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A short history of investing in gold – and what to expect for 2017

cityamThursday 8 December 2016 3:46pmby David Brett (Schroders)

Gold is coveted by investors for its rarity. As a precious metal with limited supply, it is seen as a store of value when the real value of other assets, and currencies, can be manipulated.

But fundamentally, its high worth is underpinned by its usefulness and attractiveness. Not only is it highly malleable but it also conducts electricity, given rise to many industrial uses. Its visual appeal, worn as jewellery for millennia, is more obvious.

A brief history of gold

Gold was used as a form of currency as earlier as 550 BC when King Croesus minted coins in what is now Turkey. But the adoption of the gold standard in the late 1800s, cemented its value in modern day finance. This was when most major nations fixed the value of their currency to the gold price.

In recognition of golds importance to the global financial system, the Federal Reserve was created in 1913 to help to stabilise the gold price and currency values.

Amid the turmoil of the 1930s Great Depression, some countries abandoned the gold standard in 1931 in the UK and 1933 in the US. The gold market even closed during the Second World War.

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Afterwards, the gold standard was readopted at the famous Bretton Woods agreement, reached to help with economic stability as the post-war rebuilding process began.

The gold price remained pegged below $200 an ounce for much of the last century.

The gold standard was abandoned entirely in 1971, allowing currencies to move freely against each other.

Inflation and geo-political concerns in the 1980s saw gold spike above $400 for the first time. But the rally was short lived. Prices were left languishing for nearly two decades.

It was only in the new millennium that demand steadily returned, partly because some central banks slowed their selling of gold reserves.

But the biggest gains came amid the financial crisis of 2008 and the years that followed. This was mainly in response to the substantial programmes of quantitative easing undertaken by central banks.

The theory was that this would create inflation, and gold is considered a store of value at such times, rising with, or ahead of, wider price increases.

A brief history of gold

Three reasons investors hold gold

1. Scarcity

Gold is scarce, durable, versatile and tangible. As such, it maintains its value and is considered a safe haven investment.

2. Protect global purchasing power

Gold is seen as a store of value during times of persistent deflation or extreme inflation. To some, it is considered to be a highly-valued global currency, a reputation earned in the gold standard period.

3. To diversify

The price of gold often behaves differently to stock and bond markets. It is possible that when a portfolio is suffering because of shocks for shares or bonds, that the gold price can rise, or vice versa.

Four reasons investors might sell gold

1. Rising interest rates

Rising interest rates damage demand for gold, particularly if central banks are trying to

PHYS01_Animated_Gif_2_MPUcontrol inflation. Gold is perceived as offering protection from inflation so central bank success in controlling it might hold back the price.

2. Strong US dollar

Gold is valued predominantly in dollars. If the dollar is strong it costs more for international investors to buy therefore demand might fall.

3. Pace of gold production

Oversupply can dilute the price of gold, just like any other commodity.

4. A growing need for income

During periods when interest rates are low investors will look for alternative higher yielding investments such as shares. Gold provides no income and may fall out of favour. This factor may have contributed to falls in the price in recent years.

How do I know if gold is cheap or expensive?

Gold is notoriously difficult to value. It provides no yield, coupon, rent or profits therefore it is a difficult asset for investors to value compared with shares or bonds, for example.

Investors are left trying to judge a number of factors, explained above, that feed into demand for gold. It is understandable that the price has seen periods of extreme price volatility.

Without the usual valuation metrics that might be applied to traditional investments, working out when might be a good time to buy can be difficult. This has increased focus on alternative measures.

The gold-silver ratio is one such measure, simply comparing the price in ounces for each precious metal.

In 2000, the ratio was 50 to 1, with gold 50 times more expensive than silver.

A higher number suggests gold is more expensive compared to the silver price, a lower number suggests it is less expensive.

At the time of writing the gold/silver ratio is just above 70.

The ratio is a niche tool used by traders as one way to work out when to move in and out of gold.

