x Abu Dhabi, UAEMonday 24 July 2017

An asset frozen in time

Is it worth its weight? Conrad de Aenlle examines whether you should be investing in gold.

Gold is a basic chemical element and perhaps the oldest portable form of wealth - the first example of walking-around money in human history. Its value does not depend on credit ratings, yield to maturity, the fine print in a profit-and-loss statement or location, location, location. But there is a deceptive complexity to gold. Investors must weigh various and often surprising factors that combine to determine its value before deciding whether to own it, and in what form.

A decent return can be elusive. That may be especially true in the UAE and other Middle Eastern countries, investment advisers warn. The performance of gold last year indicates how hard it is to figure out. The metal has a reputation, above all, for being the asset to hold when you don't know what to expect but you expect it's going to be bad. Unexpected events occurred in 2008, and just about all of them were awful. Yet a funny thing happened to the price of gold: it managed a gain of only 4.3 per cent, ending the year at just under US$870 (Dh3,196) an ounce.

"Given everything that was going on and is still going on, gold should have done more," said John Hathaway, the senior managing director of Tocqueville Asset Management. Even so, he thinks it has done more than many realise. He pointed out that last year was the eighth in a row in which the price rose, tepid though the gain might have been. And tepid stacks up pretty well against the plunging price of almost every other asset, said Jonathan Golub, who runs an investment strategy firm, Golub Market Insights.

"Instead of comparing it to its own price level, compare it to stocks or a basket of commodities or real estate," he advised. "The price of gold versus oil or corn or copper has gone up." What kept gold from performing even better was, partly, the relative strength of the dollar, market professionals say. The dollar, like gold but to a lesser degree, can be a hedge against global economic uncertainty. The need to buy dollars to repay debt as the credit bubble unwound last year also supported the currency.

Forced selling of gold futures contracts and other paper equivalents by speculators, another consequence of the grand global need to cut debt and raise cash, kept a lid on the price, too, Mr Hathaway observed. That selling helped conceal robust demand for physical gold in the form of coins, bars or exchange-traded funds that hold the metal, said Rebecca Patterson, the global head of foreign exchange and commodities for JP Morgan Private Bank.

"We are seeing a tremendous amount of interest to buy gold among clients," she remarked. "It's unlike anything I've ever seen." Some account holders go so far as to get bars with identification numbers and keep them in Morgan's vault. That ensures that the bars will be segregated from the bank's general liabilities if something goes wrong. "They're afraid of what could happen to the global financial environment," Ms Patterson said. "They see it as the safest way to guard against every bank blowing up."

A scenario that is bullish for gold and considered more likely to occur is a run of global inflation. The chief concern of investors and policy makers for the moment is deflation, a general decline in prices of investment assets and consumer goods that tends to persist and sap the life out of an economy. Deflation is bad for gold because falling prices enhance the worth of paper currencies, limiting the metal's utility as a medium of exchange. That is another reason that its price has been held in check.

Deflation is such a corrosive condition, however, that authorities will do anything in their power to prevent or eradicate it. Their actions could exact a toll on the economy later on and ignite a rally in gold. "I really believe inflation is going to rise globally," said Josephine Jimenez, the chief investment officer for Victoria 1522 Investments, a firm specialising in emerging and frontier markets.

"It's just a matter of time," she said, declaring herself "a huge fan" of gold. "Governments are going to be printing money for stimulus packages, and down the road there will be a pickup in industrial activity." Mr Hathaway envisions a similar future. "While we're in this slump, the US Federal Reserve and other central banks are going to keep creating all this money to stimulate the economy," he said. "The cure may be worse than the disease, but that's tomorrow's problem. I don't know when that will dawn on people."

When it does, he said, "gold trading steadily at US$2,500 is not unthinkable." The best play on a sustained rise in gold, even to more modest heights, is not the metal but rather mining stocks - at least in theory. Because profits only kick in once production costs have been met, every incremental increase in the price of physical gold beyond a miner's break-even point should produce a larger rise in its earnings and share price. It often fails to work out that way in practice, though, and investment advisers, even ones with a rosy outlook on the metal, counsel caution.

A comparison of the prices of gold and a popular benchmark for mining shares, the PHLX Gold and Silver Sector Index, shows how unrewarding a proxy mining stocks can be. Despite the small gain in gold last year, the index fell 28.5 per cent. The longer-term picture is hardly better. Gold rose close to 70 per cent in the three years through Dec 31, one of the best runs it has had in nearly three decades. Over the same period, the PHLX index produced a whole lot of nothing - a 3 per cent decline.

