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NOOB
11th June 2010, 12:11 PM
Gold is a great safety net if things go wrong
Tom Stevenson
June 5, 2010
http://www.telegraph.co.uk

Gold is hovering close to its all-time nominal high just above $1,200 an ounce, having risen around five-fold from a low of $250 an ounce 10 years ago. That steep rise might give investors pause for thought, especially when you compare it to the lost decade for equity investors over the same period, but I think there are several reasons why the yellow metal could have further to go.

Gold hit its low point near the top of the dot.com boom. As with most investment bottoms, it also coincided with a rush to the exit by investors, including, of course, our own Government, which sold nearly 400 tonnes of gold at an average price of $275 an ounce. It is no coincidence that gold should have been so out of favour 10 years ago. Famously described as a "barbarous relic", gold could hardly have been more different from the hi-tech investments in vogue at the time.

In a world in which the government of the day was boasting of its role in eliminating boom and bust, a reliable store of value through turbulent times seemed an irrelevance.

Today that complacency looks absurd, and the macro-economic and geo-political backdrop for gold could hardly be more supportive. From the troubles afflicting the eurozone to the fight against inflation in emerging markets; from the real or threatened conflict in Korea, Thailand and Israel to the biggest environmental disaster since Chernobyl in the Gulf of Mexico, the watchword for investors today is capital preservation. Gold's time has come again.

There is a string of other reasons to expect the price of bullion to continue rising. Credit Suisse argues that gold has tended to outperform when the real, inflation-adjusted Fed Funds rate has been below 2pc, as it is now. With the principal short-term danger in the US and Europe continuing to be deflation, rates should stay low for an extended period, I believe.

In the 20 years following the 1930s financial crisis and Depression, base rates in the UK did not rise above 2pc. The OECD's call for them to rise in Britain to 3.5pc by the end of next year looks wide of the mark to me. Over in the US, the output gap is a yawning 5pc, bank credit is hard to come by and fiscal tightening is starting to kick in. Loose monetary policy will be necessary to keep the economy on an even keel.

Supply and demand is also supportive of the gold price. Over the past 10 years or so, exchange traded funds have amassed nearly 2,000 tonnes of gold as investors have looked for comfort in a world in which the value of most of their other assets is at risk of being inflated away. Despite this inflow, these funds still represent less than 1pc of total assets under management.

The same is true of government holdings of gold, which for the biggest creditor nations, China and Japan, are trivial. Credit Suisse estimates that they hold respectively just 1.6pc and 2.5pc of their foreign exchange reserves in gold compared to about two-thirds for both the US and Germany.

It would only take a small increase in Chinese and Japanese gold holdings to massively distort the supply and demand balance. Moving to the world average of 10pc of reserve holdings would demand a significant multiple of annual mine production. The gold price would rocket.

The cost of production of gold is another reason to believe that the price is well-supported. Margins for gold producers are much lower than for the miners of other industrial metals, and with forecasts of the marginal cost of production rising to $1,400 an ounce, it is hard to see much of a fall in price from today's level.

The narrow gap between the cost of production and the gold price is one reason why gold mining stocks are relatively cheaply-priced at the moment. The potential operational gearing that a rising price would exert on miners' profits means that the cheapest stocks probably represent the best way for an investor to profit from gold.

Taking a long view, gold has, broadly speaking, held its own in inflation-adjusted price terms but there have been significant cyclical swings over time. Today's price, although a nominal high, is considerably below the peak hit at the time of the late-1970s crises in real terms.

Clearly that point represented a bubble and no one should base an investment strategy on the expectation that a similar price surge would necessarily happen. But a small investment in gold would ensure that if history did repeat itself you wouldn't end up kicking yourself. That seems to be a sensible insurance policy to me.

Tom Stevenson is an investment director at Fidelity International. The views expressed are his own.