How to value gold: what the gold/silver ratio tells us

How much gold should I have in a portfolio?

Like any investment portfolio, if you have just one investment in it then you leave yourself exposed to heavy losses should the investment fail. A balanced portfolio will hold shares, bonds and perhaps commercial property, depending on the aims, risk appetite and timelines of the investor.

The World Gold Council claims modest allocations to gold of 2% to 10% could protect and enhance the performance of an investment portfolio.

What is the outlook for gold?

Having risen sharply since the turn of the millennium and peaking after the global financial crisis in 2011, gold has retreated.

Given the gains that had come before, some market watchers were not surprised by the slide in the price.

If the next chapter in the story of the global economy involves extreme inflation or deflation, then gold may perform well. Or indeed, if there are severe market shocks.

Other less dramatic scenarios may be less positive for gold.

The table below offers explanation on how the gold price has moved during different global periods, although these patterns are not guaranteed to be repeated. As canny investors know, past performance is not a guide to the future.

Ultimately, the price of gold is driven by the mood and mindset of investors, said Matthew Michael, Product Director in Commodities and Emerging Market Debt.

Theres any number of reasons that can drive investors to buy it. Faced with uncertainty, potentially significant inflation, currency weakness they tend to buy gold.

Insider's Guide to gold and silver

Fund manager views

James Luke, Schroders Metals Fund Manager, said:

Is the global environment now bearish for gold? We dont think so, not even in the US. Prospects of a hike in interest rates have been rising faster than inflation expectations, which is bad for gold in the short term but we doubt this will continue for long.

With energy prices rising, the US labour market tightening and building expectations of hawkish US trade policy, inflation expectations could build rapidly, supporting gold.

The potentially positive economic elements of a Trump presidency have been priced in by markets. The potentially negative elements, including higher inflation, higher geo-political risks and increased protectionism have been largely ignored.

And as weve said many times before, gold remains an under-owned hedge against global central bank credibility and under-appreciated global risks.

Potential inflation, currency and financial market outcomes globally are arguably more extreme now that at any point since the end of the Second World War.

Table illustrating the highs and lows of gold since 1970

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A century later, could silver beat gold to become India’s preferred investment option once again?

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2 Dec 2016

The Indian government has been trying to reduce its citizens demand for imported gold through a number of means over the last few years. This is part of a wider crackdown on the currency used in the black market, that included the withdrawal and replacement of its two largest-denomination banknotes in early November. The strategy will likely have some unintended consequences if we take our cues from the events of 1910.

Indians famous love for gold has created serious and ongoing economic issues for the nation. In 2011, Australian investment bank Macquarie estimated that 78% of Indias household savings were held in gold.

In effect, this means that India has a dual currency system where people choose to save mostly in gold rather than rupees. This is unlike any other major economy and begs the question: how do you wean a population off a precious metal?

Bling and buy sale

Building up savings in gold rather than deposits in a bank creates a permanent drag on Indias growth. This happens because the savings do not increase the available funds for lending within the banking system. One reason it is so difficult to put this gold to work as investment capital is that 79% of it is bought as jewellery, rather than bars or coins.

Insider's Guide to gold and silver

India is the worlds largest consumer of gold jewellery at nearly 700 tonnes in 2015 according to the GFMS Gold Survey 2016. However, it mines less than two tonnes of gold a year. This means India must import gold worth US$25 billion each year, pushing up its current account deficit and pulling down the value of the rupee.

In 2015, prime minister Narendra Modis government introduced a Sovereign Gold Bond scheme which allowed gold holders to swap their gold for an interest-bearing bond. At the end of the bonds life, investors would effectively be returned the same amount of gold. This move reduced the minimum amount of gold necessary to participate in such a scheme to two grams. As of November 2016, 14 tonnes of gold had been subscribed to the two gold bond issues, with another five tonnes collected through the older gold monetisation scheme (which has a larger minimum deposit of 30 grams).