One problem with gold stocks is that they are, well, stocks. When the market is in panic mode, as it has been lately, shareholders often sell first and determine the wisdom of their move later. The selling of gold stocks can be driven by emotion, but it can make sense, too. Portfolio managers grumble that mining executives make poor decisions, hedging against price declines near a bottom when they should be most exposed or using takeovers to add mine capacity as a downturn looms.

"Return on capital is poor," Mr Hathaway said. "They've issued too much stock and made stupid acquisitions." Vahid Fathi, a commodity analyst for the research firm Morningstar, highlighted another problem confronting miners last year, one not of their own making. As gold was rallying, input costs, mainly other commodities like oil, were going up even more. "Raw material costs went up for the miners and destroyed their margins," he said. "Production costs went up to US$600 to US$700 an ounce, which is where the gold price was."

But after the collapse in the prices of industrial commodities, "the story has changed", Mr Fathi said. "With those prices down and gold holding its own, margins will expand and then you'll see investors coming back in droves into mining." He recommends three South African companies: Anglo Gold Ashanti, Gold Fields and Harmony, and such North American stalwarts as Barrick and Newmont Mining. Mr Hathaway may not think the best of mine officials, but he, too, finds Gold Fields, Barrick and Newmont worth owning given his positive outlook on the physical metal. Other selections include Goldcorp in Canada and Centamin, a London-listed company with operations in Egypt.

Ms Jimenez said that her "natural inclination is to invest in shares" to build exposure to gold. Her favourites include Harmony, Zijin Mining in China and the Russian producer Polyus. Whatever the outlook for these or any mining shares, they still may be the wrong play for investors eager to own gold as a hedge against social or economic chaos. As one portfolio manager put it, "if we have Armageddon, who are you going to sell your gold stocks to?"

For those who fear the worst, owning gold in its pure metallic form - less walking-around money and more getting-out-of-town money - makes more sense. The volatility of the Middle East suggests that owning gold is especially sensible here, but other factors argue against it. Mr Hathaway noted that there is an active retail gold market in Dubai and that supply shortages can send prices above the global market price, occasionally well above it.

"There was a very scary period last year when people didn't trust anything and were willing to pay enormous premiums," he recalled. "I would never buy retail at a time like that, that goes without saying." Mr Golub offered another reason for Middle East investors to avoid gold. Although last year was an exception, gold is likely to move in the same direction as other markets vital to the region's economic health.

"We generally think of gold as the alternative, a hedge," he explained. "Think about what they're hedging against." The region is "a commodity-based economy, and the link between gold and oil is extremely high". Mr Golub and other professionals, even those with extremely positive views on the metal over the short or medium term, contend that there is little cause for investors in any corner of the world to own gold except as a hedge against declines in the values of other assets. That is because gold, almost uniquely among major assets, has no intrinsic value of its own.

There are numerous influences on the price, but because gold pays no income, produces no profit, and no rent can be collected on it, they are all subjective. If the metal is not a hedge against something, it is an object of pure speculation. "Gold doesn't generate any cash flow, so therefore you need to have a larger hurdle to buy gold over bonds or stocks or something else," Mr Golub said. "All else being equal, don't buy it."

Mr Hathaway is similarly sceptical about gold over the long haul. His outlook for inflation persuades him to recommend the metal now, but he acknowledges that it thrives in few other backdrops. "I don't think gold belongs in a portfolio unless there is a driving macroeconomic reason for it," he advised. "From 1980 to 1999, there was no reason in the world to own gold." Ms Patterson, at JP Morgan, is less dismissive. She believes that gold can add value by helping to smooth out returns in a portfolio.

"Long term I believe gold is a good thing to have," she said. "There will be periods when the correlations between gold and other assets are positive, but those are exceptions." She pointed out, however, that typically it is the other assets that are rising in value and gold that is falling, so its role generally should be a supporting one. Gold is the right investment for a certain variety of hard times, but despite recent evidence to the contrary, times are usually easy.

"Would I buy gold here if I thought the world was about to blow up?" Ms Patterson asked. "Sure, but I don't think it will." Conrad de Aenlle, who is based in Los Angeles, has covered business and investment topics for nearly 20 years