What lies ahead?

I recently got a SMS that said, "What does the future hold for you? SMS your zodiac sign to know what lies ahead..." Isn`t it interesting how horoscopes, tarot cards and crystal ball gazing instantly grab your attention? Well, it`s all about knowing what the future has in store. And, nothing wrong with that, because it only helps you better plan your present.

Now, I can do a little future-telling too! Only that, my predictions (if I may call them so) are based on analysis of a trend and understanding global aspects that could impact that trend. And, of course, the only topic that I can play soothsayer for is - Gold!

"Coming events cast their shadows before..." - Thomas Campbell

Now, you must have noticed how over the last decade, gold prices have gradually moved beyond the $1500 per ounce mark. So, it`s quite evident that the concept of owning gold is steadily gaining ground.

The table below gives you a look at the growth in the price of gold over the years. For the ease of comparison, we have shown the growth as per various currencies.

Gold`s performance over the decade

Data Source:Bloomberg
Compiled By:Quantum AMC

Impressive numbers, wouldn`t you agree? But let`s dig a little deeper to see what has really fuelled this growth.
Now, global markets have struggled with uncertainty due to various reasons. To gain a little temporary control over the situation, central banks of developed nations have started printing paper money. Unfortunately, this initiative has only postponed the issues plaguing the economy, and has caused a wave like pattern across the globe. Nations continue to pump more money into their economy - the European Union (EU) has been pumping more cash to bail out its EU members, Japan is expanding its money supply in an effort to avert deflationary pressures and now, to weed out of the natural disaster that struck them. These countries stay blissfully oblivious to the fact that they are participating in a currency devaluation race! Who will eventually make it first to the finish line still remains to be seen.

And, everyone knows for a fact that the only supply constraint currency that remains is - Gold!

So, all in all, a mix of macroeconomic factors, including, a slow economy, low opportunity costs, negative real yields, wealth preservation, and central bank buying - have buoyed gold prices and are likely to continue supporting gold going ahead.

Gold and Inflation

You read, hear, discuss and crib about this everyday - Inflation, the omnipresent bane of the end consumer today! So, when you consider investing, give some thought to the "real interest rate" of your asset. Real Interest Rate is the rate of interest you expect to receive after subtracting inflation.

And how does Gold fare in comparison with Real Interest Rates? Let`s take a look...

When the US Federal Reserve System (Fed) embarked on an easy monetary policy to bail out speculators and the so called "too big to fail" highly levered financial institutions, it lowered the cost of funds and forced the benchmark interest rates to drop to near zero levels. Though this move was supposed to repair balance sheets and control any increase in borrowing costs, it actually led to real interest rates falling too low to offer realistic returns for bond investors. A jeopardy of sorts for the Fed! Because, if it continues to control nominal rates under headline inflation levels, then real rates will continue to remain negative.

Take a look at the chart below: Gold as compared to the Real Interest Rates!

You should be able to note that even though gold doesn`t pay a yield, it is able to pace inflation. And hence is a much better investment than bonds which lag behind inflation.

Chart: Real Interest rates and Gold
Source: Bloomberg

Thus, it`s not altogether surprising to see an increasing number of investors shifting to gold in times of monetary inflation.

Also, "Quantitative Easing", Fed Chairman Ben Bernanke`s answer to the collapse of the bond market in 2008, has only created inflationary prospects over the long term and increased the possibility for asset bubbles to appear in the economy. Instead of helping in recovery, increased liquidity on account of money pumping by central banks is feeding into asset prices. In an environment of increasing uncertainty, one would prefer holding on to a real asset like gold. Thus, it`s not surprising to see investment demand for gold increase significantly.

Here`s a glimpse of the Money growth and inflation scenario in the US:

Do you own Gold?

If you do, that`s good! But not everyone has gold to their name. Despite all the hype that surrounds gold`s prices rising because of significant buying; the fact still remains that it is considerably under-owned.

But the future looks brighter, when gold will be in the spotlight. This commodity will gain faith because of investors losing faith in paper currencies. Also, gold is more sought after because of its ability to preserve purchasing power and avoid wealth destruction.

The Fundamentals

The demand for gold as an investment asset has been highly robust since people are slowly losing confidence in the government`s ability to undertake rightful measures to support the economy and its currencies. This fact apart, gold has always witnessed a continuous price increase because of the strong demands from traditional buyers.