However, relative to Indias estimated privately held gold stock of 20,000 tonnes, these deposits represent tiny amounts and it still doesnt seem like a solution.

Unintended consequences

An alternative would be to permanently reduce gold imports. To that end, in 2013, the government started to increase import taxes on gold imports to 6%; this now stands at 10%. However, falling gold prices during that period meant that there was still a 12% increase in gold imports in 2015 as consumers snapped up what they saw as bargain prices.

And here is where we go back more than 100 years to see how this all worked out last time. You see, India has battled precious metals imports for quite some time. In 1910 the government of India increased the import tariffs on silver from 5% to 11%. A market report in 1912, by Pixley & Abell, a gold wholesaler, pointed to a 28% fall in silver demand in the Indian bazaars in the three years following the increase. They attributed this to not just a fall in demand for silver due to tax increases, but also a substitution of gold for silver in peoples savings as gold became more attractive on a relative basis.

Between 1910 and 1930 net imports of silver in India fell from 98m ounces to 31m, according to British Geological Survey reports. After this time India gradually became the worlds largest gold consumer, a position it finally lost to China in 2015.

PHYS01_Animated_Gif_2_MPUAnd it seems a return to silver as a major investment for consumers in India may be on the cards. Following the recent import tax hikes for gold, 2015 saw Indian silver imports grow to almost 8,000 tonnes, 14% up on the previous 2014 record. At the same time, demand for gold jewellery, which accounts for 75% of all Indian gold demand, is down 30% for the 12 months to the end of September 2016, according to the World Gold Council. This points to a possible shift back to silver as a more prominent investment in India.

Gold makes up the vast majority of Indian jewellery sales. But the graph below shows the rapid growth in silver jewellery demand in India, which is up over 600% in ten years, relative to the marginal growth of only 25% in gold jewellery demand.

Of course, silver is not the only precious metal investment option available. If investors want a more compact form of wealth, then platinum, worth 56 times more per ounce, might suit. But a swap to silver in India, as was the norm pre-World War I, seems more likely and could have a major effect on prices. For a sense of scale, the Indian gold jewellery market in 2015 was worth US$25 billion, while the total world silver jewellery market was worth only US$3.5 billion.

Even a small substitution from gold to silver would result in a massive increase in the price of silver. A 10% reallocation from gold jewellery investment to silver in India would nearly double world silver jewellery demand. Mines and other sources would not be able to fill the gap immediately; prices would rise, further fuelling demand and creating a new, shiny headache for those trying to marshal Indias unusual economy.

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Sharia finance gives the green light to gold

A breakthrough was made this week at the World Islamic Banking Conference in Bahrain to ensure gold is an accepted product under strict Sharia finance rules. This news is a major boost to the gold market after recent rumours circulating that India are considering restricting gold imports. While many gold bugs feared the news coming out of India, gold has once again proven it’s endurance as a huge new market opens its doors.

What’s been agreed?

After lengthy negotiations, the World Gold Council (WGC) and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) have agreed guidelines for gold and silver to be actively traded by Islamic financial institutions. Negotiations have taken more than a year to finally lay out uniform Sharia finance guidelines for gold. The previous fragmented and ambiguous treatment of gold was a major hindrance to its development within the Islamic world. The WGC anticipate the new ruling will ensure gold is a more widely accepted investment.


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How will gold work within Sharia finance?

Parameters have been laid out to satisfy strict Islamic restrictions on speculation. Any gold trades must be fully backed with physical gold and settled the same day to qualify as economic activity rather than a speculative investment. Trading gold for future value is not permitted. The rules allow purchasing gold through agents which will permit buying gold backed Exchange-Traded funds (ETFs), Gold Certificates, mining shares and online retail platforms.  Full acceptance of gold within Sharia finance is overdue, joining the previously approved asset classes of property, equities, Islamic bonds (Sukuk) and insurance products (Takaful).

