Gold does not fear a furnace

This old Chinese proverb comes to mind as the price of gold hit a record high of US$1.241 in mid-May 2010, with global currencies under pressure in the Eurozone debt crisis and the American crunch. Since 2000, gold has been rising steadily off a base of US$290.28. Here, Hilton Davies, chief executive officer of SA Bullion, argues that in the good times, people invest in gold as a commodity. However, in the bad times, gold is a currency. And we are into a generational period of bad times.

The case for cash

We need to view gold similarly to the way we view cash in the bank. In fact, gold should be seen as a competitor to cash in the bank. Cash is where investors park money when they are bereft of good investment ideas. It is the asset class that assures, at best, stodgy performance when taxes and inflation are factored in.

Most of the time, however, we see the need for some cash – perhaps 5% or 10% of one’s total holdings. This need we see for two reasons:

·         The possibility, and occasional incidence, where the markets in general and one’s investments in specific are struck by unforeseeable and catastrophic events. In such an instance, at the time when one’s holdings are hurt along with everything else, cash is on hand to take advantage of the massive opportunities that have suddenly presented themselves due to re-pricing of assets. This methodology creates a self-righting system; or

·         Cash for risk diversification. This is the possibility when one is completely wrong in one’s investment strategy and therefore needs to keep a little in cash to safeguard some of one’s portfolio.

There are times when we love cash. At the time of a market crash, we love to be loaded up with cash. Liquidity is a tremendous advantage when the great investment opportunities come along to invest heavily in value situations such as high-quality companies with sustainable earnings and high prospective dividend yields.

We do not know if we will have a tremendous investing opportunity anytime soon, but we are convinced that this is the right time in the cycle to be going high in cash exposure and low in share exposure.

Currency selection

A cash decision requires a currency decision. There is no cash investment without a currency decision, whether deliberate or by default.

Up front we must declare that we do not advocate cash exposure to one currency only – no matter what one’s take on currencies. Cash is the safe haven asset and therefore should not involve excessive risk-taking in terms of exposure to a currency. Naturally, the investor does need to factor in the currency exposure of the other assets in the portfolio.

Over the years, we have learnt that currency direction cannot easily or accurately be discerned. Particularly not in the short term.

For the last 20 years of the previous century, there were no compelling reasons to hold gold and every reason to hold dollars. Within the United States, the essential conditions required in order to maintain dollar strength remained intact.

The dawning of the new millennium corresponded with a turning of the tide. Y2K even aided and abetted the sea change, by virtue of the Federal Reserve’s monetary response to the computer changeover problem that was not.

So far, this century we are in a period of euro, franc, renminbi and yen strengthening relative to the dollar, and a period of gold strengthening relative to all the major currencies.

Decline of the US dollar

The US government and the Federal Reserve will not protect the dollar. Safeguarding the currency would imply significantly raising interest rates and tax rates. Were such a course to be followed, the US could anticipate a Japanese-style deflation. America’s unspoken mantra must be “inflate or die”.

US money supply is increasing approximately five times faster than gross domestic product growth presently, and a century of favourable socio-economic forces have reversed for the US.

The country confronts an inability to raise interest rates to required levels to combat inflation, an inability to control rampant money supply growth, loss of economic dominance, a profligate government with an inability to raise taxes, a dearth of savings, extreme indebtedness, and rapidly declining global confidence in the senior currency. These forces conspire to raise inflation, introduce weakness in the economy and accelerate dollar decline.

South Africa is an emerging market country and the rand is a commodity currency. These factors have caused the country and the currency to benefit enormously over the last five years.

The spreads, or risk premiums, as applied to emerging markets, have declined to extraordinary lows in recent years. All emerging markets have prospered from a lowering of the cost of capital as risk premiums have all but evaporated.

South Africa is thriving with a strong economy, low inflation and a strong rand. All this would seem to indicate to us a low upside and potentially considerable downside. Real interest rates are fairly high and therefore seemingly providing some protection for the rand, but also putting a question mark over the capacity for the central bank to raise rates to stem a run on the rand.

