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Posted On Wednesday, Jul 25, 2012
Gold suddenly looks lacking in luster and is moving in tandem with risk assets. Is gold that generally rises when there`s risk aversion not the case anymore? Has gold lost its luster? We do not think so. We should not generalize based on something that we see in the short term and ignore the long term characteristics of an asset.
Markets are currently working on a perverse logic where bad is construed as good. Markets have been reacting positively to poor economic data as deterioration in economic data reflects a higher probability of more easing measures from the Central Banks. In the past too there have been similar instances where Central Banks had suggested that they would undertake more monetary interventions as a solution for all fiscal problems. More money infused in the system will eventually flow to asset markets lifting prices of most of the investable assets. Speculators would embark on such opportunities to make quick gains in anticipation of such events unfolding. The probability of monetary intervention works like an on/off button. When markets expect a high probability of more monetary intervention - it`s in the "on" mode, i.e. asset prices move higher. It`s like a rising tide that lifts all boats. And, when market reads economic conditions improving, it assigns a lower probability of monetary intervention by the central bank - it`s in the "off" mode.
Monetary intervention would also mean creating money out of thin air aka money printing. When Central Bank creates more money assuming other things being equal it results in currency debasement. In simple words, it means loss of purchasing power of the currency as more amount of money would be shelled out for the same amount of goods and services. When money loses value, it loses its value against goods and services it can buy over time and against other forms of real money which are not being debased like Gold (Gold is a form of money which cannot be debased or printed). Therefore when Central Bank increases its money supply, the price of other currencies including gold adjusts upwards, its value is automatically appreciated.
As seen above, gold and so called risk assets tend to rise together when market assigns a higher probability for further monetary intervention. However, the rationales remain very different. Though initially it may seem that both are driven by speculation but the fact remains that when it actually happens, increase in risk assets tends to reduce with time whereas the increase in gold prices seems more fundamental in nature.
Given the current economic backdrop, where Governments are struggling with problems like rising deficits and unsustainable debts, it is indeed logical for gold prices to increase in value. With policy makers continuously debasing currencies, gold will be viewed as a preferred investment, lending some solace to investors.
The uncertain economic environment and looming inflationary threat over a long term reiterates the need for gold in one`s portfolio. It is advisable to make a strategic allocation to gold because it`s the counterweight to paper money which is continuing to lose credibility. Review your allocation to gold to make sure it remains adequate enough to be able to serve as an effective portfolio diversification tool; an allocation of 10 -20 % of your portfolio. That way the precious metal can act as a shock absorber to help protect from any unexpected bumps in the financial system.
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