Gold - Your shield during uncertain times

Posted On Wednesday, Sep 22, 2010

Investors feel highly puzzled given the uncertain macroeconomic scenario. There are two schools of thought - either you believe that all the measures undertaken by governments across the globe will work and we will see a return of the ‘Good Times’, or you believe that all these measures will fail and the world will plunge into economic chaos. So investors will be confronted with either inflation (if all the government stimuli work) or deflation (if all the government stimuli fail).

However, given the efforts that all Governmnets are putting in to revive their fragile economies, inflation looks the likely outcome. However, some argue that given the output gap and high unemployment in industrial countries, it would be very difficult to generate inflationary pressures at least in the short run. In such a scenario, the risks remain tilted towards further disinflation.

Most investors agree having gold in ones portfolio is a protection against any adverse economic condition. The protection against inflation thesis has become conventional wisdom emanating more from what wasexperienced during the 1970s. The notion that gold is a hedge against inflation, and conversely been shunned on thought s of deflation.

Gold would be an ideal asset and an effective hedge against both deflation and inflation. Given the current scenario, we are of the opinion that gold remains in a win-win situation irrespective of the likely outcome that unfolds. However, this very idea defies logic because it is not possible for something to be a hedge against one financial outcome and to simultaneously be a hedge against the opposite outcome. It certainly makes no sense to just buy gold and assume that you are going to be fine regardless of whether we get inflation or deflation. However, in today’s scenario, of monetary excesses and the central banks attitude and approach to economic issues solicits an allocation to gold.

How would gold perform in a deflationary global recession?

Deflation is defined as falling levels of both economic activity and falling price levels on an absolute basis. This contraction of economic activity is generally preceded by an unsustainable boom period and is usually kickedoff by an event which causes loss of economic confidence. In a deflationary scenario, there’s a “dash for cash” as instability increases and credit quality deteriorates. There’s a clear shift of preference from capital growthto capital preservation. To use a nautical example, investors tend to maintain a steady course rather than moving full steam ahead.

When the perceived value of currencies is under question, like it is today, there would likely be an increased tendency to own gold. Both the dollar and the euro have seen sharp declines recently and are losing confidence bythe day. Thus the only ‘safe’ alternative is gold.

Having said that, there is also a possibility of some initial weakness in gold but once it dawns upon masses as to how difficult and painful this deflation would be for over-indebted countries and households, gold prices would likely soar.

Let’s go back to the 1930s

The 1930s deflation is a classic case. At that time, gold was closely linked to money. Under such a monetary system, when the purchasing power of the national currency rose as a result of deflation there was a subsequent rise in the purchasing power of gold.

Under the current monetary system gold is not the official form of money. Unfortunately, this means there aren’t any historical examples of how gold performs during deflation when the metal is not the official form of money. However, we can get an idea of what to expect from gold if deflation were to occur now by looking at how silver performed during the 1930’s.

Quantum Mutual Fund_Asset performance in a deflation
Source: JP Morgan

After peaking in 1929, the DJIA or the Dow Jones Industrial Average fell sharply to less than a quarter of its peak value. Gold, because of its fixed price, was unaffected. Silver fell too, but it significantly outperformed the reported DJIA on the way down. What is also encouraging is that after the deflation bottomed in 1932-1933, silver bounced back quickly, and by 1934 it was higher than its 1929 level. Intriguingly, gold seems to parallel this with it’s repricing to $35/oz in 1934.

Silver performed well in relative terms. If gold was freely traded in the 1930s, it’s performance would have probably been much better that of silver.

There’s one more proxy to get some idea of how would have gold performed during the 1930s depression. We can see how a gold mining stock i.e Homestake mining Co. performed during the period.

Dow Jones Industrial average and Homestake mining
Quantum Mutual Fund_DowJones Industrial average and Homestake mining
Chart created by GOLD EAGLE Technical Staff (C) 1997

Homestake mining really performed well and an allocation to it would have helped to reduce losses on account of the fall in equity markets.

Gold’s value during recessionary periods…

What deflation does is create a change in behavior for both consumers and businesses as prices spiral downwards over time. Businesses are forced to lay off more and more workers and reduce spending as they receive less moneyfor goods sold, and consumers, expecting to pay lower prices in the future, hold off on purchases.

All this ensues into a recession. Therefore, it becomes important to see how gold has performed during periods of recession since gold was liberalized from paper money (after 1971).

Gold in recession post 1971
Quantum Mutual Fund_Gold in recession post 1971
Source: WGC, Bloomberg

As seen above, there is no set pattern that gold follows in an economic recession. Even the recent slowdown that began in 2008 saw a sharp rally in gold prices.

The likely Outcome

Deflation can be much more difficult to stop than inflation where central banks simply increase interest rates to stop escalating prices.