Fundamentals of the gold market

A declining dollar, a declining rand, high money-supply growth rates and increasing inflation are undoubtedly good for gold.

However, gold does not generate positive performance only as a result of negative currency performances. Gold also goes through its own cycles, mostly brought on by fundamentals.

Gold is experiencing supply-side constraints.

For years, central banks have been suppliers of cheap gold, but this trend is rapidly changing as inventories become depleted and price action dictates a different course.

The Asian banks are holders of colossal reserves of US treasuries, and have been watching value destruction in these reserves due to dollar depreciation. Several of these banks have stated that they are looking for diversification and some, including the Chinese central bank, have identified gold as a currency choice.

Gold miners were contributors to their own problems with their forward sales programmes. But that is in the past. Miners are scrambling to de-hedge.

Demand for gold is rising strongly.

The human population is adding enormously to its number each year and the economic advancement of many poorer people, particularly in China, is rapidly expanding the gold-consuming base. Political sensibilities today are also US-unfriendly in many countries, and their population groups favouring gold.

Investors are looking for new return generators and becoming interested in gold.

Professional money managers and wealthy investors are on the whole weary, to say the least, of the global bubble in asset prices.

Increasingly, professional money managers are conducting research into the inclusion of commodities in investment portfolios.

A 2006 research report concluded that the commodity asset class has historically produced the highest returns of any asset class and in addition had the lowest correlation to other asset classes. It concluded that investment portfolios containing commodities produced higher returns and resulted in a superior efficient frontier. Many of the world’s largest investors are following these findings – including the world’s largest investor, Calpers.

According to SA Bullion, the most cost-effective and secure way for serious investors to trade in gold is via the Krugerrand.

·         It is exempt from value-added tax (VAT);

·         It has the lowest commission fee structure on the buying and selling price of gold. It carries only a small premium (markup) on the value of the gold content versus a

higher premium paid for rarity and condition of numismatic or collector coins;

·         Unlike shares, there is no counterparty party risk in holding Krugerrands, since the title is individually held;

·         It is accepted worldwide as legal tender;

·         It was introduced into the market in 1970 and today is the world’s most widely circulated gold coin;

·         It is traded internationally with a steady market of buyers and sellers;

·         The price is easily monitored and set daily using an international standard; and

·         The Krugerrand is minted in 22-carat quality gold for more durability than 24 carat gold.

SA Bullion provides a specialised gold investment product called The BullionGold Facility, which enables investors to make lump-sum or recurring monthly premiums into a call account.

The BullionGold Facility provides a 24-hour turnkey solution for investors to buy, vault, insure, sell or take delivery of their gold worldwide.

In conclusion

Some cash exposure is generally a good idea, but a higher than usual cash exposure would be appropriate today given that competing asset classes are at record high levels and presenting considerable downside risk.

The US dollar is a currency in decline, but there are also risks in the other major currencies due to excessive money supply growth and competitive depreciation. Equally, there are risks to emerging market currencies, including the rand, due to potential hot-money outflows through capital accounts and unfavourable trade deficits. The rand has the additional overriding risk of being a commodity currency.

Gold is firmly established in a strong uptrend and the fundamentals are excellent. The gold market is coming off a low base and investors are starting to notice the price action and entering the gold market in growing numbers and volumes. This gold up-cycle is in an early stage and will peak in many years' time, only when the global population is fully involved and at prices that at this time would be regarded as unseemly.

This is an abbreviated version of Hilton Davies’ report. For the full report, click here

Davies is founding director of SA Bullion, a specialist gold investment firm based in Cape Town, South Africa. He is the former managing director of Allan Gray Unit Trusts and a director of Fjoord Investment Managers, acknowledged as a global thoughteader on the gold market. He can be contacted via e-mail: This e-mail address is being protected from spambots. You need JavaScript enabled to view it