Managers see little downside to gold

By Mark Noble | March 24, 2009 | Last updated on March 24, 2009
5 min read

Has gold replaced oil as the favoured long position speculative trade? Maybe. There’s no denying the precious metal is popular right now — along with government bonds, it’s performed remarkably well in the downturn. Proponents of gold investing say there is a fundamental reason to allocate a portion of a client’s portfolio to gold: it preserves real value.

Sadiq Adatia, chief investment officer of Russell Investments Canada, points out that it serves an important function in certain market conditions. The argument right now between economists and market strategists is about whether we’re in a prolonged deflationary environment or headed toward a period of hyper-inflation, based on the amount of money being printed by the governments around the world. Either way, gold will do well, he says, and speculative traders are increasing their allocation to gold.

“I expect to see gold hold up quite well in the environment we see today,” Adatia says. “The U.S. dollar has been strong. Economic jitters have dominated the market, and that’s what’s driven the movement towards gold. If the markets turn around a little bit, the economic jitters will go away, and the U.S. dollar will weaken a bit, and as time goes by, we will see inflation down the road.

“[Either way] bullion still stays strong with a pullback and will probably stay in a decent threshold for a period of time. I don’t see it dropping down to the $600 to $700 level anytime soon.”

The difficulty advisors face is in determining how to give client’s exposure to gold. At the most basic level, there is the decision of whether to invest in gold mining stocks, or in gold bullion.

Gold equities offer more potential upside growth, but they come with the risks associated with investing in any company, whereas investing in bullion is more or less a currency hedge if an investor is planning to hold it for a long period of time.

It may make sense to have a mixed allocation to both.

Either way, an allocation to gold over the long term is going to have a baseline that is more sound than non–hard-asset categories, as hard-asset prices go up with inflation.

In inflation-adjusted terms, commodity prices are at historic lows, but these are being offset by the sheer amount of money being printed by the U.S government, according to Jamie Horvat, senior portfolio manager of the Sprott Gold and Precious Minerals Fund.

“Copper, oil and gold and these other commodities are probably at their all-time low in real value. In real terms, materials, commodities and gold and oil are actually down in price because of efficiencies in getting them out of the ground, the use of modern capital equipment and the expansion of these operations. The actual unit cost of production is down, but you’re debasing the money supply,” he says. “An ounce of gold could have bought you a nice robe and great pair of sandals in the Roman Empire. It would have bought you a nice suit and a nice pair of shoes in the Great Depression, and today an ounce of gold still gets you a nice suit and a nice pair of shoes. It’s held its value over time.”

More profound, Horvat points out, is the growing account deficit between the U.S. and China. The U.S.’s recent quantitative easing policy is viewed as simply printing more money with no fundamental wealth underlying it. The U.S. can do this because it controls the world’s reserve currency. That puts America’s creditors in a tough spot, because it devalues their reserves.

Some have questioned why China doesn’t simply just call in the debt, but it doesn’t seem to have the power to do that yet. This would essentially end the U.S. dollar’s dominance as the reserve currency, and the implications for the global economy are unknown.

“When you’re in a position of strength like that, and you feel someone else is going to pull one over on you, you dump it, you sell that currency. China can’t. It seems to me that is their weakness,” says Christine Hughes, senior vice-president at AGF Funds and lead manager of the AGF Canadian Balanced Fund. “The alternatives are more unsavoury. They will have to eat the dollar devaluation. It is better to have their trade imbalances with the U.S. rectified.”

Horvat says some sort of debt negotiation situation will likely result, with the U.S. most likely trading hard assets in exchange for China agreeing to buy more Treasuries. The result would be that the U.S. dollar and most world currencies would be devalued.

“China buys $400 billion of Treasuries based on the trade with the U.S.; meanwhile, they are going to put up $20 billion to secure a long-term supply of oil. They are trying to buy Veranex Energy; they bought Petro-Kazakhstan a little over a year ago,” he says. “What they’ve been saying and doing with Treasuries are two different things. They have been trying to diversify and get off their treasury holdings.”

Horvat says the U.S. found itself in a similar situation in the 1960s and 1970s, when it had to trade its hard assets to the Middle East, Japan and South Korea to settle its accounts and get those counterparties to revalue their currencies.

He suspects a similar process is underway in China.

“I’ve been hearing rumblings that China has been discussing U.S. debt relief. The U.S. has been stating you can’t buy our hard assets, you can’t buy ConocoPhilips, and you can’t buy our port facilities. Unfortunately, it’s the same situation they were in from 1965 to the early 1980s cycle, where Japan and South Korea were the global growth engines,” he says. “The U.S. had to finally come to the table and negotiate with Japan, the Middle East and their debtors, and say, ‘OK’ as part of the debt forgiveness. ‘We have to give you portions of your hard assets and get some debt relief.’ It eventually led to the Plaza Accord. Japan revalued their currency peg.”

Read: Where to get your gold


Mark Noble