Why Gold is considered an asset class?
Like no other commodity, gold has held the fascination of human societies since the beginning of recorded time. Gold is respected worldwide for its value and rich history. Gold is held globally by central banks as a reserve for perpetuating its worth, and is a highly liquid asset class which is held in form of investment and jewellery. It is also used in industrial application like electronics, memory chips, dentistry etc. Gold acts as a diversifier to mitigate losses in times of equity market corrections and uncertainties.
History and Correlation of gold with currencies
Gold is one of the most valued commodities in the world. Gold and currencies are strongly co-related.
Gold Standard
Prior to 20th century gold standard was used. The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold. With the gold standard, countries were agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. It was used as a world reserve currency wherein countries weren’t allowed to print the currencies if they did not have gold up to the same value. The main advantage of the gold standard was not just to avoid the evils of inflation but also deflation to help promote a stable monetary environment. Gold standard was abandoned in 1973 and completely replaced by fiat money.
Fiat Money
Fiat money is a government-issued currency that is not backed by a physical commodity such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, its reserves, borrowings, trade deficit, fiscal deficit etc. rather than the worth of a commodity. Most modern paper currencies are fiat currencies, including the U.S. dollar, the Euro and other major global currencies.
Since fiat money is not a scarce or fixed resource like gold, central banks have much greater control over its supply, which gives them the power to manage economic variables such as credit supply, liquidity, interest rates, and money velocity.
Main disadvantage of fiat money is because it is not linked to physical reserves, such as a national stockpile of gold or silver, it risks losing value due to inflation or even becoming worthless in the event of hyperinflation.
Gold plays an important part in central banks reserves
Gold plays an important part in central banks reserves management, as they are significant holders of gold. Below table represents the trend in official gold holding by countries. Countries like US, Germany, Italy, France, Netherland, Kazakhstan and Portugal hold more than 60% gold as a part of their reserves.
The Indian central bank purchased a record 29 tonnes of gold, as part of its reserves, in the first half of calendar year 2021. This takes the RBI's total gold reserves to 705.6 tonnes, as of June 30, 2021. This marks a nearly 26.4% absolute percent surge in the past two years. The gold holding of the RBI, at the start of 2018, had stood at 558.1 tonnes. The share of gold in the central banks reserves stood at 6.5 percent in June 2021 quarter.
RBI, with 705.6 tonnes of gold reserves, now ranks 9th amongst all the recognised central banks in the world in terms of gold holding as part of their reserves.
What has been the global trend with respect to usage of gold?
Below table is representation of how global demand for gold has changed historically in form of Jewellery, Investment and Central banks reserves.
As per the above data the demand for gold in form of Jewellery was recorded at 1,401.1 tonnes in 2020 down by 34% from 2,123.2 tonnes during 2019. Consumption of gold in the form of Jewellery has a direct relation with lifestyle of an individual, main reason for sharp fall in Jewellery demand was due to covid related restriction in terms of special occasions, celebrations, movement restrictions & mass gatherings. However, the demand has picked up and reached to 880.7 tonnes during first half (Jan – June 2021) with ease of covid related restrictions.
On the other side the demand for gold in form of Investment was recorded at 1,773.5 tonnes in 2020 up by 39.1% from 1,274.9 tonnes during 2019. Main reason for sharp increase in investment demand was due to Economic uncertainties during beginning of Covid19. However, during first half (Jan – June 2021) demand for gold in form of investment was recorded at 465.7 tonnes. This decline in investment of gold is mainly due to outperformance of equity, thanks to the stimulus and liquidity infusion by central banks globally which made investors chase riskier asset class and increase their allocation to equity vis-a-vis to gold.
From the above table the demand for gold in form of jewellery is been decreasing from 2,533.2 tonnes during 2014 to 1,401.1 tonnes during 2020 on the other hand demand for gold in form of investment has been increasing from 923.2 tonnes in 2014 to 1,773.5 tonnes during 2020.
Factors in favor of gold outlook:
1. High Inflation and Negative Real Rate of Interest
Gold as an asset class tends to give superior returns during high inflationary environment. Below table represents trend in CPI inflation across selected countries; from the below data we can see that inflation rose sharply during Oct/Nov 2021 in developed countries like UK - 4.2%, US - 6.2%, Australia - 3.0% & Germany – 5.2%. In emerging countries like Brazil- 10.67%, Russia - 8.13% & Turkey - 19.89% inflation has spiraled up significantly. The increase in inflation is attributed to high commodity (energy, gasoline, steel etc.) prices and supply chain disruptions globally.
Recently, inflation rate in the US surged to 6.2% in October 2021, the highest level recorded in last 3 decades.
The above table indicates that investors investing in central bank bonds are generating negative real returns on their holdings due to high inflation. Considering the negative carry, it creates a case for investing in gold.
2. Global debt at all-time high and geopolitical uncertainties:
Most Central Banks globally have expanded their balance sheet through debt during the onset of covid crises to support their economy.
Below table highlights the % Gross Debt to GDP of Advanced Economies and Emerging Economies :
From the above data it could be seen that total % Gross Debt to GDP on an average for Advanced Economies has increased to 122.7% in 2020 from 103.8% during 2019. In case of Emerging Economies % Gross Debt to GDP on an average has increased to 64.0% in 2020 from 54.7% during 2019.
Geopolitical uncertainties:
Although the vaccination programs are going well in many countries however, Omicron another variant of covid could be a concern and create uncertainties around it. Some of the geopolitical uncertainties like unclear US-China trade relations, the power shortages and real estate debt crisis (Evergrande and other realtors) in the world’s 2nd largest economy China could result deterioration in their economy which could have global spillover as well.
