Gold Rush

New Star's Mark Harris gives his outlook for gold: Global demand for gold reached new heights in the second quarter of 2008, rising 9% year-on-year to $21.2 billion according to figures from the World Gold Council. Investment demand also surged strongly, reaching $3.5 billion over the same period, 29% higher than in the equivalent period in 2007, with particularly strong demand from the US, China, Egypt and Vietnam. The gold price has retreated from its high of the summer but remains popular with investors seeking diversification.

Gold is a traditional safe haven because its price tends to be resilient during times of uncertainty. Its dual status both as a commodity and a monetary asset is part of its appeal. Given the sectoral and geographic diversity of its demand, price changes in the precious metal are relatively insulated from Western economic cycles while recent volatility has highlighted the advantages of its tangibility, especially since the financial turmoil stemmed from the credit market. There is no credit or default risk associated with gold and, whatever else happens, an investor in gold is left with a physical asset rather than a piece of paper. It is this stability and lack of correlation with other asset classes that has led to the increasing popularity of gold as a portfolio diversifier, both for institutional and retail investors.

ETFs are the popular choice

In terms of investment in gold, exchange-traded funds (ETFs) have been the main beneficiary in the flight to safety. According to the World Gold Council, ETFs enjoyed their strongest quarterly inflow in the third quarter of this year since the first gold ETF - SPDR®Gold shares - was launched in November 2004. ETFs are shares that track the gold price and can be traded daily. They are an increasingly popular way to invest in gold because they offer direct investment in the gold bullion market without requiring physical delivery. The New Star fund of funds team has invested in the Lyxor Gold Bullion Securities (GBS). Each GBS share represents one tenth of an ounce of gold and is backed by bullion held in vaults.

Jewellery remains a crucial component of gold demand, representing about three quarters of global demand for the precious metal. The biggest jewellery markets are in emerging Asia and the Middle East but India is the largest participant. Gold is an intrinsic part of the culture in the country, forming part of the dowry at weddings and commonly given during religious events. China is another large force in the jewellery market, with its growing middle classes increasingly choosing to spend some of their disposable income on gold.

As testament to the current appetite for physical assets, over recent months dealers globally reportedly ran out of popular coins such as South Africa's Krugerrands while the US Mint temporarily suspended sales of American Buffalo gold one ounce coins after its stocks were depleted. Bullion coins have the added benefit of being exempt from VAT for private investors in the European Union.

Supply is tight

Supply in the gold industry remains constrained. Mine production declined by 4% year-on-year in the second quarter to 590 tonnes, bringing output in the first half of the year to 1,133 tonnes, 6% below the same period in 2007. Central bank sales of gold also slowed dramatically. Signatories to the Central Bank Gold Agreement (CBGA) sold the lowest amount of gold in the year to 26 September 2008 since the CBGA was established in 1999.

That said, the price of gold has tumbled over recent months, finishing September at $877.60 after having hit a peak of $1,010.60 an ounce in March this year. Gold price volatility has also picked up sharply. Nevertheless, the gold price remains less volatile than most other commodities as well as the major stockmarket indices.

While there may be further short-term setbacks, gold remains attractive with investors because it is potentially valuable in either a scenario of inflation or deflation since it is a globally accepted store of value. The recent oil price fall has dampened short-term inflationary pressures although inflation remains above target in many developed countries and in double figures for a large proportion of emerging markets. The world largely relies on fiat money and the confidence placed in this money. With national debts expected to climb and banks widely distrusted as a result of the unprecedented government bailouts to ease the banking crisis, the paper promises of central banks and government bonds are that bit less solid than they seemed a year ago. This should work in gold's favour over the coming years. Industry officials at the annual London Bullion Market Association meeting in Kyoto recently forecast bullion prices of about $958.60 an ounce by November next year.

Why are gold shares so cheap?

Mining shares are another way to protect against money creation and currency debasement. Gold mining stocks had been boosted by speculative money but have fallen recently as investors fear a recession will lead to reduced demand. The share prices of gold miners have retreated considerably and do not reflect the fact that the gold price is significantly higher than a couple of years ago. We may, therefore, see some strong moves in these companies as they start to reflect the translated benefit of the strong gold price over the past year. The long-term outlook remains favourable, with both jewellery and investment demand likely to remain strong while gold mine output remains constrained. This is positive for gold prices in the long term.

Some of the New Star fund of funds portfolios hold the BlackRock Gold & General Fund, which invests in the shares of gold mining companies as well as shares related to gold and precious metals. At 30 September, 70% of the BlackRock fund was invested in the gold sector.

Funds that invest in the shares of gold mining companies tend to be more volatile than those investing in pure gold bullion because the share prices of mining companies, by their nature, tend to fluctuate more aggressively.

One of the most reliable indicators of the value within precious metals companies is the Gold/XAU ratio. This ratio is calculated by dividing the price of the Philadelphia Gold & Silver Index (XAU) into the current gold price and plots the relative strength of gold companies' shares versus the metal. Historically, when the ratio has been greater than 5.0 the XAU has delivered annualised gains of 89.6% on average. When the ratio has been 4.0, the XAU has made average annualised gains of 27.4% while when the ratio has been less than 3.0 (where gold shares are high relative to the physical precious metal) the XAU has declined at an average annualised rate of 36.6%.

According to Dr John Hussman, a former University of Michigan professor who has made a detailed study of the ratio, the risk/return profile for precious metals shares tends to be more positive if the economy is weak. For example, when the Gold/XAU ratio has been greater than 5.0 and the ISM Purchasing Managers Index (PMI) has been less than 50 (indicating a contracting US manufacturing sector) gold companies' shares have risen at an average annualised rate of 125.6%. In contrast, when the Gold/XAU ratio has been less than 3.0 and the Purchasing Managers Index has been greater than 50, these companies' share prices have fallen at an average annualised rate of 49.9%.

Time to buy?

In late October, the Gold/XAU ratio rose to more than 10 while the latest PMI is 43.5%. Dr. Hussman's study would suggest, therefore, that this is an excellent time to buy miners' shares.

Nevertheless, while gold shares are historically cheap relative to the physical metal, the record peak may also prompt a degree of caution. The process of global deleveraging may be affecting many previously reliable ratio signals, so it is important to monitor the activity of the constituent instruments.

Many investors have retreated from mining stocks due to concerns about a slowdown in emerging markets' growth and the potential effects of inflation on consumer spending, particularly in China, the world's fourth largest gold producer. Any slowdown in growth would be from a high base, however, and many emerging market economies continue to enjoy healthy growth on a relative basis. China's gross domestic product growth was at 10% in the second quarter, according to the International Monetary Fund, significantly higher than the 3.9% forecast for global economic growth.

The New Star fund of funds team believes that the recent underperformance of gold stocks represents a necessary correction following a lengthy commodities bull run. It anticipates higher levels over the coming months and expects to increase its holdings in the sector to benefit from these moves. Overall, stockmarkets are likely to remain highly volatile, perhaps even retesting lows in the short term. In such circumstances, gold should remain a useful portfolio diversifier.