Gilt hedged

Investors worried about the inflationary effect of so many stimulus plans should buy gold, the World Gold Council says.

Gold is much scarcer than most people realise. If you gathered together every single ounce that has been mined during the past 10,000 years of human civilisation and melted it into a single cube, it would stand only about as tall as an eight-storey building. And, if no new discoveries are made, the world's gold mines will be empty in about 10 to 15 years.

Unlike most other commodities, this scarcity plays a big role in underpinning the value of gold, which is why investors have been buying it in record numbers since the start of the financial crisis. In a normal year more than half of all the demand for gold comes from jewellers, particularly in India and China, but in the first quarter of 2009 investors made up the bulk of demand for the first time in almost 30 years, according to the World Gold Council. As a result, the price of gold has risen to close to $950 an ounce today, from a low of almost $700 at the end of last year.

The big question is where it goes next. Common sense demands that the price of gold should fall as investors move back into equity markets and other risky assets, but common sense also tells us that the price of gold should rise when the dollar is weak and inflation is high. All these things are on the cards, so what does it mean for gold?

Speaking to journalists in Hong Kong on Friday, Marcus Grubb, managing director of the World Gold Council, argued that the early signs of economic recovery do not necessarily spell bad news for gold. "We believe the world has changed significantly since the crisis," he said. "The model of wealth management has changed. Investors are thinking more about risk and that's positive for gold."

It also helps that investing in gold is so easy now, thanks to products such as exchange-traded funds, said Grubb. "ETFs have added a very useful and liquid way to invest in gold."

ETFs now account for around 30% of gold investment, with State Street's $34 billion SPDR Gold Shares fund by far the most popular.

However, it is by no means clear that Grubb is right about investors having learned an indelible lesson during the past year or so. "We don't see an outflow from gold just because equities are coming back," he said. "I think that's naive."

Indeed, a return to stability should be positive for jewellery demand, which is typically a bigger share of gold demand than investing anyway. But economic recovery poses investors with a much greater threat in the form of inflation, said Grubb. The massive amounts of liquidity that central banks have injected into banking systems, combined with huge stimulus packages, will drive inflation to levels that have not been seen for decades.

In that environment, gold is a good hedge. Some studies even show that gold is a better inflation hedge than inflation-linked bonds such as Tips. In 1979, for example, when inflation hit 13%, the price of gold spiked more than 120% during the course of the year.

Given the size of government spending around the world, inflation could easily reach those levels in the coming years and now is the time to prepare for it. "Investors are right to think about inflation right now," said Grubb. "Next year they may be too late."

Even in the absence of inflation or risk aversion, gold has a role to play for all investors, said Grubb. "Gold will almost always improve the risk/return profile of a portfolio."

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