By Marcus Grubb
NEW YORK (MarketWatch) — The recent decline in the price of gold has led some market commentators to the conclusion that gold is no longer performing the function for which it was bought: as protection against macro-economic uncertainty.
If it was, goes the argument, the price would be rising as people continue buying. This reaction is unsurprising given gold’s
strong performance since the onset of the financial crisis, with the price climbing to just shy of $2,000 an ounce last August on rising demand in response to continued volatility and the accelerating sovereign debt crisis.
Why, many are asking, is gold not responding to pronounced uncertainty now in the same way it did in 2011? It is a valid question, the answer to which can be found when one examines gold’s performance during previous crisis periods.
Marcus Grubb is the managing director of investment for the World Gold Council.
It is not uncommon for gold to have a delayed reaction to macro-economic events. As one of the few assets which holds its value during turbulent economic times, investors often sell gold in order to raise liquidity to meet actual and potential margin calls in other sectors.
Take Black Monday of October 1987, which saw markets around the world crash and billions wiped off stock prices over the course of the month. Rather than increasing in response to demand for safe haven assets, the price fell as gold was sold to generate cash and shore up accounts.
Moreover, research conducted by the World Gold Council shows that gold has a vital role to play as a protector of wealth within portfolios, not solely as a liquidity asset, a role very much in evidence during the course of October 1987. During this period, according to our research, investors would have gained or saved between $22,000 and $178,000 for every $10 million invested by holding 3% to 6% of their portfolio in gold.
Perhaps the most extreme example of gold’s delayed reaction to a crisis, and its vital role as liquidity, was during the Asian currency crisis of 1997-1998. When the Korean won became unacceptable in international currency markets, the Korean government offered to buy gold from the local populace in return for interest-bearing won-denominated bonds.
The population responded and the Korean government refined the 250 tonnes of recycling it received in the first three months of 1998, sold it into the international market to raise dollars and was thus able to service its debt.
At crucial moments during the early stages of the current financial crisis, gold has also performed this liquidity function. In the period after the collapse of both Bear Stearns in March 2008 and Lehman Brothers in September 2008, gold experienced a decline in price initially as investors sold for liquidity before emerging as the strongest asset class in the following months as the credit crunch unfolded.
We are now at the early stage in a new phase of the crisis, with gold’s historical pattern of behavior repeating itself. Gold is being sold by investors to meet margin calls and may also be being lent into the market to provide European banks with liquidity. As a result, gold is not yet reacting to the worsening euro zone news and its current behavior is much like its behavior prior to and shortly after the Lehman bankruptcy.
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Some have also expressed the view that gold’s diversification properties have been overstated.
While it is true that gold’s correlation to equities and other risk assets during the first quarter of this year was higher than average, the long-term correlation between the two is statistically insignificant. The price of gold is driven by a unique set of factors, often quite at odds with those driving other assets, particularly equities.
Gold is flat on the year but equity markets in many countries have given up all their gains, with some down by as much as 20%. Gold’s performance remains largely independent of risk asset performance.
Finally, the fundamentals which underpin gold demand remain firmly in place. From a rapidly expanding middle class in China purchasing more gold, to central bank buying and the lasting cultural affinity Indian consumers have with gold, demand remains supported by a diverse set of drivers. One should also consider that jewelry demand comprises the largest component of overall demand and, especially in India and China, is less affected by events in Europe.
No two periods are ever the same and we are currently experiencing extraordinary economic events for which there is no precedent. There is however a precedent for gold’s current behavior. A bumpy period for gold may be ahead until clarity on the future of the euro zone is established.
Once a sense of direction does materialize and margin calls have been met, history suggests that investors will return to an asset which is proven to hold its value and can be relied upon as liquidity and a protector of wealth during extreme uncertainty.
Martin Grubb is managing director of investment for the
World Gold Council
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