This increase in % Gross Debt to GDP at alarming levels along with risk associated with aging population in European economies and Japan would leave many questions unanswered with respect to servicing of such debts along with geopolitical uncertainties which create an environment which is supportive to gold.
As in the past we have seen during uncertain times like in 2008 post subprime mortgage crisis, gold prices spiked up significantly. Similarly during 2020 when Covid 19 pandemic hit globally, gold price escalated from 1497.82 USD/oz on 9th March 2020 to 2036.58 USD/oz on 27 July 2020 due to its safe haven appeal.
3. Expensive Equity Valuations :
Global equity market are trading at expensive valuations. The same can be explained with the help of Shiller PE for S&P 500. Shiller PE is a price to earning ratio based on average inflation-adjusted earnings from the previous 10 years. This factors in, earnings from the previous ten years and is less prone to wild swings in any one year.
From the above chart, it could be seen that prior to great depression Shiller PE for S&P 500 surged from 11.15x in December 1925 to 32.56x in September 1929. The Great Depression hit US during October 1929 post which the markets started correcting sharply to an extent that Shiller PE for S&P 500 PE corrected to a Multiple of 7.87x in March 1933.
Similarly, the valuations of equity markets grew exponentially during the dotcom bubble. There was a rapid rise in US Technology stocks equity valuations fuel by investments in internet-based companies. During the bull market in the late 1990’s. Shiller PE for S&P 500 surged from 21.15x to 44.19x between (March 1995 to December 1999). It was hovering at an average Shiller PE multiple of above 40x until August 2000. Markets started to correct post that and the bubble burst between 2001 and 2002 with equities entering a bear phase. The Shiller PE for S&P 500 corrected to a level of 21.31x in March 2003.
Prior to covid-19 Shiller PE for S&P 500 was on an average 30.3x between 2017-2019. It corrected to a level of 24.4x in March 2020. Due to spending and stimulus infused by global Central Banks led to drop in interest rates and surplus liquidity in the system which generated interest in equity markets and other speculative products in a conquest to chase higher returns.
If we look at 10 years (2001-2010) average Shiller PE for S&P 500 was 24.45x, and 10 years (2011-2020) average PE was 26.5x. The Shiller PE for S&P 500 is now trading at a levels of 39.67x as on 8th December, 2021, indicating historically expensive valuation.
Below table represents how gold has outperformed during negative years for equities (S&P 500 Index).
From Indian context one can invest in gold in three ways (I) Physical Gold, (II) Gold ETF, (III) Sovereign Gold Bond
Physical Gold: Traditionally Indian families prefer yellow metal as an asset class and is considered very auspicious. The purchase of gold happens in the physical form of gold coins and bars for investments and jewellery for consumption. Usually households purchase gold directly from jewelers. However there are concerns with respect to quality and safety due to risk of theft and storage.
Gold ETF: Gold Exchange Traded Funds are mutual funds that invest in gold bullion and track gold’s international prices . They are backed by gold with a purity of 99.5% or 99.9%. Gold ETFs are held in dematerialised form and are an alternative to physical gold for investments. This gives investors an opportunity to get exposure to gold and participate in the market. Since, Gold ETFs are listed on exchanges one can purchase and sell their ETFs on exchanges at any time. Moreover, since they are in a dematerialised format, there is no risk of theft and no additional storage costs. However, brokerage and transaction costs and expense ratio are to be paid by the investors. It is preferred by Ultra HNI’s, Trusts and Corporates for their allocation in gold.
Sovereign Gold Bond (SGB): The Reserve Bank in consultation with the government of India started to issue Sovereign Gold Bonds in November 2015. The main objective of introducing SGB was to reduce the demand for physical gold and shift a part of the domestic savings used for the purchase of the yellow metal into financial savings.
As per RBI’s Annual Report 2020-21; The Reserve Bank in consultation with the GoI issued twelve tranches of SGB (Sovereign Gold Bond) for an aggregate amount of INR 16,049 crores (32.35 tonnes) during 2020-21. A total of INR 25,702 crore (63.32 tonnes) has been raised through the scheme since its inception in November 2015 till March 2021.
Some of the key advantage of SGB over Physical Gold and Gold ETF’s are:
It pays guaranteed interest of 2.5% p.a. on the issue price of the bond, payable every 6 months
If SGB’s are held till the maturity of the bond (8 years), the capital gain tax is exempted. However, tax on interest paid on SGB bond is taxable as per tax slabs
Special digital discount of Rs.50/gm is given on the issue price when individuals apply online
Only Individuals , HUF’s , Trusts, Universities and Charitable Institutions can apply in SGB’s
Below is a detailed comparison of Investment in gold in physical form, Gold ETF and Sovereign Gold Bonds
Considering the above comparison SGB is far more superior product for investment in gold for investors like Individuals, HUF’s, Trusts, Charitable Institutions and Universities. Since, it has an advantage of capital gain tax exemption if bonds are held till maturity (8 years), also it provides guaranteed interest of 2.5% p.a. on the issue price, which is not applicable on either Physical Gold or Gold ETF. Another advantage of SGB is that it is issued at a discount of Rs. 50/- per gram on its issue price if applied online.
Corporates, Ultra HNI’s (those HNI’s who want to invest more than 4 kgs of gold in a financial year), Trusts/ Charitable Institutions (those who want to invest more than 20 kgs of gold in a financial year) Gold ETF is preferred over SGB since there is no maximum limit of investing in gold.
Keeping in mind the triggers such as high inflation, currency debasement, negative real interest rate, higher % of Debt to GDP ratio, geopolitical economic risk, equity markets at expensive valuations and covid related uncertainties, etc. make a strong argument for allocating to gold as a strategic asset class.
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