and in 2013 alone purchased more than 2,000 tonnes of gold, which is the majority of all the gold mined around the world each year.

Demand from these countries is only likely to increase in the coming years, as they both continue to modernize, creating higher standards of living. They also have incredibly favourable demographics, particularly India, where some 65% of the population is under 35, and where gold is the most prized wedding gift.

In China, where individuals save 30% of their income, there will be more than 600 million people classified as ‘middle class’ in the coming years, which is one of the major reasons why the World Gold Council forecast a 20% increase in gold demand by 2017 there.

Summary

The fundamentals for physical gold and silver are incredibly positive, a conclusion that we feel anybody who conducts an objective analysis of the supply and demand characteristics for the metals will agree with, especially in light of the risks the global economy still faces.

With that in mind, the next few years could be incredibly profitable for those who choose to invest in this space.

Most importantly though, anyone who decides to allocate a portion of their portfolio to physical gold will be buying into an asset class that provides the ultimate wealth protection and peace of mind.

Investors in gold don’t tend to buy it because they want things to get worse in the economy, or because they want to see the stock market fall, but because it makes sense to be prepared in case they do.

Disclaimer

This publication is for education purposes only and should not be considered either general of personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, past performance is not necessarily indicative of future performance. Any prices, quotes or statistics included have been obtained from sources deemed

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