Gold bullion or gold equities?

Financial-market turmoil is strengthening the case to add gold exposure to portfolios as more “insurance” in the event of a sharper equities market sell-off. It is also providing an opportunity to capitalise on the precious metal’s improving medium-term prospects.

Gold’s role as a ‘safe-haven’ has come to fore this year. The US-dollar gold price has rallied from a low of US$1050.72 an ounce this year to about US$1,200. The all-important Australian-dollar gold price (for local producers) has rallied from A$1450 an ounce in early 2016 to A$1,695.

Chart 1: US-dollar gold

The S&P/ASX All Ordinaries Gold index, influenced by Newcrest Mining’s high weighting, has a total return (including dividends) of 25 per cent over 12 months. The S&P/ASX 200’s total return is minus 13 per cent after heavy falls this year. 

Gold’s recent outperformance, of course, follows several years of horrible underperformance. Over five years, the All Ord Gold index has an annualised return of minus 14 per cent. Gold equities, collectively, have destroyed significant valued over that period. And the US-dollar gold price is still well below prices above US$1,800 an ounce in 2011.

Gold bullion is due for a price pullback after strong gains this year – possibly to US$1,150. That could be an opportunity for patient investors to add gold exposure at lower prices and position portfolios for stronger gains in the gold price in the next few years.

Three caveats are needed. First, most long-term investors should allocate 5 per cent or less of their portfolio to gold bullion: at the high end during periods of rising volatility and less when risk appetite has returned and volatility recedes. 

Second, focus on gold bullion rather than gold equities if you want pure exposure to the precious metal. Gold shares have their place, but tend to underperform gold bullion when equities sell off, and come with company and market risk. 

Third, watch the Australian dollar. Some exchange-traded products that provide gold exposure are unhedged for currency movements. A rising Australian dollar, relative to the Greenback, is bad news for local investors who are exposed to the US-dollar gold price and unprotected against adverse currency movements.

Risks aside, there is more to like about gold’s prospects. I became bullish on gold for The Bull in March 2014, noting: “The precious metal’s short-term prospects are rapidly improving – partly because it was horribly oversold at the end of 2013.” 

Several factors this year have strengthened that view. First, China’s devaluation of the Yuan, falls in emerging-market currencies, and an intensifying global currency war reinforce gold’s appeal as a store of value when currencies tumble.

Accommodative global monetary policies are another positive. Negative interest rates on Japanese 10-year bonds, almost unthinkable given the amount of monetary-policy stimulus in that country, suggest the risk of global deflation is rising. Deflation is a negative change in the general level of prices and services and an insidious problem because it encourages consumers to delay purchases in anticipation of lower future prices and weighs on economic growth. Again, it adds to gold’s appeal as a store of value. 

The Australian dollar is another positive. Although it remains stubbornly above US70 cents, I expect it to trade at US60-65 cents by year’s end. My base case is for further falls in commodity prices this year and the Reserve Bank cutting official interest rates at least once to support a sluggish economy. In theory, that should drive the Australian dollar lower and benefit gold investors, although falls in our currency will be slower from here.

An increasingly fragile global economy further supports the case for gold. Unprecedented monetary-policy stimulus in Europe and Japan is failing to lift inflation, and the US economic recovery has less vigour than anticipated. Rapid US interest-rate rises and a sharply higher Greenback in 2016 seem unlikely given this weakness.

Again, that supports gold. Gold historically has a negative correlation with the US dollar; it falls when the Greenback rises and vice versa, although the relationship is not always clear cut. Slower rises in the Greenback would buoy gold bulls.

Nevertheless, do not expect gold to race higher or a new bull market in gold to unfold – at least in the short term. But as headwinds for the global economy build, there’s enough to suggest gold’s outperformance this year has further to run. More importantly, there are sound asset-allocation and diversification reasons for long-term investors in the asset-accumulation phase to have a small exposure to gold bullion in portfolios.

My preferred vehicle for gold exposure is the ANZ ETFS Physical Gold ETF. It provides exposure to US-dollar gold, is unhedged for currency movements, and is one of this market’s largest ETFs. Investors wishing to eliminate currency risks could use the BetaShares Gold Bullion ETF – Currency Hedged.

I prefer the unhedged variety because the Australian dollar has further to fall. ANZ ETF Physical Gold (ASX Code: ZGOL) has rallied from about $14.60 to about $16.80 this year in a tumbling sharemarket. 

Chart 2: ANZ ETF Physical Gold ETF

Source: The Bull

Those who expect higher financial-market volatility to persist in 2016 (as I do) could consider a gold ETF. The trick is buy it after the gold price pulls back, which seems inevitable in the short term given the extent of price gains so far this year.

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Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at February 10, 2016.