The ‘Gold’en Era?

Gold has outperformed almost all major asset classes since the beginning of the recession in October 2007 and the subsequent financial crisis.

The precious metal has also surged by 280 per cent since the year 2000 after being in a bear market for almost 20 years. In an investment environment characterised by swift movement of money from one asset class to another, it is important to figure out if the best part of the rally for gold is over or, the best is still to come.

Discussed below are some critical factors that determine the price of the precious metal. These factors would help investors understand the possible trend for gold prices for the next decade.

The long-term trend of any fiat currency plays a crucial role in determining the price trend for gold. In general, fiat currencies share a high negative correlation with gold.

The importance of this can be understood from the fact that gold has gone up 242 per cent in dollar terms in the last decade. However, during the same period, gold has only risen by 148 per cent in terms of currencies that make up the Dollar index. Clearly, a significant part of the rally in gold has been due to Dollar weakness against other currencies and hard assets.

It is worth mentioning here that the dollar has lost over 95 per cent of its value since 1913 and, in my opinion, the dollar would continue to trend down in the next decade. If one reads through the budget and economic outlook (2010-2020) released by the CBO, the rationale for this assumption would be clear. The CBO expects cumulative budget deficits of $6 trillion during this period.

This enormous budget deficit would be funded by borrowings and debt monetisation leading to further weakness in the dollar. This would be bullish for gold prices as investors seek to park their money in assets which are still a store of value (which happens to be one of the most important functions of money). The simple logic that applies here is that the supply of gold can’t be increased at the same pace as the supply of paper money.

Therefore, paper money in general would depreciate in value against gold. Dr Marc Faber made a very important observation in one of his recent interviews. Dr Faber pointed out that around 70 per cent of today’s $7 trillion foreign reserves are with Asian Central banks. However, less then 2 per cent of reserves in Asia (including Japan) are in gold.

This has important and bullish implications for gold. Asian Central banks are increasingly looking at diversifying away from the dollar and increasing their gold holdings. The purchase of 200 tonnes of gold in 2009 by the Indian Central Bank from the IMF is a good example of the same. China has also increased its gold holdings by 76 per cent to 1,054 tonnes since 2003.

This trend of gold purchase by Asian Central Banks is expected to continue in the foreseeable future and this would be bullish for gold prices.

Geopolitical tensions are another upside trigger for gold prices as investors seek protection in real assets in times of tensions and conflict. I can say with a lot of conviction that geopolitical tensions would be high in the next decade. As China pushes for a greater say over global issues, tensions between the United States and China might escalate with time. At the same time, there is a high probability of a conflict in Iran. Tensions are also running high in the Indian sub-continent.

For those who believe that gold prices are in a bubble stage, a look at the inflation adjusted prices would provide some interesting conclusions. Gold peaked out at $850 an ounce in 1980. A dollar in 1980 had the same purchasing power as $2.6 in 2009. Therefore, adjusted for inflation, gold prices should have been $2210 in 2009. From this perspective, one can say that gold is still significantly undervalued.

However, one might argue that when gold peaked out in 1980, prices reflected irrational exuberance. Therefore I would also take gold prices at the beginning of 1990 (when prices has corrected over 50 per cent from the peak of 1980) and adjust it for inflation to get a more rational result.

Gold was trading at $399 an ounce at the beginning of 1990. When adjusted for inflation, gold prices should have been $658 currently. This means that in the last two decades, gold has gone up by only 70 per cent (inflation adjusted) considering the current prices of $1121 an ounce.

This certainly does not give any indication of a bubble. I would rather conclude that the best part of the upside is still to come with robust demand from individuals, central banks; ETF’s and even pension funds (as reported recently by the World Gold Council).

Therefore, in my opinion, gold is all set for another glittering decade and every investor’s portfolio should have some exposure to the precious metal.

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