Gold may Glitter but can it Deliver?

The classic “safe-haven” investment has seen a strong uptrend in its value since the autumn of 2008. Risk aversioninflation fearsfalls in the dollar and demand from the east have all been credited as drivers of this move. But just how supportive are these factors going forward — what is the risk gold could lose its lustre?

A Hedge against Inflation

The fear of inflation is heating up as on Wednesday the Bank of England suggested that “there is a good chance” inflation will hit 5% later in the year, far above the target rate of 2%. Elsewhere, on the same day, Chinese inflation figures surprised on the upside. However, is gold an adequate hedge? It can be shown graphically that it is not. Charting the inflation rate (CPI change year on year) against the gold price, we can see that over the past decade the relationship breaks down. Indeed, if the gold price kept up with increases in general price levels, it would be valued at $2,600 an ounce instead of around the $1,500 level. How about if instead of actual inflation, we look at the market’s expectation of inflation? Even in this case, the relationship does not hold. Instead, there are other factors at play. As previously discussed, investors may be more focused on the sustainability of the economic growth rate and allow for some inflation. Inflation alone may not provide sufficient support.

The Gold Price (white) vs. CPI change year-on-year (orange). Source: Bloomberg

A Beneficiary of Risk Aversion

So — could upcoming economic, fiscal or political disappointments sufficiently boost the gold price? Here the case looks stronger. From sovereign debt crises in Europe, to the tragic tsunami in Japan and the turmoil in the Middle East, there has been enough newsflow to stoke fears and flows into gold (a “whopping” $679m of capital was invested in precious metals in one week alone at the beginning of April). Furthermore, a lack of confidence in the dollar further boosted investment for those looking for a more reliable base.

Demand from the East and Central Banks

In addition to jewellery demand, central bank purchases may provide much support for gold as we move forward. Russia needs to acquire more than 1,000 tons and China 3,000 tons to have a gold reserve ratio to outstanding currency on parity with the U.S. This is even likely to be an understatement with China stating publicly they would like to acquire at least 6,000 tons and there are unofficial rumors that this may go as high as 10,000 tons.

A bubble with no clear end

George Soros described gold as the “ultimate asset bubble” and with sentiment driving the price as much as fundamentals, it’s unclear when the trend will reverse. An increasing monetary base is looking for a home. As Marcus Grubb, MD of Investment at the World Gold Council was quoted as saying at a ‘WealthBriefing’ Breakfast on Thursday: “In the next 10 minutes the world’s gold producers will mine $3m of gold, while the US prints $15m.” However, an often-overlooked drawback in investing in gold is its lack of yield. With some stock offering attractive dividend yields and investors wanting their investments to provide attractive returns during the life of their investment, capital flows may wander.

The Investment Insight

Remain wary of relying on one driver of returns; it can often be overshadowed by another. Instead build a complete picture and continuously question your base case scenario. Gold is a more complex asset than many give it credit for and as always, it pays to be well diversified.

The Ags Appeal – Commodities with upside potential leaving demand undimmed…

“If there is no struggle, there is no progress. Those who profess to favor freedom, and yet depreciate agitation, are men who want crops without plowing up the ground.” Frederick Douglass

In an environment of high correlation, where can we gain diversification benefits? And with such a significant divergence of returns within the commodities space, which ones look interesting and why? With so much focus on China, which investment opportunities have the strongest demand outlook?

Correlations High

By the end of last year the 12 month correlation between asset classes had risen to a near record high of almost 0.8 against a historic average of 0.5 (according to Goldman Sachs using data from Datastream and MSCI). Whereas the increase in speculators in the oil market led to the commodity being traded inline with other risk assets, the speculators in the agriculture space (now amounting to around 80% of the market) have continued to trade according to weather patterns.