It is indeed very logical to expect an increasing demand for gold during period of deflation. As discussed above, most periods of deflation are accompanied by sharp declines in domestic demand and systemic financial sector problems. Governments and central banks are forced to step in aggressively to offset the slowdown in private sector demand and repair the balance sheets of financial institutions. This generally happens through large inflows of paper currency forcibly printed and being infused in the system.

As the supply of currency rises and concerns about debt levels rise, investors fear paper currency devaluation and look for alternative assets to hold. In addition, concerns about financial institutions – and even the government – solvency and counterparty risk raises demand for alternatives to paper currency. In an environment like today’s, when all major economies are facing severe recession, potential deflation, systemic financial sector crisis and the risk of currency devaluation (similar to the situation during the Great Depression), gold seems to be the only viable alternative to paper currencies.

The last remaining official link between gold and the dollar was severed in 1971 and, not coincidentally, deflation hasn’t occurred since that time. This testifies policymakers vow to avoid deflation by way of monetary infusions.

The transformation from disinflation to inflation is a slow process. It not only benefits the first receivers of money but also leads to mal-investments leading to wastage of scarce resources. Inflation would likely spread on the basis of where the liquidity moves and would be seen in varying proportions in different sectors and different parts of the globe. What we are seeing in emerging markets are likely first signs of the inflationary transformation.

Hence, dear investor, hedge your risks with Gold.


The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments.

Investment Objective: Quantum Gold Fund’s (QGF) investment objective is to generate returns that are in line with the performance of gold and gold related instruments, subject to tracking errors. However, investment in gold related instruments will be made if and when SEBI permits mutual funds to invest in gold related instruments. The Scheme is designed to provide returns that before expenses, closely correspond to the returns provided by gold. Asset Allocation: QGF will primarily invest in physical gold and if allowed under SEBI Regulations, also in gold related securities including derivatives, and the scheme may invest in Money Market Instruments, short term corporate debt securities,CBLO and units of Debt and Liquid Schemes of Mutual Funds to meet liquidity needs. Terms of Issue: QGF is an open-ended Gold Exchange Traded Fund. Each unit of QGF will be approximately equal to the price of half (1/2) gram of Gold. Units will be issued at NAV based prices. On an ongoing basis direct purchases from the Fund would be restricted to only Authorised Participants and Eligible Investors. Units of QGF can be bought /sold like any other stock on the National Stock Exchange of India Ltd (NSE) or on any other stock exchanges where it is listed. Entry Load: N.A. Exit Load: Nil in case of Authorised Participants; 0.5% in case of Eligible Investors. Risk Factors: All Mutual Funds and securities investments are subject to market risks including uncertainty of dividend distributions and the NAV of the schemes may go up or down depending upon the factors and forces affecting the gold and securities markets and there is no assurance or guarantee that the objectives of the scheme will be achieved. Quantum Gold Fund, is the name of the scheme and does not in any manner indicate either the quality of the Scheme, its future prospects or returns. Scheme Specific Risk: The QGF’s NAV will react to the Gold price movements. The Investor may lose money over short or long period due to fluctuation in Scheme’s NAV in response to factors such as economic and political developments, changes in interest rates and perceived trends in bullion prices, market movement and over longer periods during market downturns. Trading volumes, settlement periods and transfer procedures may restrict the liquidity of these investments of the QGF. It is to be distinctly understood that the permission given by NSE should not in any way be deemed or construed that the Scheme Information Document for QGF has been cleared or approved by NSE nor does it certify the correctness or completeness of any of the contents of the said Scheme Information Document. The investors are advised to refer to the Scheme Information Document of QGF for full text of the ‘Disclaimer Clause of NSE’. Statutory Details: Quantum Mutual Fund (Fund) has been constituted as a Trust under the Indian Trusts Act, 1882.Sponsors: Quantum Advisors Private Limited. (Liability of Sponsor limited to Rs. 1,00,000/-)Trustee: Quantum Trustee Company Private Limited. Investment Manager: Quantum Asset Management Company Private Limited (AMC). The Sponsor, Trustee and the Investment Manager are incorporated under the Companies Act, 1956..The past performance of the Sponsor / AMC/ Fund has no bearing on the expected performance of the scheme. Mutual Funds investments are subject to market risks. Please read the Scheme Information Document(s) / Key Information Memorandum(s) / Statement of Additional Information / Addendums carefully before investing. Scheme Information Document(s) /Key Information Memorandum(s)/ Statement of Additional Information can be obtained at any of our Investor Service Centers or at the office of the AMC 505, Regent Chambers, 5th Floor, Nariman Point, Mumbai – 400 021 or on AMC website www.QuantumAMC.Com /

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