Gold: To buy or not to buy?

Gold: To buy or not to buy?

Gold: To buy or not to buy? should you invest in gold or stock market dhanteras 30stades

Gold has been a poor asset in the last 12 months or so. The yellow metal’s prices in India are still down around 10 percent from the highs of August 2020 despite a strong rally in other financial and physical assets during the period. For example, the equity benchmark BSE Sensex is up nearly 60 percent during the period and most commodities are trading at record high prices and continue to stay strong.

This has caused some anxiety among gold investors. 

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But historical data suggests that current low prices offer a good opportunity to accumulate the yellow metal rather than worry about its poor performance in the last one year.

Most analysts believe that gold is one of the most undervalued assets in the markets right now and it’s a matter of time before it starts catching up with other competing assets such as equity, base metals or real estate, all of which are rallying right now.

For example, the London Metal Exchange Index (LMEX) that tracks the prices of industrial base metals such as aluminium, copper, lead, zinc, nickel and tin is up around 50 percent in the last 12 months as it touched a new all-time high. And most analysts expect a further rally in industrial metals in the coming months given the underlying market fundamentals. If this happens it will provide a tailwind to the gold prices.

Also Read: Mark Mobius has turned bullish on gold. Should you buy the yellow metal?

Historically, the LMEX and gold prices have kept pace with each other and though they don’t necessarily move at the same time or in the same intensity. For example, a sharp rise in gold prices in late 2019 and the first half of 2020 was preceded by an equally sharp rally in base metal prices in 2016 and 2017 that has made gold relatively cheap compared to other base metals.

Given this, the current rally in base metals such as copper and aluminium creates the base for the next stage of the rally in gold prices. 

This is not surprising given that gold is also a base metal and most base metal ores contain small quantities of gold and silver. As such, most base metal producers also produce small quantities of these two precious metals.

Gold vs equity investment

Gold is very cheap when compared with equity prices. In the last ten years, gold has hugely underperformed equity prices in India but the yellow metal has largely kept pace with equity prices over 25 years. This has created a performance gag that the yellow metal will try to fill in due course. (See the chart below)

Also Read: How to get the right mix of equity, gold and fixed income in your investment portfolio

In the last 25 years, the gold to BSE Sensex ratio had moved in a range of around 1.8X to 0.5x with a median value of around 1X. This means that the event period of big out-performance by the Sensex has been followed by an equal rally in gold prices that had filled this performance gap. 

At the current prices, 10 gm of 24 carat gold in India (excluding taxes) is worth 70 percent of the value of one unit of Sensex that is currently trading at around 61,000 level. 

In the last 10-years, the BSE Sensex is up 263 percent, rising at an annualised rate of 13.8 percent. In the same period, gold prices in India are up 53 percent cumulatively, translating into an annualised return of 4.3 percent. This superior return in equities is however deceptive as two-third of these returns came in the last 18 months in the post-pandemic period.

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Gold vs equity investment 30stades

The post-pandemic rally in equity prices has been driven by monetary factors and the resulting rerating of stock prices rather than a big jump in corporate earnings. The monetary factors that fueled the rally in stock prices are now reversing. The interest rates are off their lows globally and central banks have begun to raise rates.

For example, the yield on 10-year US government bonds is up nearly 110 basis points from its historic lows in July last year and it could rise further in 2022 as the US Federal Reserve starts tapering its bond purchases later this year. This may trigger the de-rating of stock prices globally and force many investors to move their money in gold as a way to protect their capital from market volatility. Historically, gold has acted as a good hedge against volatility in the financial market.

Also Read: Rising inflation: Where should you invest your money as yields on FDs turn negative?

Inflation to give a boost to gold

Gold is also likely to benefit from the rising tide of inflation globally that favours physical assets over financial assets such as equity and bonds. The global rally in equity markets and the ever-rising valuation of growth stock was underpinned by declining interest rates that were the product of low inflation on a historical basis. This has now reversed and prices of food and industrial items are now growing at the fastest pace in nearly two decades.

If the trend sustains for a few more months, inflation could become sticky leading to lower margins and corporate profitability. This will also force central banks to start raising interest rates aggressively in a bid to tamp down on inflation. This will create volatility in equity markets but will be a tailwind for gold prices.

Also Read: How investment in gold can protect you from inflation and rupee depreciation

A combination of high inflation and still low nominal interest rate has translated into a negative real interest rate which is good for non-interest (non-yield) bearing assets such as gold. 

For example, top banks in India currently offer interest of 5 to 5.5 percent per annum on fixed deposits, while inflation is at 5-6 percent. This means little or no interest rate on bank FDs when adjusted for inflation.

The global and the Indian economy also faces economic uncertainty from record levels of public debt accumulated during the period of record-low interest rate in the last decade. In India for example, total public debt is now at an all-time high of 90 percent of GDP. The ratio was around 60 percent a decade ago. If interest rates continue to rise further the interest on public debt will suck up most of the tax revenues creating a spiral of higher inflation, higher taxes and low growth.

This will be negative for financial assets such as equity and bond but would turn gold into a safe haven asset.

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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