Gold: An Investment Outlook

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By Hareesh V

WHY INVEST IN GOLD

Historically, gold has been an important investment avenue. Apart from its traditionally known characteristic of a hedge against inflation and an asset to protect during financial distress, gold acts as an exceptional source of diversification to an individual’s investment portfolio. Gold’s peculiar nature of low correlation with other assets typically assists investors to efficiently manage risks by protecting from unexpected negative events. It also acts as a currency hedge, especially against the U.S. dollar. Studies have shown that using gold as a portfolio optimizer one can reduce portfolio volatility without compromising on expected return.

For better portfolio diversification, gold is an ideal investment. During extreme conditions, gold investment can mitigate risk in a portfolio by way of risk-adjusted returns. Though gold is considered as part commodity, part luxury and as a financial asset, its price does not always behave like commodities or at par with other assets. Additionally, the bullion market is highly liquid, globally, and most gold investments are free from credit or counter party risk. Short-medium-long-term investors, including individuals and institutions, can consider utilizing the unique characteristics of gold and achieve better returns during times of turmoil. Based on Portfolio Allocation Analysis (in reference to the seminal work of Richard and Robert Michaud), WGC (World Gold Council) suggests that an investor who holds gold in his portfolio between 2% to 10% can substantially improve the portfolio performance.

MARKET TREND

Gold had showcased an unprecedented run-up from 2004 to 2011, when the price of gold went up from $400 to $1,900 and silver from $6 to $50 an ounce. Since peaking in 2011-12, gold and silver are now trading down by 30 and 60 percent respectively.

Rising global stock markets, prospects of U.S. rate hikes and global geopolitical tensions swayed the yellow metal. In 2017, despite a superb stock market performance and rising U.S. interest rates, gold managed to gain about 13 per cent.  The benchmark London spot rates varied in a tight range of $1,158.8 to $1,357.54 an ounce throughout the period. Domestic gold prices echoed the trend as well. Even as the year 2018 unfolds, prices seem paused in the aforesaid region.

The lackluster undertone in prices for the last few years was due to overwhelming changes triggered across its key fundamentals. Prices were under pressure owing to strong U.S. dollar on account of interest rate hike by the U.S. Federal Reserve and prospects of further rate hikes.

Gold and the U.S. dollar are inversely correlated. There is a psychological tilt towards gold when the U.S. dollar depreciates. A drop in the U.S. dollar lifts the value of other countries’ currencies and steps up the demand for commodities like gold, leading to price hike. Additionally, gold is treated as an alternative investment source to store value when the U.S. dollar depreciates. The U.S. dollar has fluctuated abnormally during the last few years. The Dollar Index, an index of the value of the U.S. dollar relative to a basket of foreign currencies, started surging since July 2014 from a low of 78 to 103.8 by January 2017 and suddenly retreated to 89 recently. Such wide swings had a huge impact on the yellow metal.

The bearish stance in gold was also accentuated by demand concerns from consumers like China and India, which form the major market for the commodity. As per World Gold Council data, global gold demand in 2017 dropped by 7% to 4,072 tons compared to 4,362 tones in 2016. Total consumer demand for jewelry and technology sector has moderately gained, while investment demand has sharply dropped. Supply was down by 4% to 4,398 tons in 2017 from 4,591 tons in the previous year. Though mine production was at record levels a drop in recycling led to decline in total supply.

Traditionally, demand for gold comes from three sectors, viz., jewelry, investment, and industrial segments. Global jewelry demand recorded a growth of 4% in the previous year, the first year of growth since 2013. Lower gold prices and seasonal factors aided a recovery in demand from top consumers China and India.

Investment demand for gold in 2017 has declined by 23 percent. A moderate demand for bars and coins has been coming from China and India while inflows to the Gold-backed ETFs declined sharply. The United States recorded its biggest drop in demand during 2017 as investor attention was focused on U.S. equity market, which surged to record highs.

Demand from the technology sector saw an overall gain of 3 percent in 2017. Consumption from electronics industry especially from the wireless sector was higher while dental sector registered a decline in growth. The volume of gold used in technology increased for the first time in seven years. At the same time, central banks of various countries purchased 5 percent less gold compared to the previous year.

Mine production was fractionally higher in 2017. China continued to be the top producer albeit annual production declined by 10 percent due to tough environmental regulations, which resulted in closing down of some marginal operations in 2017.

Sanguine global economic outlook is the other reason why gold is not in the limelight nowadays. Usually, gold gets ignored during low inflation and upbeat economic sentiments. Improved global economic sentiments and soaring stock markets prompted investors to shift their focus away from gold. There was a talk earlier that, due to the spectacular performance of digital currencies, gold has been hugely affected. However, there is no evidence of mass migration from gold to any digital currency.

INDIAN SCENARIO

Gold is the second top imported commodity to the country after crude oil. India meets substantial part of its gold appetite through imports. Indian gold demand is primarily based on marriage and festive requisites. The conventional investment form in gold is as jewelry. Investment in the form of gold bar, coins and ETFs is also common among investors. The schemes like Gold Monetization Scheme and Sovereign Gold Bonds are also available for investment. Under the first scheme, an investor can deposit his physical gold and can earn an interest rate of 2.5 percent annually. In the latter scheme an investor can buy gold in paper form, which can earn a stipulated interest rate apart from the possibility of capital appreciation.

Indian gold investors had to face some challenges last year apart from the various global developments. Changing tax regime and tighter regulation around jewelry transactions has a huge bearing on bullion market as well as investors. Introduction of three per cent GST since July 2017 was another contributing factor. The government had planned to bring the jewelry industry under the PMLA umbrella in August, but later exempted it after acknowledging difficulties faced by the industry. Rising stock market also affected the investment demand in gold. Another challenge for the gold market is the higher import duty of ten percent making domestic gold costlier, attracting illegal imports. The industry players had urged the government for a duty cut to battle against the illegal import, but this is still under consideration.

Now, the government is planning to make gold an asset class, which may transform the Indian gold industry soon. In the last union budget, the Finance Minister announced that re-branding of the existing Gold Monetization Scheme and framing of policies for making gold an asset class are under consideration. Furthermore, a recent report pointed towards government’s moves to announce a new gold policy shortly in order to institutionalize and bring in more transparency in gold trades. Setting up of spot gold exchange and Gold Board, to regulate the vast domestic bullion spot market later, is also under consideration.

OUTLOOK

Looking ahead, the present choppiness in prices is likely to continue unless key fundamentals change. Nevertheless, prices are likely to display a mid-term turnaround. Policies of the U.S. Federal Reserve and its repercussion on U.S. currency, geopolitical factors, performance of stock market coupled with physical demand from China and India may sway the trend of the yellow metal. On the domestic front, Government’s policy decisions, rural demand and currency fluctuations will influence the prices as well.

With the current market fundamentals being unfavorable for gold, a wait and watch approach may make better sense. Still, buying small quantities at periodic intervals with a view of holding for a longer period would be an ingenious idea.

(Reference: World Gold Council reports)

 

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