To hold Gold or not to hold Gold

‘Gold will be around, gold will be money when the dollar and the euro and the yuan and the ringgit are mere memories.’

Richard Russell

"To Gold or not to Gold, that is the question" (with apologies to William Shakespeare)

As financial markets weather the current bout of volatility an asset class that is much debated from time to time has become quite a favorite in recent times. Bullion has recorded a lifetime high, and it appears set for a significant run given the uncertainty in financial markets. Should investors allocate a portion of their portfolio to this asset?

Asset Allocation:

Many times, certain assets gain significantly and sustainably to catch the attention of investors and over time become eligible for consideration in global portfolios as well. Emerging market equities in the 90’s and more recently cryptocurrencies come to mind. However, should an asset be considered purely based on its appreciation over a period or should there be a more fundamental reason for their inclusion.

In this sense, bullion has always been in the consideration set of global investors since times immemorial. In history, gold has been the motivation that moved capital across nations and became a measure of success and wealth of a nation. Higher the gold reserves of any country during colonial times higher was the respect it commanded in these times. Wealth and its definition over time has of course changed. As the world became more industrialized, physical assets as a measure of wealth and prestige, gave way to assessment of wealth in means of industrial production.

Wealth increasingly was regarded as the ability of a nation to produce goods and services that demonstrated its preeminence. Cheaper and more efficient means of production became arbiters of determining the wealth of nations. Colonial powers that were rich in dominion over land and gold ceded to nations that excelled in means of such mass production and delivery of services. The US, Japan and more recently China emerged as leading nations in this category. More recently the focus has shifted from merely industrial production to high end services and high value technology products leading to a change in the world order yet again.

Gold over this time moved away from being a measure of wealth to an asset of choice for investors who regard it as a defensive asset. In the past whenever there were capital market disruptions that led to weakness in financial assets, gold emerged as a store of value amid such global uncertainties. However, these instances were rare and such conditions existed for a relatively short period of time. As a result, gold prices over a considerable period remained stable and appreciation in its value was regarded sub-par compared to financial assets.

Valuation of financial assets follow a set pattern. Usually, the most accepted format that most investors follow is that the value of such assets are the sum of future expected cash flows, discounted for a certain rate. While this is not a defining measure of value for any financial asset at any time, the components of the metric are logical and critical aspects such as cash flow and a reasonable return expectation is set.

‘We have gold because we cannot trust government.’

Herbert Hoover

Gold has no cash flows

How does one value gold?

Unlike the above method to ascertain a rough estimate of absolute and relative value for financial assets, gold, which does not generate intervening cash flows is difficult to model. The valuation is therefore purely left to the market forces at any time. That means demand versus the supply available for any level of standard purity freely traded in markets determines the price. One may have a price offered and bid, but what is the value? This debate can never be resolved in the manner financial assets can be assessed for value. All commodities also have similar characteristics however demand for global commodities is driven by global industrial factors and the supply dynamics.

For starters Gold has very limited new supply. Gold mining is progressively done at much higher cost than historically and the large reserves once available across the gold mining reserves of the world are declining. Purity and availability of high-quality ore is declining. In other words, there is not much supply available. This makes for interesting supply-demand dynamics if demand were to fly off from here.

But the debate remains – what does an investor in gold get? Only the possibility that demand for this shiny metal increases in the future, and hence its price. Pretty thin logic and one that is always susceptible to buoyant capital and stable currency markets.

So, should one hold gold?

At best, holding gold for higher return expectation may be purely speculative. For investors who regard the current bout of uncertainty in the financial markets to remain a feature for an extended period may be forgiven for thinking that demand for this measure of “store of value” may remain robust and as a result, prices. This may provide added security in the face of volatile financial and currency markets, especially about the possibility of a weak USD.

Indian investors have been loyal to this asset for other emotional reasons and so have the Chinese to some extent. Demand locally though famously thought of to have tapered off recently has surged back again and we can expect the same to retain in the future

However, in the overall sense gold could, at best, be some insurance in the portfolio against steep corrections in the financial markets but clearly no replacement for equities or fixed income instruments as mainstay of wealth allocation.