The Hindu Business Line : What gives gold its glitter

A look at the factors that drive the yellow metal in the global markets, and what investors need to track if they want the sheen of the precious metal to rub off onto them.

C. Rajalakshmi

To investors, gold is more than just a symbol of purity, royalty and prestige. Gold is also increasingly being sought after as an investment avenue. Investing in gold is an ideal way of protecting one’s wealth against erosion in purchasing power of money under inflationary conditions.

Over the years, gold has also shown a negative correlation with the other widely preferred asset classes such as stocks and bonds. This is because the fundamental factors that impact the other asset classes don’t significantly affect gold.

Indian investors, for whom gold is a new investment option, need an understanding of the demand and supply side factors that impact prices in order to gauge its return potential. This apart, keeping track of global economic events, the rupee dollar exchange rate and trends in crude oil prices are also becoming increasingly important as all these can impact returns on gold.

‘Gold fix’

Historically, gold has been the asset that has commonly backed the currencies of various countries. Though both spot and futures contracts in gold are widely traded across various global commodity exchanges, the London “Gold Fix” is the most commonly followed benchmark for gold prices. The Gold Fix is the procedure by which the London bullion market fixes the price of gold and this is used as a benchmark for pricing the majority of gold products and gold derivatives across world markets.

Gold : Supply side factors

One unique facet of gold as a commodity is that its existing stock with the world’s central banks has a key bearing on its supply. Central banks across the world procure and stock gold as a part of their reserves to bail them out at difficult times. The view that central banks across the world take on the direction of gold prices, and the expected liquidation of gold inventories by them, is an important influence on prices. Large gold sales by central banks can lead to a spike in gold supply and weigh on prices. Another facet of gold is that it also acts as an alternative to the US dollar in the reserves held by central banks. Fears about a sustained decline in the value of the dollar can thus prompt central banks to lean towards gold as an investment option. This is one key reason for the inverse relationship between the US dollar and gold prices. The latter tends to rise when the former depreciates.

Gold mining companies, another key source of gold supplies also base their production decisions on price trends. An extended period of low gold prices may make it unviable for miners to make investments in their operations. Sustained increases in gold prices may lead to a re-opening of mines and higher supplies into the gold market.

As in the case of other commodities, the balance between supply and demand is a key influence on the price of gold. At present, the demand side fundamentals do look strong with year-on-year demand for gold rising by 30 per cent to $20.7 billion in the third quarter of 2007 (Source: World Gold Council). Investment demand, rather than jewellery demand for gold has been the key driver of this. Recent years have seen increased investment in gold exchange traded funds, which invest in physical gold. India is the world’s largest gold jewellery market and thus Indian demand for gold is a key fundamental factor affecting gold.

US Market & Dollar Value

Fundamentals apart, investors need to keep watch on other key macro factors that have an impact on gold prices- trends in the US dollar, crude oil prices and global economic or political events.

One feature that makes gold attractive as a safe haven asset is that it is a hedge against an erosion in the value of currency, particularly the US dollar. In recent months, fears of sub-prime issues hurting the US economy have weakened the dollar, indirectly contributing to increasing global gold prices. Any negative news about the US economy, such as slowdown in consumption, rise in inflation, or a cut in interest rates by the Federal Reserve, that weakens the dollar could strengthen gold prices.

However, Indian investors in gold need to remember that returns on gold prices in rupee terms may be quite different from those in dollar terms. In dollar terms, gold has given a return of 19.5 per cent this year.

But with the rupee appreciating by 10.9 per cent, domestic gold prices have gained only 6.6 per cent. It may make sense for Indian investors, seeking to replicate global returns on gold, to invest in Exchange Traded Funds that track global gold prices.

Crude fires gold too

If currency movements impact gold, another key influence on gold prices comes from crude oil prices. Inflationary conditions in crude oil markets, which stoke uncertainty, have inevitably sparked a rally in global gold prices. The oil crisis of 1980 was the previous occasion when gold flared to all- time highs. In 1980, crude oil prices rose by 120 per cent, and this pulled gold prices up by 99.74 per cent, too. Other factors influencing crude oil prices are accidents, bad weather, transport disruptions from producers, labour disputes as well as other disruptions to production, including war and natural disasters. Therefore, if, as an investor, you are worried about a brewing energy crisis, you should be adding gold to your portfolio.

Equity market turbulence

Volatile financial markets also appear to be good for gold as an investment. As gold is seen as a safe haven asset, any turmoil in the equity or bond markets sparked by fears of an economic slowdown, downturn in an industry or political disturbance, can drive investors to gold. Since mid-August this year, when sub-prime woes in the US first raised fears of a global credit crunch, global gold prices have appreciated by almost 21.4 per cent.

But this inverse relationship between the financial markets and gold may not necessarily hold good for Indian investors, as our gold requirements are almost completely imported. A plunge in the domestic equity market because of political turmoil may not impact gold prices, as domestic gold prices are largely a function of global trends. All this may suggest that investing in gold is no less complicated than investing in the stock markets.

You may have to research fundamentals, keep track of economic and macro factors as well as global events to time your investments in gold to a nicety. But allocating 5-10 per cent of your portfolio to gold is relatively simple and you can do this to provide a “safety net” to your equity portfolio.

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