Is Gold not a safe haven?

Sep 1, 2011

In this issue:
» Has slowdown in India finally arrived?
» Investors lose Rs 11 m per second in August
» Are subprime home loans more credible than the US economy?
» Will the US to return to gold standard after 2012?
» ...and more!

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The recent volatility in stock markets has sent investors scurrying to the safe havens. The obvious choice has been gold. And they appear to have been rewarded as the yellow metal has been smiling since the dawn of crisis. Gold prices have touched nearly US$ 1,918 an ounce last week, recording one of its best performances historically.

But all good things appeared to have come to an end when the gold prices corrected by almost US$ 120 an ounce within a week. This was a correction of almost 6% from the peak. While it questioned the safe haven status of gold, experts commented that gold prices are in a bubble territory. The recent increase in the demand for gold may lead many to believe that gold is indeed in a bubble state. As per the World Gold Council, the demand for gold has more than doubled since 2009. This demand is purely for gold coins and bars. At the same time, the demand for jewellery has actually declined by 18% since 2004. This shows that people prefer to hold on to the more liquid form of gold that they can sell on a later date. On a pure face value it may indicate that gold is in a bubble state. And whenever the bubble bursts, it would lead to a sharp fall in gold prices.

But we beg to differ from this opinion. Gold is a natural hedge against inflation. And inflation has been raging upwards. In addition to this, the tumultuous times in the world economy has led asset prices across the board to correct sharply. At times like these, it is natural for investors to turn towards gold to hedge their risks. While it is true that some part of the increase in gold price maybe based on speculation but largely it is a result of higher demand. Not to mention that even central banks and pension funds are looking to increase their gold exposures. Therefore, gold will remain a safe haven at least for as long as it takes for the world to come out of this inflationary crisis. But as Ajit Dayal, founder of Equitymaster, recently commented at a webinar, buy gold as an insurance not as an asset with a target price.

Do you think gold is still a safe haven or is it a bubble waiting to burst? Share your comments with us or post your views on our Facebook page.

 Chart of the day
The world is witnessing one of the worst recessions. But even as the developed world wrestles with the crisis, the Asian countries continue to witness spectacular growth rates. True that growth rates have cooled off to some extent, but even then growth rates north of 5% are much better than the recessionary rates seen in other countries. So it is little wonder that Asian countries are expected to add maximum number of millionaires by 2015. As per a study carried out by a noted wealth manager, Asia will add 1.66 millionaires by 2015. The growth would be led by China and India; the world's fastest growing economies.

Data source: Financial express

Is a GDP growth rate of 7.7% for India really 'disappointing' as claimed by our policymakers? Well, not if you consider the fact that it is a good 1.2% higher than India's average GDP (Gross Domestic Product) growth of 6.5% over the past decade. Also if the Reserve Bank of India (RBI) is expected to do away with the high inflation numbers, there is no surprise in the impact of high interest rates on growth. Over the past 14 months the central bank has warned about its monetary tools impacting growth prospects. With the supply side issues showing no signs of relenting there is little that the RBI can do to avert inflationary crisis. Also the targeted GDP growth in excess of 9% cannot be achieved in the absence of critical reforms and effective implementation of 5- year plans. The 11th plan period (2007-12) is not expected to end on a very congratulatory note. With such hurdles, there is little beyond India's consumption story that has been cushioning its GDP prospects. We really hope that the government goes beyond criticizing the numbers and gets down to some effective policymaking.

During the tumultuous month of August 2011, global equity markets lost close to US$ 5.7 trillion of market capitalisation. That's equivalent to over four times India's gross domestic product (GDP). Indeed, a very massive figure. Let's take a quick look at what conspired in the Indian stock markets during that same period. In August, the benchmark BSE-Sensex lost over 1,500 points. As a result, investors' wealth was eroded by almost Rs 5.6 trillion (equivalent to US$ 121 bn). This means that investors lost an average of Rs 11.3 m in every second of trade during the month. The losses would have been much higher if not for the sharp recovery during the last two trading sessions of the month. Even then, it was the biggest monthly loss since January 2011 when the stock markets had lost over Rs 7 trillion. In fact, August 2011 turned out to be the fourth month in a row to report monthly losses. The markets had also registered losses in May (Rs 1.8 trillion), June (Rs 9.2 bn) and July (Rs 1.1 trillion). The aggregate four-month loss equals almost Rs 8.5 trillion.

