AMMAN, 8 March 2004 — Investing in gold is perceived as an efficient diversification of portfolios. Gold has traditionally had about zero correlation with equities and virtually no correlation with bonds. An inflationary environment very positive for gold is likely to be negative for bonds and stocks. However, during an economic rebound, both gold and stock prices may rise, with gold likely to lead rather than lag the equity rebound. Because gold prices are denominated in dollars, those investors who are concerned about a further decline in the dollar exchange rate might be interested to add gold to their portfolios. As a matter of fact, gold’s recent surge is noteworthy only in dollar terms. In euros, gold price is still lower than at the beginning of 2003. This highlights the strongest case for gold, that it is a useful diversification element in one’s portfolio.
Gold and commodity prices tend to be a good hedge for inflation. During the high inflation period 1973-81, the Goldman Sacks Commodity Index (GSCI), which includes gold, achieved a real average annual compound return of 3.3 percent compared to -3.8 percent for the US stock market index (S&P 500). However gold and other commodities had a real average annual growth rate of 5.6 percent over the low inflation period 1982-2002, compared to 9.6 percent for the S&P500. While gold provided a valuable diversification element during individual years (e.g. 1987, 1990, 2000), extended periods of falling inflation and declining interest rates during the 1990s were significantly more beneficial to equities and bonds than gold and commodities.
Gold has bounced from the lows of $257 an ounce in early 2001 to a high of $425 in late 2003, before dropping to the $400 level recently. But even at $400 an ounce it is still 53 percent lower than its all time high of $850 attained by the end of the 1970s. The price of gold has fluctuated significantly in the past ten years but the general trend was down until mid 2003. In 1991, gold prices per ounce averaged $362.1, fell to $343.8 in 1992 and then climbed back up in the next four years to reach $387.8 in 1996. On Nov. 26, 1997, the spot gold price closed below $300 (at $296) for the first time since March, 1985. Gold ended 1997 at $289, however it averaged $331 for the year. The annual average price of gold retreated further to $ 279.1 and $ 273.2 in 2000 and 2001 respectively, before rising to an average of $309 in 2002 and $363 in 2003.
Central banks worldwide have long held part of their reserves in the form of gold. At the end of 2003, gold reserves at central banks and monetary authorities around the world stood at around 950 million ounces, which is well below the level that prevailed in the 1970s. Gold reserves held by eleven Arab countries (Bahrain, Egypt, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia, Syria, UAE and Yemen) amounted to 22.5 million ounces in 1991, remained steady at that level until 1994, and then declined gradually to reach 20 million ounces in 2003, a drop of 11 percent on their level in 1991. This was mainly due to a significant decline in the gold holdings of three countries; Jordan, Yemen and Qatar, while gold reserves of the other Arab countries remained unchanged throughout this period.
Lebanon is by far the largest holder of gold reserves in the region, with 9.22 million ounces (286 ton) at the end of 2003, followed by Saudi Arabia with 4.6 million ounces, Kuwait 2.54 million ounces and Egypt 2.43 million ounces. At 62.2 ounces per head, Lebanon has the highest level of gold to population in the world. The rise in gold prices recorded last year had led to a substantial increase in the value of gold held as reserves by central banks around the world. For the Arab countries, the value of gold reserves held by central banks and monetary authorities rose from $5.8 billion by end 2001 to $8.7 billion by the end of 2003, a gain of 50 percent or $2.9 billion. Lebanon, with 37 percent of Arab world’s total gold reserves, recorded a gain of around $1.1 billion last year.
Holding reserves in the form of gold carries a substantial opportunity cost. Traditionally, gold earned no return unlike financial securities such as bonds or bank deposits. This has changed in recent years with the development of the gold leasing market. This market allows central banks to earn up to 1 percent a year (depending on maturity) on the gold holdings they are willing to lend to the market place, which is still lower than the return on other assets. Around 118 countries including several in the Middle East did lend more than 35 percent of their gold reserves in 2002.
It is not yet clear which is a bigger threat to the world economy today inflation or deflation. Deflationary pressures are still visible in Japan and to a lesser extent in Europe. In the US, the Federal Reserve would like to see inflation higher than current levels to allow a cushion against falling prices before changing its accommodative monetary position. Those who are currently buying gold and commodities as a hedge for inflation are betting that the huge budget and current account deficits of the US are unsustainable and would sooner or later lead to higher inflation. Central banks around the world have been buying the US currency and building dollar reserves in the process to limit the upward move of their currencies. But there is a limit to how much foreigners are willing to buy US Treasury bills and bonds. Adding to inflationary pressures are higher oil prices, while the excess liquidity conditions and low cost of credit are fuelling higher real estate and share prices.
All this suggests that inflationary pressures in the US may become more visible later in the year, but no one is expecting a surge in inflation, with the consumer price index in the US rising to 1.5 percent by yearend compared to the 2003 level of 1 percent. Until the threat from inflation becomes clearer, investors are unlikely to devote too much of their portfolios to gold. And if interest rates in the US start rising later in the year, the forward price of gold will become higher than the spot price, making forward selling by mining companies and hedge funds more attractive and this will put downward pressure on gold prices. Equally important, higher US growth rates and dollar interest rates would limit any further decline in the exchange rate of the American currency, reducing the need to buy gold as a hedge against weaker dollar. Central banks around the world may also want to realize some of the profits they made last year on their gold holdings by selling part of the gold reserves they have.
To conclude, until the short-term threat from inflation becomes clearer, investors may not want to devote too much of their portfolios to gold. Under current conditions, gold and other commodities should make up an inflation hedge of not more than 5 percent of investors’ portfolios.
(Henry T. Azzam is chief executive officer at Jordinvest.)
