Killing me softly with his song...

For starters, the headline is a lift from Roberta Flack’s record-breaking 1973 solo, while the tweaked strummer is from Neil Young’s 2005 flick, Heart of Gold. But what follows has got nothing to do with either of the two. It’s just that the composition worked well for what is being written about…gold…the precious metal that has been an eternal part of the great India consumption story as well as the shadow economy for several decades now.

The herd that got away

A weak rupee saved the blushes for Indians, who piled into ETFs when gold peaked internationally last September

This voracious appetite, coupled with a rising price, has been conveniently used by money managers over the past five years to peddle gold exchange-traded funds (ETFs) all over the world. While there is no empirical evidence to prove that it is Indian consumption that drives gold prices, we are no longer the world’s biggest consumer having lost the title to the Chinese dragon.

According to the World Gold Council (WGC), a body funded by the world’s leading gold miners, for the past two quarters China has been topping the charts in terms of demand for gold. What better ammunition, then, to justify a rising price than the world’s fastest growing economy increasing its consumption? And when you have had an 11-year bull run, almost anything flies.

The ensuing central bank liquidity injections post the 2008 credit crisis infused new life into all financial assets. It was not only equities that benefited, commodities such as crude oil and aluminum as well as precious metals like gold did as well.

The European Central Bank keeping its refinancing rate at 1% to bail out the Eurozone just added more fuel to the fire. Then, after the latest bailout package was announced, gold, too, rallied with equity markets — so much for it being a safe haven. If it was indeed a safe haven, should its appeal not have dimmed?

The fact is almost everybody likes to ride momentum, more so the hedge funds. While George Soros looks smart with his timing, John Paulson isn’t after the correction in gold stocks. But that hasn’t stopped institutions from hyping up gold. Over the next 12 months, Bank of America and Morgan Stanley have forecasted a price of $2,000, while Goldman Sachs has a target of $1,940 and Barclays $1,790. The median estimate of 11 analysts tracked by Bloomberg shows gold averaging at $1,740 per ounce for the year.

Merry go round

If the momentum sustains, gold could end up with another winning year. However, this is at the cost of increasing volatility, but more on that later. Back home, gold, in rupee terms, is still on a high. The reason: the fall in international prices from its high has been camouflaged by the 27% depreciation in the rupee over the past 10 months.

Losing its hedge

Inflation-adjusted return shows that gold is not what it is perceived to be

In fact, had the currency not depreciated, retail investors, who invested a record Rs.988 crore in domestic ETFs when gold peaked internationally in September 2011, would have been staring at a loss. In fact, even as gold went into a tailspin from its peak, investors kept flocking to ETFs (See chart: The herd that got away). They were too bedazzled by the domestic rally to notice the goings on overseas. 

All that glitters ...is the deficit

High value of gold imports has accentuated India’s current account deficit 

If one digs deeper, the ugly truth emerges that had the currency not depreciated the way it did, adjusted for inflation, returns would have been negative. So much so for the metal being touted as a hedge against inflation (See table: Losing its hedge). But then no one is complaining, neither investors nor the ETF fund managers. 

Gold ETFs, which made their debut in India in 2007, had assets under management (AUM) of Rs.10,312 crore spread across 14 fund houses as of March 2012. Intensifying competition means fund houses not only want to hold on to every AUM rupee, but pull in more, even if it means using a distorted spiel.

Hiren Chandaria, fund manager of Reliance Gold ETF, which runs the country’s second-largest gold ETF with Rs.2,651 crore in assets, says, “The rupee depreciation has helped but given that more than 75% of the gold is consumed outside the US, prices for non-US investors are more resilient. This has increased its appeal as a portfolio diversifier.” In other words, Chandaria believes his investor is better off leaving money on the table. A similar thought is voiced by Lakshmi Iyer, head (fixed income and product) at Kotak Asset Management, which manages the country’s third-largest ETF with Rs.1,027 crore in assets.

Haven or just another bubble

Rising ETF assets is an indication that gold is becoming more of an alternative investment class rather than an inflation hedge

“The mutual fund business is distributor driven. On our part, we are advising the agency that gold has to be part of an investor’s asset allocation plan. Now it is up to the investor to decide if he has to book profit or stay put depending on his asset allocation model.”

It’s not just self-preserving ETF players who believe that investors need to stay on. Hitesh Jain, commodity analyst with domestic brokerage IIFL, feels that with no credible solution to the Eurozone crisis any time soon, it is more than likely that the Eurozone will collapse. “Naturally, in times like these an asset class such as gold offers a safe haven.” Chirag Mehta, fund manager (commodities) at Quantum Fund Asset Management agrees. “You cannot solve a debt crisis by creating more debt. This will merely intensify future problems. Till such time we endure short-term pain, gold remains a safe bet,” he says. 

Then, we have the WGC, another vested party, which says consumption will only increase and investment demand for gold under domestic ETFs will continue to be strong. “In future, gold investments made under ETFs may double,” Ajay Mitra, managing director (India and Middle Eastern region), WGC, told reporters at a press meet recently.