Securitization is the process of bundling various assets into pretty packages and selling them off to investors. Rating agencies like Standard & Poors (S&P), Moody's and Fitch helped condone this process by assigning the highest ratings to these sometimes toxic assets. But when the subprime bubble blew up, there was no market for these securities. It cost the world more than US$ 2 trillion in losses. Major writedowns were seen at most top financial firms, and billions had to be handed out in bailouts. It set off a global recession, which countries are still struggling to recover from even 3 years later.

Now, what is even more shocking is that S&P is still giving an AAA rating to securities backed by subprime home loans. S&P awarded AAA ratings to more than US$ 36 bn such securities in the US this year. Has the rating agency gone bonkers to give these assets a higher rating than what it assigns to the US government? Well, S&P defends its stance by saying that structured finance securities can deserve top grades if they're backed by enough collateral to weather a US default. However, while the US government has the ability to raise taxes, these securities have no way to earn additional revenues. While the US downgrade made sense, since it needs to go on a debt diet, assigning AAA ratings to potentially toxic securities is absurd. Either rating agencies need to change their method of working. Or investors need to completely disregard their opinions.

Gold Standard set to return in the US? This may very well be true post 2012 US Presidential elections, says Mr Steve Forbes, publisher of the famous Forbes magazine. For the uninitiated, gold standard bases the value of dollar to gold. Although gold has been used as money for thousands of years, the Gold Standard had been abandoned in the US in 1970s under the Bretton Woods system.

At present the currencies are valued in relation to each other (foreign exchange rates). All over the world, countries use the US dollar as a reserve currency to trade with each other. What this practically implies is that this gives the US Federal Reserve the liberty to print as much money as it wants. It is no brainer that more money in the system results in higher inflation, one of the major problems being faced by countries all over the world. Returning of gold standard would mean that the US would lose this liberty. It will also strengthen the US dollar and curtail the borrowing ability of the government. This is because, there is a limited supply of gold and the government cannot go on printing money recklessly. But will it actually happen?

Chinese Premier Wen Jiabao is not happy with the way the things are progressing in the world. He has warned that debt problems in Europe and the United States cannot be solved in the short term. In such a scenario, it is inevitable that China's GDP growth is likely to slow down, as lackluster global demand will negatively affect Chinese exports. To top this, the fact that inflation in China is still running high worsens the situation further. As at the end of July 2011, inflation in China stood at 6.5%, the highest level in the last three years. The Chinese government has drawn out several severe steps to arrest the rampant inflation in the second half of the year. But some of these steps would also impact the country's economic growth. China's central bank has already increased interest rates several times in recent months. As inflation continues to remain high, there is likelihood that it may yet again increase the rates for the sixth time since October 2010. However, whether that brings inflation under control or not is something that remains to be seen. But one thing is for sure, the spiraling inflation combined with the global recession is definitely eating away the dragon nation's growth in the short term.

The Indian stock markets were shut today on account of Ganesh Chaturthi. Most other Asian markets closed higher with Hong Kong leading the pack of gainers. However, markets in China closed in the red and Indonesia.

 Today's investing mantra
"Every once in a while, the market does something so stupid it takes your breath away." - Jim Cramer

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Equitymaster requests your view! Post a comment on "Is Gold not a safe haven?". Click here!

9 Responses to "Is Gold not a safe haven?"

issac thomas

Sep 25, 2011

regularly invest in 100gms of gold every month.price change is not a problem

Like (1)

Prakash C

Sep 5, 2011

who to Invest my money
i gold

Like (1)

Rajeev Ghosh

Sep 4, 2011

Yes gold is still a safe heaven because the gold is a hedge against inflation and right now the inflation demon is hitting heavily. so as long as inflation and global crisis is there it is safe to invest at least for next 6 month.but wait for a correction to enter. Think gold start side ways move technically.

Like (1)


Sep 2, 2011

Dear analysts of Equitymaster,

I think you may be missing a trick here in your understanding. Money supply is not the only variable in inflation picture. Here is an equation:


where M= money supply, V = velocity of money, i.e. how fast it moves in the economy. P = price of goods/services, Q = quantity of goods/services produced.

