What you should know to invest in gold

Gold is an asset that has dazzled investors in recent times. And investors have all the reasons to be happy about owning gold. Since the end of 1978, the yellow metal has delivered nearly 620% in terms of returns. The following graph is a testimony to the good times that gold has given to people who believed in it and held it for a long time. 

Data Source: World Gold Council

Even since June 2011, the precious metal has delivered a return of nearly 6%. Obviously if you compare it to the peak yearly return of 52% that it delivered in September 2011, this return looks low. But nevertheless, there are still investors who swear by gold. And they have every reason for it. 

Reasons to buy gold 

Gold has long been considered as a natural hedge against inflation. This means that in terms of price of the essential items, gold has not lost any value over time. So if back in 1978, you could buy x number of loaves of bread with one ounce of gold, you can still buy the same x number of loaves with the same one ounce of gold. This is one of the biggest reasons why investors love gold. While inflation eats away returns on other asset classes, till now gold has managed to remain insulated from it. 

Another major reason for buying gold is its safe haven status. At a time when uncertainty and volatility have become the words of the hour, gold's ability to preserve its value becomes invaluable to investors. The crisis in the Euro zone, slowdown in US and the seesawing US dollar, all combine to help direct the flow of money to gold. Since the supply of the metal remains restricted, the higher demand can only result in prices moving northwards. True, that in recent times, gold has seen some decline in prices, but most rational investors look at it as an opportunity to invest. 

But does it mean that investing in gold comes without any risk? Not at all. Like any other investment option, gold too has an argument against it. 

Reasons to not buy gold 

The one big area of concern in investing in gold is its price. Like any other investment option, it is necessary to keep valuation in mind when it comes to putting money in gold. The prices of gold have run up quite a bit in recent times. If we look at the following 5 year price chart for gold, we can see that the prices of gold have only moved north. 

Source: World Gold Council

But prices have corrected since their peak in September 2011. Since then, the price of gold has dropped by nearly 14%. But does that mean that gold looks good to invest in? Unfortunately, there is no clear answer to this question. The reason for this is that unlike other asset classes, it is not possible to pin point a definite intrinsic value on gold. Due to its aspirational value as well as its safe haven status, gold investment is largely driven by what investors expect the price movement to be. So if they expect prices to fall in the future, they sell gold and vice versa. It is more of an individual decision. 

Another problem with investing in gold is the form in which it should be bought. Some investors prefer to own gold in its physical form but that has a problem of storage and insurance involved in it. Some prefer to invest in e-gold or gold ETFs (Exchange Traded Funds) but in that case there are transaction costs involved which could cut down the total returns. 

Most important reason to not invest in gold is its 'hedge against inflation' status. In fact this is a reason that has been cited by even the legendary Warren Buffett. Though investing in gold can help to preserve the value of the investment. But if in time, it does not cover inflation rates or help earn returns higher that inflation, then what is the point of investing in it? 

Though it has its own pros and cons, gold nevertheless has caught the fancy of nearly every investor. And particularly for Indians like us, gold will always remain an object of desire. So the next question that pops into mind is how to go about investing in gold. In the next article we will discuss the various ways in which you could invest in gold. And the pros and cons of each way.

The Taper uncertainty

At the behest, as the uncertainty concerning the debt ceiling and nomination of Fed chair seemed to wane, the tapering was due. The Fed seems to have caved into market pressure to reduce the monetary extravaganza. Tapering in a more real sense would have involved giving an end point for when they will stop increasing the balance sheet.

Currently, the consensus estimate is that the Fed will continue to reduce the size of its QE program through 2014 and ultimately wind it up by the end of the year. However, this isn't necessarily a guarantee given that a) the program is data-dependant and b) both the Fed chairmanship and the several board positions will change early next year. As a result, both the timing and extent of the QE withdrawal remains uncertain.

In its endeavor to roll back QE, the Fed needs to strike a careful economic trade off. It needs to transform the growth trajectory from being policy-induced to a more sustainable private sector investment cycle-led impetus. This requires much higher levels of business and consumer confidence and a more distinct policy framework.

The real impact

The Fed has been seeking a measure of inflation for five years now without success. Also, that economic growth has disappointed despite such aggressive stimulus suggests that monetary policy is not working very well. If the Fed were to suddenly suspend QE3, it is doubtful whether the real side of the economy mainly concerning spending, production and employment would show much impact. Beyond a point, the asset markets could start feeling the pinch of withdrawal.