Crude oil price (yellow), commodity index (orange) and the msci world index highly correlated, in contrast to agriculture (green). Source: Bloomberg


Attractive Supply and Demand Characteristics

In addition to the portfolio construction benefits of investing in this space, the supply and demand dynamics for certain crops are attractive. 3 years of poor yield (due to weather disruptions) has limited the supply of many. China, the focus on the demand side, has just started to import corn (2 – 3% of total consumption but the beginning of a trend) and signed a $1.8bn deal to import soya beans from the US. How strong is this demand? The USDA (United States Department of Agriculture) reported that despite increases in the price of corn, consumption will be left “undimmed”. With the EU proposing to loosen import restrictions, the case strengthens. Moreover, in addition to having a limited “shelf life”, the capacity for storeage is limited. India left a third of their food to rot last summer due to this fact.

Less Downside Risk to Demand

Finally, comparing the demand dynamic with that for certain metals highlights another key point. Keeping in mind the already high inflation figures coming out of EM (suspected to be higher than published figures in certain cases), some countries will be under pressure to reign back infrastructure spending which would dampen demand for commodities used in construction.  However, with China having 14 million new mouths to feed each year (more than twice Ireland’s population), the question is do you think the higher risk is that China will cool their economy or let any of their people starve?


In addition to price targets, pay close attention to supply, demand and correlation characteristics of individual commodities. For example, sugar is now trading with a substantially higher degree of correlation to oil and equities – implying it is now perceived as an “energy commodity” with the significance of its use in ethanol production. In contrast to passive, energy focused ETFs, actively picking commodity exposures (or investing with a manager that does so) seems a smart idea. Despite the strong rally so far, agriculture exposure remains attractive…

Commodities – Looking for diversification? Your search doesn’t end here!

Wide diversification is only required when investors do not understand what they are doing – Warren Buffett

The above quote is a key support for my view that investing in index-wide vehicles is merely an exercise in di-worse-ification. It’s time to get specific. Commodities have often been lauded as a “key diversifier” but within the last 18 to 24 months, the case has broken down. Investors using commodity ETFs to enhance the risk-adjusted return of their portfolios may be falling foul of Buffett’s quote. Here I provide a warning to those who may be taking on more risk in their portfolios than they realise…

When constructing a portfolio, diversification is a key focus. Capital is allocated across asset classes in an attempt to produce an attractive risk / return profile. The search is made for investments which post returns completely uncorrelated to other investments, thus helping reduce the volatility of the portfolio since at times when one market may be experiencing a pull-back, another may be exhibiting strong returns entirely unaffected by the input moving the first market.

Historically the commodity markets have been used as such an asset class. An essential ingredient to a well-diversified portfolio, especially one heavily invested in equities. The commodity markets were used mainly by commodity producing companies to lock-in the price for their output (by taking the other side of the trade using options) and enable management to budget adequately.

However, recently this relationship appears to have been contaminated. In speaking to George Zivic (Managing Partner of Almanac Capital) to get a better insight, he maintained that this is a structural change. The increase of investors speculating in the commodity markets has led to a higher percentage of the traders treating the instruments inline with any other risk asset.

Source: Bloomberg. The price movements of the S&P Index (white) and the S&P GSCI Commodity Index (orange), a composite index of commodity sector returns. Note the recent high correlation highlighted in blue

As you can see from the above the movements in the price of the US equity index and that of the commodity index have exhibited a heightened level of correlation.

Furthermore, as you can see from the below chart, the differential between the winning and losing commodity returns has been a great trade for an investor wishing to minimise net exposure to a highly volatile market



Source: Capital Economics. Selected Commodity Prices in 2Q10 (% Change, $ terms). Note the dispersion in returns, again highlighted in blue.


It is no longer the time to gain exposure via passive investing / ETFs etc. The smart money will be making smarter investments – DIFFERENTIATE between commodities, with their different supply / demand characteristics – again, EXPLOIT CONTAGION when some will be over-punished or over-pushed. With the majority of an “all-commodity” ETF invested in the energy markets, at least for the short term alpha generation will focus on the markets with far less visibility, less research focus and less investor attention. “Niche”-type investments in weather derivatives, agriculture etc. offer less correlated returns and greater diversification benefits.