There has been a massive increase in money supply over the last 25+ years or so and especially since the 2007-08 crisis hit. But the velocity of money has dropped like a stone. All the activities in the shadow banking system in the developed world has drastically gone down reducing the velocity of money. When velocity falls, it is deflationary and not inflationary.
Secondly, if Q goes up, all things being equal, P will fall. Note how since 1982-83 onward money supply kept going higher, Velocity also kept going higher causing the product MV to go higher. But inflation was moderate because of a big increase in Q, the total economic output (thanks to productivity gains and the entry of countries like China into the economic world).

It is hence very simplistic to say that because money supply has gone up, inflation will necessarily go up and hence gold prices will go up. Should velocity of money increase again, and should we have supply shocks that constrain output (like can't increase food supply, can't increase oil, can't produce more copper and steel etc) and demand picks up again, we run the risk of inflation worldwide (I am not talking about emerging markets like India where inflation is a problem). The developed world faces the prospects of deflation currently. In the long run, whether we shall see inflation or deflation, the jury is still out on that. One can makes good cases for both scenarios.

The demand for gold comes from usage and investment. Gold prices wrt investment go up because others expect them to go up and hence they want to buy before others do (no different from stocks or any other asset). As far as usage is concerned, high prices eat into demand and they have dropped over the last 6-7 years. But higher prices bring in the speculators and the investors who want to get aboard the gold bus before it takes off. In times of financial system stress, like much of the developed world is facing today, speculators would want to get into gold because they expect gold prices to move higher (on account of other speculators thinking the same). And so it triggers buying that forces prices up.

Difficult to say whether gold is in a bubble or not because it does not have 'valuations' like stocks. But it has gone up 8-9 years in a row. It is already up 35% this year alone. Last time an asset went up continuously was in the 1990s, i.e. the US stock markets. We know what happened thereafter...Also note that the price of gold over the last 40 years has gone up about 60 times in USD and 130 times in rupee terms appreciating about 13% CAGR. Has inflation in India been 13% per annum since 1971? Data from RBI database suggests 'NO'. Average inflation since 1971 has been 8% or so. At 8%, gold should have been higher by about 22 times and not 130 times as it it now. (Ok, I am cheating here because in 1971, paper money got free from gold when Nixon broke the link of USD and gold, plus there always is increasing demand and also increasing supply of gold which also acts as a variable set, but you get the essence)

But I would agree with you that gold should act as a hedge against system collapse/turmoil. As an investment, it fairs poorly with risk assets like stocks or even (currently inflated) real estate. Buy gold as a hedge against a collapse of the system. If you are a speculator, watch the price.

Like (1)


Sep 2, 2011

the price of will fall generation dont want too much ornement.this increas in gold price is only for some years will cant produce any thing otherthan ornements.

Like (1)


Sep 1, 2011

Dear Sir,
MR.Ajit dayal says gold is a real money because its been getting appreciated along with the inflationary factor but not the currency, so the gold is gold, OK.,Value increase of any thing usually based on its volume and quality of its usage, of course this may linked to an extend on the requirement and demand for consumption,but actual demand for yellow metal is not for the real consumption, but for dubious attraction and the consequent mirage acquirement. The final effect of the gold accumulation will lead no where, but to the void. An individual may save on gold until people realizes that its nothing, un fortunately if a Nation also get in to this, no doubt that country also likes the status of zombies and get crunched by it self.Money by definition " Value and Unit of our Effort and Labor, that is nothing but GDP" Money can not be replaced the Gold as it never reflects our unit of GDP.

Like (1)

Valerian Menezes

Sep 1, 2011

For the present the gold seems to be a good avenue for investment, either as a real investment or as an insurance against inflation. But if you go back to the happenings of mid-Eighties of the last century when the price of gold fell overnight from USD 400 per ounce to USD 200 there is no guarantee that history may not repeat. Due caution is necessary while investing in gold.

Like (1)


Sep 1, 2011

Dear Sir,
I beg to differ with the views of Shri Ajit Dayal, for investing in gold as insurance and NOT as asset. My logic is based up on the price trend as under: [ per ten grams]

It may be true that the price appreciation trend may not be maintained or sustained at the same rate of increase, but definitely, prices will go up. Investment in gold is a must for long term.

Like (1)


Sep 1, 2011

demand & availability are two major factors for increase in price of commmodity. i dont think these two factors will be on side of gold in future say net decade.

Like (1)
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