True State of the Economy

At the first glance, the Fed’s decision to slow down bond-buying, starting with a $10 billion reduction in January, is a sign of confidence that the economy is starting to stand on its own two feet. But a closer look at the underlying economy indicates a very weak labor market – the most important indicator of the health of an economy.

Although, the unemployment rate has fallen from its peak of 10.0 percent in 2009 to 7 percent in 2013, this seems to be mostly because people have given up looking for work. The labour participation rate stands at 63% - a multi decade low. The employment to population ratio is just 0.4 percentage points above its low for the downturn suggesting no real improvement as suggested by the unemployment rate. It is still more than 4.0 full percentage points below pre-recession levels, corresponding to 9.5 million fewer people with jobs.

And this is not a story of retiring baby boomers. Employment among people aged 25-54 is down by 4.0 percentage points from its pre-recession level. Furthermore, the weakness of the labour market drags down large segments of the workforce as many workers find it impossible to get wage increases when the labour market is so weak. The number of people living on food stamp assistance is at record highs testifying a weak labour market.

Policy – the way forward and potential pitfalls

It remains an undisputed fact that debt levels across major economies still remain unsustainable. Central banks are making it easier to carry this debt overload by keeping interest rates at record-low levels. But lowering the financing costs is only a partial and temporary solution because the absolute condition of balance sheets matter and we should not be surprised that this is a factor weighing on consumer and business confidence. People are smart enough to know that high government debt levels mean higher taxes and/or reduced services down the road.

There is a good chance the unemployment threshold for the Fed to begin thinking about rate hikes will be lowered from 6.5% to 6% as the decline in participation rate would suggest. And that means zero rates could be with us until well beyond 2015 if the economy shows fewer signs of improvement.

Once the cash injections end for the Fed then their insistence that rates will remain low for a long period of time until the economy recovers is what is likely to keep markets under check. However, the real test is whether they will be believed by markets who determine the rate at which they will lend to the government over the longer term. When a central bank holds interest rates below their natural market level, it stands there to provide however much liquidity is required to keep the rate suppressed. QE is one form of this liquidity, and the extent to which QE is reduced must be compensated for by other means if interest rates are going to be kept at the target level.

After all, in line with Fed’s endeavor there is a growing belief that inflation will take off given the vast amounts of money infused in the economy. If so, then market participants are unlikely to lend money at a low nominal interest rate since their real return is the difference between the nominal rate and inflation down the line.

Gold – the reaction and way forward

With the Fed beginning the end of their bond buying, and inflation numbers remaining well below targets the precious metals simply have fallen out of favor with many investors. Markets have been busy running ahead speculating on their expectations not just with gold but other asset markets akin. Government bond yields, particularly for the weaker eurozone states do not reflect credit risk. Equity markets are priced on the back of zero rates as far as the eye can see. Even credit is being extended on the back of the assumption of a prolonged period of zero rates. The important point is not tapering, but a hazardous assumption of zero rates.

It’s going to be extremely complicated task of juggling market expectations to perfection. All those stashing gold, linking it just with unwinding of QE are effectively pushing a one-sided argument and ignoring the moral hazards of cheap money policy and have tended to forget the Greenspan era.

Some of the tail risks facing the global economy may have diminished, but many structural problems remain. There still exist serious imbalances and problems in many countries, including excessive private and/or public debt, the unsustainable divergence between record corporate profits and steadily declining wages, rising inequality, and mispricing of asset markets at best. It is futile to think that easy money and higher asset prices can really be a solution to current economic problems. We are in a phase of experimental central banking, which is likely to end badly due to the dislocations of capital it has caused through prolonged periods of negative rates.

The explosive growth in central bank balance sheets can result into unpleasant long-run consequences of generating high inflation and can derail financial stability. Policymakers who got us into this mess are unlikely to navigate us out of it as exit processes lack a clear road map and therefore could be indeed confusing for the current state of highly sensitive markets. The unintended consequences of such unconventional polices on asset markets would probably be felt at the time of unwinding.

Year end positioning by investors looking to book losses to offset big gains in the equity markets could add additional selling pressure on the precious metals as we move into the last trading week of 2013. Meanwhile, if the global economy is indeed trapped in a subpar growth environment then it will likely translate into central bankers getting further aggressive in building ever-greater balance sheets with ever-greater negative consequences down the road.

Investors would do well to remember that gold is one of the good portfolio diversification tool and thereby may be helping you to reduce overall portfolio risk.

Data Source: Bloomberg, World Gold Council