According to a report published by the World Gold Council, India`s gold consumption numbers for 2010 have been at record levels pegged at 960 tonnes. This indicates that buyers have adjusted to prices and that`s mainly supported by expectations of higher prices in the future and this demand for gold is likely to maintain its current levels.

The Chinese demand for the metal has also increased dramatically over the years. There have always been indications on the Chinese potential for gold consumption and their sudden appetite for gold has taken many by surprise. With liberalization of the gold market and the Chinese government encouraging gold consumption, Chinese demand will only increase from here on.

Demand from central banks like Russia and China can be expected to continue, given its low allocations to gold as they move away from the dollar. Central banks of Mexico recently purchased 93 tons of gold amounting to more than $4 bn in value. We are increasingly seeing central banks add gold to their reserves in order to diversify away from the falling dollar.

On the supply side, mining saw some positives. Even with increase in mine supply, demand for gold has largely exceeded its supply, thereby lending support to prices. Going ahead, demand would ideally continue to outpace supply at least over the next few years as investors continue to increasingly allocate to gold.

Headwinds - can Gold prices be corrected?

Well, actually - Yes!

We recently saw a correction in gold of about $100 in a week`s time. It was more of a speculative sell off then anything to do with a fundamental change. Gold fell by almost -7.3% as compared to the much talked about asset silver, which fell by -33.5%. We would suggest that investors should consider owning the asset by looking at the importance of the asset in the portfolio and the exposures it provides and whether sharp rallies are supported by fundamentals or not.

We can see such corrections again as well which can even be much bigger. Once the speculative sell offs begin, stop losses start hitting and positions start to unwind exacerbating the declines. Let us look at reasons as to what triggers could generate the speculative sell offs.

High gold prices seen over the past few years were mainly due to the debt woes in the European region and Quantitative Easing measures adopted by the US. However, over a period of time, the Fed would be forced to pause further money creation to accommodate inflationary pressures. And this increase in rates may provide speculators enough influence to lower gold prices.

There is a common belief that a growing economy would create a dent in the demand for gold as an alternative, and investors would start dumping gold and moving to bonds as interest rates would increase. However, currently, negative real rates are one of the main drivers of gold. The current policies are not poised to increase rates so much that they are transformed to positive. With the growth in the economy, inflationary aspects would be seen at large. It is probable that short term sentiment could be impacted (as and when it happens) leading to a correction in gold prices. These times would in fact, be good opportunities to buy gold.

You just can`t ignore these indicators!

Here`s why we think Gold is trending upwards:

When a central bank increases their money supply, the price of other currencies rises. Since gold is a currency itself, it too adjusts to such changes in global monetary conditions. Thus gold is rightly increasing in nominal value, as it is the only currency whose supply is highly constrained.

Long-term trends in gold prices are driven by changes in the overall level of confidence in the monetary system and the economy. Therefore, to analyse gold over the long term, it needs to be seen as a monetary asset rather than a commodity. Given the current economic backdrop, where governments are struggling with problems like rising deficits and unsustainable debts, it is indeed logical for gold prices to increase in value. With policy makers continuously debasing currencies, gold will be viewed as a safe haven investment, lending some solace to the chaos.

The macro-economic and supply-demand drivers point to a continued increase in gold prices.

Demand from consumption centers like India and China seems to be on a firm footing.

Investment demand has been robust and would continue to grow, lending support to gold prices.

If you worry about whether gold is moving towards a bubble stage, then consider the fact that relatively high gold prices seen recently are strongly supported by fundamental factors. Currency debasement, rising inflationary fears and diversification of reserves to gold are broad themes that would drive gold prices. Gold as a percentage of total investments is still very miniscule. Even a small shift to gold can lead to large price increases. Institutional investors like pension funds have started considering gold allocations more seriously. If concerns surrounding Quantitative Easing, monetization and European sovereign debt defaults trigger another broadly based loss of risk appetite, investors would no doubt want to increase their gold holdings.

The uncertain macroeconomic environment and looming inflationary threat over a long term reiterates the need for gold in one`s portfolio. Make a strategic allocation to gold because it`s the counterweight to paper money which is continuing to lose credibility as a store of value.

The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.