May 17, 2013, 12.46 PM IST
There is one asset class, which we Indians particularly love and also believe they understand it – is Gold. Besides the traditional options like buying physical gold, there are a plethora of new options available like the National Spot Exchange, Gold ETFs and also Gold Fund of Funds. Read this space to understand the gold as investment.
Investments, although very difficult for most of us to theoretically understand, practically apply and emotionally stick to as to what asset allocation should we follow (stocks, bonds, real estate, commodities etc) or what time frame to adhere to and what are the risks attached to it; but there is one thing which most of us, particularly Indians, love and also believe they understand it is Gold. A common person may not understand the benefits of investing in stocks for long term wealth creation or bonds to enhance the purchasing power in a deflationary environment or hoard cash to preserve capital in an uncertain economic world but the same person might easily understand and believe that he knows the value of Gold.
Besides the traditional options like purchasing jewelry or investing in gold bars and coins, there are a plethora of new options available like the National Spot Exchange, Gold ETFs and also Gold Fund of Funds. Although, many local investors shunned equity funds over the past couple of years but their investments in gold funds and ETFs multiplied in direct proportion to the increase in gold prices. And why not, gold bulls made a killing over the past decade with gold prices multiplying more than 7 times in 11 years from Rs.4300/10 gm in the year 2001 to Rs.31799/10 gm by the year 2012. However, the recent unprecedented crash in gold prices by a near 20% in few days have left the most convinced gold bulls also to question themselves is gold really a good investment option, what determines the true value of gold and what is the future of gold prices. Let us attempt to answer this intriguing but tricky questions.
What do we mean by an investment asset - it would mean an asset which puts money in our pockets by generating income. For example, a bond gives interest, equities give dividends, house gives rent etc. But, what cash flow does Gold give - probably nothing. Therefore, gold cannot be termed as an investment asset but merely a “speculative item” because the person buying gold is “speculating that the price of the gold will rise in future and he will be able to sell it at a higher profit to realize gains - there is simply no interim income from it”.
Most assets have some use like steel is used in construction and auto industry, oil in running autos and factories, power in running machines, copper in making wires etc but what is the industrial use of Gold. Besides making “golden tooth”, the industrial use of Gold is practically nothing. Then what is the value of Gold why is it so costly. Its value is high because Governments and Central Banks (led by the US Fed) are running their money printing machines continuously, relentlessly and at a brisk speed. The US Dollar has lost 97% of its value against Gold over the past 40 years! Hence, its not Gold which has gone up but it’s the US Dollar which has gone down because of the indiscriminate money printing by the US Fed.
Now, has Gold risen consistently over the past few decades. No, not at all. International gold prices crashed from US$850 per ounce in 1981 to US$250 per ounce in 2001, negative return over a long 20-year period. However, the “rupee value” of gold was up during the same period simply, because the Indian Rupee which was Rs.8 per US Dollar in the year 1981 crashed to Rs.45 by the year 2001. Hence, because the Indian currency lost significant value against the US Dollar, that’s why Indian gold prices in rupee terms went up while actual international gold prices in US Dollar crashed during the same period. And has Gold given great returns over a long term 20-year period. No. Indian Gold prices are up by 8.9% CAGR over the last 20-years while the BSE Sensex has given returns of 15.3% CAGR over the same period. Infact, over the past 20- years Bank FD might have given better returns than Gold.
Lot of the so called financial experts will educate you that Gold is a hedge against inflation. However, that may not necessarily be the case. Its not directly related to inflation but to “real interest rates” of US Dollar denominated assets like US Treasuries. When the real interest rates is down and close to inflation gold is likely to appreciate in value because to hold Gold (which does not give any cash flow), the investor has to forego interest on his investments and hence real interest rates have to be low or negative so as to induce the investor to hold onto something which does not give any real cash flow. Exhibit I brings out the last 30-year history of US real interest rates, gold prices and US stock markets. It clearly brings out the fact that Gold performs well when real interest rates are very low to negative and vice versa.
Exhibit I: The Time when Gold rises in Value
Source: US Federal Reserve, * Excluding Dividends
To sum up, the following factors determine the value of Indian Gold:
1) Value of the US Dollar: Since Gold is internationally quoted in US Dollar, the weaker the US Dollar, the higher the price of Gold and vice versa.
2) Real Interest Rates in US Dollar denominated assets: Low or negative real interest rates results in higher Gold prices and vice versa.
3) Indian rupee vis-a-vis US Dollar: Since, Indians buy Gold in Indian rupees, the weaker the Indian rupees against the US Dollar, the higher will be the price of Gold and vice versa.
Future prices of Gold
Till the US Fed continues to print money the US Dollar will remain weak, till there is uncertainty in the global economy the money printing will continue, till the US Dollar remains weak some shift from Asian Central Banks like China, India etc will happen from US Dollar denominated securities to hard asset like Gold, till there is uncertainty around people will move to the so called safe heaven of Gold, till the Indian rupee remains structurally weak against the US Dollar over the long term, Indian Gold prices would be supported in rupee terms and till the woman in India keep loving Gold ornaments there would be demand for Gold which otherwise hardly has any real industrial use. So, the next time you invest in Gold or Gold fund or ETF, weigh all these factors before doing it and remember that Gold is not an income e producing investment asset but merely a speculative item whose price may go up or down depending on the conditions which determine its value.
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