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The upside to investing in gold

Jordan Eliseo
3 August 2016

By Jordan Eliseo

It’s been three years since we last wrote about gold for Switzer. At the time, we outlined our bullish thesis by noting that, among other things, “gold is still severely undervalued by historical standards”.

Even though the price has risen some 30% since that article was published, we think gold continues to play a critical role in a portfolio and offers substantial upside potential going forward.

In 2016, the metal broke out above key resistance levels, and JP Morgan said that gold had ‘entered a new bull market’. World Gold Council research found that average bull-market cycles for gold last just over five years, with gains of 385%. If this bull cycle sees similar results, we can expect it to run to the end of this decade, with a price target of USD $3,000-$4,000 per ounce.

Should that happen in an environment where the AUD falls toward USD $0.60 (as many have forecast), then we could see an Australian dollar gold price north of $5,500 per ounce, a return that would likely dwarf those of traditional assets in the coming years.

Outside of the potential for large gains, gold also offers a handful of qualities to risk-conscious Australian investors trying to navigate a difficult investing environment.

The most relevant of those factors is the low cash rate, with Australian investors facing ever-declining income streams on their cash. Gold offers a solution here, as it tends to perform best when ‘real’ rates are low. Real interest rates are calculated by subtracting the annual CPI from the RBA cash rate.

Indeed, the yellow metal has recorded average annual price gains in excess of 20% in years when the ‘real’ rate of interest is 2% or lower, outperforming other assets in the process, as you can see in the table below.

Source: ABC Bullion, IRESS, Global Financial Data

If the bond market is any guide, low to negative ‘real’ rates are set to be a feature of our economic landscape for many years, enhancing the attractiveness of gold’s role in a portfolio, especially for SMSF trustees with large cash holdings.

Another factor that should attract Australian investors to gold is its performance whenever the ASX is volatile.

In our new book, Gold for Australian Investors, our study of Australian market returns (over a more than 40-year period) found that physical gold was the highest performing liquid asset in quarters where equities fell hardest. Those results can be seen in the chart below.

Source: ABC Bullion, ‘Gold for Australian Investors’, Global Financial Data.

Whilst no one wants the equity market to fall, it makes sense to have some protection if it happens. The historical data tells us that gold is the most profitable form of insurance Australian investors can include in their portfolio. The appeal of owning gold as a hedge against a volatile equity market is only enhanced when one considers current yields on traditional defensive assets.

It’s worth noting that the gold story is not all about rising Western demand from investors seeking a hedge against falling equities, or a cash alternative due to low rates. Gold is also likely to benefit in the coming years from continued buying in emerging markets, both from central banks and consumers in these regions, with demand from the latter highly correlated to rising disposable incomes.

To this day, developing market central banks still hold less than 5% of their foreign exchange reserves in gold bullion, versus a near-20% average for their advanced market counterparts (see chart below).

Source: ABC Bullion, World Gold Council, IMF

With over USD 10 trillion in negative yielding sovereign debt, gold will only become more attractive to emerging market central banks. Indeed, Ken Rogoff, ex chief economist for the IMF, stated in May 2016 that these nations should increase their pace of gold accumulation, as the metal is both “highly liquid” and “low risk” – key criterion for reserve asset managers.

By owning physical gold, investors will not simply gain exposure to a tangible, highly liquid, zero-credit risk asset that is easy to trade and store and should continue to benefit from rising emerging market demand. They’ll also be investing in an asset that has historically been:

  • The best performing asset in low ‘real’ rate environments, like the one we are in today.
  • The best performing asset when the ASX is volatile, minimising portfolio volatility.
  • The best performing asset in periods of elevated financial or geopolitical stress.

No other single asset brings all of those benefits to a portfolio. These factors, plus the significant upside potential for gold prices in the years ahead, should be highly attractive to prudent Australian investors today.

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