Worries over high gold prices start to bubble up

If there is one client segment which has recently popularised the use of commodities, with gold the particular favourite, it is private wealth management.

The role of natural resources in client portfolios has been a topic of hot debate for years, with many investors, particularly in Asia, using them as an alternative to hedge funds.

Commodity returns should broadly track global nominal growth, says Dan Briggs, chief investment officer at Fleming Family & Partners, meaning rising prices would indicate a forthcoming economic upswing. Traders must take account of issues such as periodic supply constraints, freak weather and food demand, which can cause major price swings and form part of the attraction of buying in and out of this asset class. The major plus point is that commodities are real assets, not paper certificates, and their prices do not generally move in tandem with mainstream investments.

Some banks, expecting a slow but sustained economic recovery, are tentatively positioning clients for pick-up in commodity prices, although at this stage they prefer guaranteed investments rather than high-octane funds.

Asset selectors such as Marc Lansonneur, Singapore-based regional head of investment for Asia Pacific at Société Genérale Private Banking, believe recovery will be powered by commodities such as oil, expected to surge above its current $90 (€70) range. “Oil has a limited downside,” says Mr Lansonneur, expecting healthy demand.

“Even if we see negative news, I don’t expect oil to dip below $75,” he adds, with the market best played through range-bound structured products.

He is slightly more cautious on copper and aluminium prices, both clearly correlated to Chinese export numbers. Expecting the Chinese economy to grow at 7.5 per cent following the leadership change, any price changes “won’t be exceptional”, he predicts.

But those private investors who think they have found a more solid, easier to understand version of hedge funds are making a big mistake, says Mr Briggs at FF&P. “Commodities and hedge funds have completely different sensitivities and attractions,” he insists. “It is not a case of either/or,” in a private portfolio.

While promoters of hedge funds typically promise non-market related absolute returns, commodity investing can cover direct holdings, trend following and commodity equities. Each of these brings different portfolio characteristics. So while the asset management arm of FF&P has reduced its holdings of hedge funds, following indifferent returns, it is currently a huge fan of buying into the commodities story, particularly through exchange traded fund (ETF) investments and indirect company investing via shares.

THE SAFETY OF GOLD

Like many wealth houses, FF&P advocates gold as an independent store of value, in a world of vanishing safe havens. “Unlike nominal government bonds, the conventional low-risk capital preservation asset of choice, gold is outside the scope of governments and central banks to manipulate,” adds Mr Briggs.

Investing in nominal government-backed assets is a hazardous activity today, he believes, with paper driven to historically high valuations by central bank liquidity programmes and institutional allocations fuelled by actuarial advice. Bonds have been pushed into bubble territory partly because they were the only asset providing positive returns during the 2008-9 crisis, he says. Commodities, on the other hand, provide attractive low correlation characteristics, largely irrespective of the economic cycle.

The recent healthy fortunes of the gold price have been inextricably linked to quantitative easing, believes Mr Briggs. For FF&P, gold’s key role in client portfolios should be as a “real” capital preservation hedge rather than a source of absolute capital growth.

However, gold is still expected to continue to appreciate by the likes of Mr Briggs. “We do not regard price forecasts in the market of $2-2,500 within the next three years as inconceivable, given the current macro backdrop.”

The most enthusiastic users of gold in private client portfolios have been the Swiss banks, with typical players such as Union Bancaire Privée recommending weightings of 10 to 15 per cent in balanced portfolios.

The Geneva bank expects gold to play an “important role” for the next three to five years at least. “The price may occasionally go down a bit for a couple of weeks, but as an asset class, globally, gold is the ultimate in protection against inflation,” suggests UBP’s head of private banking Michel Longhini.

To keep gold in the news, and to ensure ongoing analysis of gold demand figures, some of the world’s largest gold mining companies finance the World Gold Council to do their talking. WGC investment director Marcus Grubb has been successful in befriending the private wealth sector, where allocations of 5 to 15 per cent are the norm, compared to minimal exposure in the institutional space.

The WGC paints a particularly negative picture of the world’s economic fortunes, expecting recessions in Japan and much of Europe, with the US corporate sector “showing signs of stress”, which suits a golden scenario of rising prices of its favoured precious metal.

“We are suspecting a new round of quantitative easing to come in 2013, unless there is a miraculous return to the Nirvana of low inflation and improving economies around the world,” says Mr Grubb.

Despite a 6 per cent fall in consumer demand in the third quarter of 2012 from China, due to the slowing economy and a 24 per cent annual slump in Indian consumer gold purchases resulting from new jewellery and import taxes, Mr Grubb says the slack from the world’s two largest buyers of gold is taken up by the surging ETF market in both Europe and the US.

The WGC has taken a lead in the financial services market, developing ETFs in Europe and currently working on a physical gold ETF in China, where the council already co-operates with leading bank ICBC on gold-linked savings plans, which boast 5m investors. The world’s largest gold ETF, the SPDR Gold Trust managed by State Street, oversees $74bn in assets, while the ZKB Gold ETF in Europe, handles €13bn.

CAUSE FOR CONCERN

Gary Duggan, CIO for Asia at Coutts, has a different take on gold, believing the current price in the $1,700 range is a cause for concern and too high to add further allocations. “The wealth industry has certainly seen the rehabilitation of gold as an asset class,” he says. “But if Spain takes a handout from the ECB, we see stability in Europe for the next 12 months and the fiscal cliff is resolved, why should you continue to hold gold without those risks?”

Investors would start to sell holdings and gold-based ETFs, currently holding assets at all-time highs, would see major redemptions.

Riskier scenarios should not be entirely forgotten, says Amin Rajan, CEO of consultancy Create, which regularly surveys institutions and private banks on their investment strategies. He paints three possible economic scenarios, which may have radically different implications for the gold price.

Firstly, there is the possibility of ‘global deflation’. A five-year flat line, like Japan suffered during the 1990s, could see the gold price trebling. With equities in the doldrums and bonds exposed to the “double whammy” of rising interest rates and inflation once things improve, gold would be the true safe-haven currency. “Gold only succeeds when other asset classes fail,” warns Mr Rajan.

“It has no intrinsic merit other than being a store of value.”

As part of the second, ‘muddle through’ option, the gold price would remain high, experiencing periodic downdrafts when equities or bonds briefly surge back into fashion. In this scenario, says Mr Rajan, gold may rise another 30 to 50 per cent, although this trend would be punctuated by sharp period falls, like the ones seen in the last 18 months.

But with many private banks and asset managers witnessing tentative signs of recovery, with a ECB getting to grips with problematic client countries and a re-elected President Obama showing concrete plans to deal with the so-called ‘fiscal cliff’, moderate economic growth would leave current high gold prices unsustainable, as equity markets kick-start and eventually roar back into life. This final, optimistic, scenario, would see the beginning of a long-term decline in the gold price, as happened in the late 1980s and early 1990s.

Indeed, the gold story is over-sold, believes Mr Rajan. Although it makes sense for pessimistic investors, who subscribe to the ‘muddle through’ or deflationary scenario to allocate as much as 10 per cent of their portfolio to gold as a capital hedge, it can be a risky investment.

The metal, says Mr Rajan, may be caught in another bubble resembling that enveloping certain, over-bought fixed income categories. “Like other asset classes, gold will eventually lose its glitter,” he says. “If the US avoids a fiscal cliff, and the peripheral nations in Europe continue to record improvement in their economies the gold price will go into reverse, until the next crisis rears its ugly head.”