Heavy lifters 

But the big “game changer” that experts both back home and overseas are talking about is how the central banks, which were net sellers of gold over the past two decades, have turned buyers, indicating that gold indeed is the haven. While central banks have bought bullion at the fastest pace in five decades, adding 440 tonnes in 2011, the lineage of central banks which are buying into the metal is suspect.

In early 2009, gold bulls started playing up the Reserve Bank of India’s (RBI) 200-tonne purchase, which was followed by the People’s Bank of China declaring in April that it had bought some 454 tonne of gold over the preceding six years. In 2012 so far, central banks have purchased almost 300 tonne of gold, led by Turkey (93 tonne), Russia (85 tonne) and Thailand (44 tonne).

The latest sentiment booster is a recent survey of central bank reserve managers, who have predicted that the most significant change in their official reserve holdings in the coming decade will be their intentional accumulation of gold. But then again, most of the time central banks don’t usually buy from the open market. In fact, the Reserve Bank of India’s latest buy was from the International Monetary Fund. 

More importantly, the RBI itself is averse to Indians lapping up gold and is ensuring ways to temper the same. The reason is not hard to fathom: crude oil imports and gold have been the biggest components in the country’s current account gap (see: All that glitters…is the deficit). India’s gold and silver imports during FY12 stood at $61 billion. 

That the central bank was well cognisant about the fact was evident in the 2002 speech made by former RBI governor Y V Reddy. “The availability and easy access to different forms of financial savings on an extensive scale, particularly for women, to protect the traditional stree dhan (jewellery given to brides) will prove to be the most viable policy option to encourage non-gold form of savings,” said Reddy.

Today, much of the central bank’s action is aimed at just doing that. Besides forcing banks to increase their rural penetration, the central bank has looked to curb lending against gold by capping interest rates and jacking up the capital requirement for gold-lending non-banking finance companies. Besides, it is also toying with the idea of banning banks from selling gold coins. But the market seems to be turning a blind eye to the fact. The truth is, gold is no longer a ‘safe haven’. It’s  just another alternative asset class that has turned speculative in nature. 

Crowding in 

While gold has seen a meteoric rise over the past decade, it has also caught the fancy of retail and institutional speculators post the 2008 crisis. As on date, almost 2,500 metric tonnes of physical gold, valued at more than $100 billion, is now held in physical gold exchange-traded funds (See chart: Haven or bubble). Not surprising that against such a backdrop, the volatility in the asset class has been increasing. In fact, gold has fallen below $1,600 seven times in the past 10 months since hitting its September high.

Mercury rising

Increased volatility makes gold vulnerable to a meltdown in the event of a price collapse

One also needs to note that the current price is 12% lower than the 2012 peak of around $1,790 and 18% lower than the all-time high of $1,920 (closing high $1,895) hit in September 2011. This is also the second-largest correction in percentage terms since 2008, when prices fell by 28%. According to analysts, this is not surprising, given the volatility of gold is as high as that of equities. In fact, gold volatility has tracked equity volatility since 2008 (See chart: Mercury Rising). “If a sell-off in gold occurred, the magnitude will be similar to the losses suffered by equities in past crises,” Ana Cukic Armstrong, joint managing partner, Armstrong Investment Managers, mentions in a report. 

The WGC, too, points out that in the first quarter of the current year, gold’s annualised volatility measured 20.4% — higher than its historical long-run average of 16%. Contributing to the volatility is also the derivatives market. This was evident in the first quarter, when the ratio of volumes in future contracts to ETF shares was substantially higher than previous months. Here again, the World Gold Council admits that short-term price trends tend to be highly influenced by derivatives trading. 

And since derivatives are highly leveraged instruments, investors can only expect the worst. Something that Christopher Wood of CLSA, too, agrees. “Gold is correcting because there are people out there who own this on leverage. You should own gold as a hedge against debt monetisation. Therefore, to own gold on leverage is a contradiction. So, if there are still speculators out there owning gold on leverage, gold can go down until those speculators are liquidated out of their positions,” Wood was recently quoted in media.

It’s not just speculation that is going to be an overhang on prices. Of late, with the euro weakening against the dollar, risk-averse investors are seeking refuge once again in the greenback. This clearly shows that the greenback still rules. Given that gold prices have been coming off the highs hit late last year, it would be better to be cautious than foolhardy. 

As Armstrong points out in her report that during the technology collapse in 2000, property and commodities performed very well and showed no correlation to broader equity markets. This set the stage for an immense amount of investment and speculation in these assets classes. “Property became an ever-increasing element in many investor’s portfolios and new instruments based on property loans sowed the seeds for the property crash and the credit crisis beginning in 2008. An allocation to gold served investors very well, but, as with all investments that seem to be perfect, when they fail, they fail spectacularly.”

With inputs from Adit Mathai