Boost to gold demand

Muslims total 1.6 billion globally, representing 23% of the world population,

Insider's Guide to gold and silverand Islam is the fastest growing major religion. Sharia acts as the legal system to the entire Islamic world. While desire for gold has existed within the Muslim community, fear of infringing Islamic law has held back demand. The clarity of the new directives is anticipated to significantly boost gold demand and therefore the gold price.

Demand for physical gold is expected to be the biggest beneficiary of the new ruling due to the strict parameters placed on alternative gold backed investments like mining shares.

The huge historical Indian demand for gold demonstrates the potential the Islamic world has for precious metals. If only 1% of Islamic financial institution funds were assigned to gold, that would equate to roughly 500-1000 tonnes per year. With an estimated current surplus of only 172 tonnes, upward pressure would be placed on the gold price.

The possible significance of the $2 trillion Islamic markets for gold demand is only matched with the impact that gold may have on Islamic finance, with the gold market worth an estimated $2.4 trillion.

Further impact

The new directive will increase the diversity of gold investment types available within Sharia law. It will also introduce gold to those Muslims who have always been reticent of breaching laws.

While the guidelines are likely to support the gold price, the sheer size and influence of the Islamic community may also have other influence. Speculation has dominated the gold market due to the huge size of the Chicago Mercantile Exchange (COMEX) and London markets. The Sharia gold standard may well redress that balance. Certainly, Islamic finance will have a greater say in the setting of the gold price over the coming years.

Conclusion

While it’s always tempting to focus on gold’s day-to-day volatility, it acts as an effective hedge against volatile markets and inflation over the long term. With 1.6 billion Muslims set to benefit from the greatest access to the gold market in modern history, gold once again demonstrates its universal appeal and longevity.

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Gold, Silver Disappoint After U.S. Election Surprise. What Now?

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By Sean Lusk Dec 01, 2016 12:31AM ET

The common thinking in the marketplace following the Trump victory was that gold and silver would be two of the beneficiaries of higher prices and increased interest among traditional safe havens. Quite the opposite occurred as both the stock market and dollar index have been the big winners following the election, with the indices scoring all-time highs while the greenback hit multi-year highs.

There’s a common perception that the new administration will decrease corporate tax burdens

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and regulation on corporations following the inauguration in January and beyond. So far equity investors have been the big winners. The dollar rally comes on two fronts with one being a direct result of the withdrawal in the bond market while foreign investors continue to pour investment into the greenback eve as they are selling any rallies in the yen, euro, and the Aussie dollar to name just a few. The safe haven investment that precious metal bulls hoped would follow the Presidential election surprise has only been met with longs liquidating a once significant position.

From last December’s low at 1044.5 to this year’s high up at 1377.5, the gold market has traded all the way down past the 50 percent retracement at 1211.4, and then down to the .38 Fibonacci retracement from last year’s low at 1172.0. I would caution that although we are staring at a quarter point rate hike soon in December, this is likely to be one-and-done tightening by the Fed until the new administration is in office and enacts legislation in its first 100 days. Near term I’m watching open interest decline for the precious metals, especially during this last $30.00 break in February futures which signifies long liquidation instead of new sellers emerging in the market. Non commercial and non-reportable came in with a net long of 185K contracts. This is significantly down from a late summer high of 362K longs in the market. So the pairing of long positions has reached almost half the summer high.

Equities have made an impressive move post election, but what’s next to drive them higher aside from the Santa rally? Fourth quarter earnings aren’t due out for a while and holiday shopping numbers are in their infancy. I look for the Fed to also come out sounding more hawkish at their December meeting which could put a floor in gold’s prices as we enter into 2017.

Those looking for a trade may consider the following. Using June 2017 options, consider buying the June 1300 2017 call while selling 2 June 2017 1000 puts for even money. This one-by-two call/put ratio has major risk to the downside as you are short puts at the $1000.00 strike basis June 2017 futures.