Drivers of investment demand

There are many reasons that people and institutions around the world invest in gold.  Clearly, the expectation that the rate of growth of demand for gold will outstrip that of supply provides a key investment rationale that is reinforced by the length of time that the gold market takes to clear.

However, there are many other drivers of investment demand and these share one common characteristic: each of them uses gold to provide insurance against a specific type of risk.  Growing awareness of the strategic role that gold can play in multi-asset portfolios has underpinned the increase in investment demand that has been seen over recent years.

Gold as a hedge against portfolio risk

The more concerned investors are about downside portfolio risk, the more likely it is that they will be attracted to gold.  Because returns on gold are little correlated with those on other assets, especially equities, gold offers investors an unusual opportunity to diversify into an asset that can be expected to become less correlated with equities under extreme market conditions.  The search for uncorrelated returns (and risks) is thus a key driver of investment demand. 

For more information regarding gold and uncorrelated returns >>

Gold as a hedge against dollar weakness

Because gold is negatively correlated with the dollar, investors who are bearish on the outlook for the dollar may consider it appropriate to use gold as a defence against this currency risk.  Whether this outlook is based on shorter term interest rate fluctuations or longer term concerns about structural imbalances, it is a powerful influence on investment demand for gold.

Gold and Trade-weighted $
Gold and Trade-weighted $

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Gold as an inflation hedge

Gold’s inflation hedging properties is one of the key reasons why investors buy it. Gold rallied strongly in the high inflation years of the late 1970s and early 1980s, providing investors with protection when they most needed it.

Although gold’s real value may fluctuate in the short term, it has consistently returned to its historic purchasing parity with respect to other goods and services. In 1900, the gold price was $20.67/oz, about $503/oz in today’s prices, while the actual price of gold averaged $582 in the 12 months to end-October 2006 – a very small change in the real price of gold over more than a century.

A recent study (Levin and Wright, 2006) supports the view that a one percent increase in prices (as measured by the general US price level) leads to a one percent increase in the price of gold. However, the mean reverting process in the event of a shock can be slow. The study also finds that the aftermath of a shock, it typically takes around five years to eliminate two-thirds of the deviation from the long-term relationship between gold and prices.

The value and purchasing power of paper currencies have declined over the years relative to gold, as most governments have decoupled their currencies from any real assets and many have suffered from high bouts of inflation. Gold is nobody’s liability – its value does not depend on someone’s ability to pay and it cannot be debased. Contrast gold with cash, bonds and equities and bonds whose value hangs on their issuers’ future ability to honour their obligations – and which can, in certain circumstances, become worthless.

Currencies in terms of Gold (Index 1900 = 100) Currencies in terms of Gold (Index 1900 = 100)

Gold as a hedge against geopolitical uncertainty

Gold has a long history of acting as a safe haven asset. During periods of political and economic uncertainty, investors have tended to increase their purchases of gold and gold-related instruments because of the metal’s perceived propensity to either hold its value or to increase in price when other investment assets are declining. This facet of gold’s behaviour is related to its role as a hedge against inflation; the political events that seem to be most effective in driving gold prices higher are frequently those with clear inflationary implications for the economies of the industrialised world. However, the safe haven role is sufficiently important to warrant separate consideration.

Apart from gold’s demonstrated ability to at least hold its value in terms of purchasing power, another reason for its continued popularity in troubled times lies in the fact that gold has a high value to weight ratio compared with other perceived hard assets; a significant amount of “value” can be transported (e.g. across national boundaries by refugees) with relative ease. The intrinsic properties of gold undoubtedly contribute to its role as a safe haven. “Its great strength is its indestructibility. Unlike silver, it does not tarnish and is not corroded by acid, except by a mixture of nitric and hydrochloric acid (known as Aqua Regia), and dissolves only in cyanide.” (“The World of Gold”, Timothy Green, Rosendale Press, 1993.) Sometimes there is no real rush by concerned investors to purchase gold as a safe haven, but speculators often start to buy as soon as bad news emerges in the expectation that some particular event may prompt genuine safe haven buying. The result is the same – higher gold prices at times of turmoil.

 

Research

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