The golden hedge

Gold has been making headlines again recently. In mid-August it was revealed that three of the largest hedge funds in the world had bought so much of the stuff that they had to report it to the US authorities. George Soros had bought a $600 million exposure, while Eric Mindich at Eton Park had $800 million invested. Topping those two is John Paulson (known for his $25 billion bet against subprime mortgages); he is understood to have a $4 billion position in gold.

These hedge funds are known for taking positions, both long and short, that go spectacularly correct. But the key to longevity for a hedge fund is to not lose money. And in that, they are supposed to live up to their names and hedge their positions. In this way, while gold can be seen as an investment, it should also be seen as a hedge. And given the level of global uncertainty, is a long gold strategy something that corporate treasurers and finance officers should be considering as part of their hedging activities?

To most professionals this might sound a little crazy. After all, it is difficult enough dealing with banks and counterparties through the usual electronic banking channels. A gold strategy would require – in theory – physical delivery and then storage of the metal in a safe place. All that would cost time and money.

However, in recent years, new products have emerged that allow investors to get exposure to the price movements of gold without actually buying the stuff. These are mainly exchange-traded funds (ETFs) that buy and sell the physical gold and undertake all the insurance and storage costs. The largest of these is the SPDR Gold Trust, which is up 12% this year.

So, if companies can get exposure to gold without the hassle of owning it, what do they get for their exposure? There is a rich academic debate about what gold actually hedges against. Is it a fall in the price of the dollar, is it inflation? Or is it a wider hedge against uncertainty?

“No American or European corporate would consider buying gold as a hedge for a falling dollar,” said Jeff Wallace, managing partner of Greenwich Treasury Advisors in Boulder, Colorado. “The issue is that if they are long US dollars, they are short some other currency, perhaps the parent currency. So, the right answer is to do a short US dollar/long parent currency forward or option, or participating forward or whatever. Then they are hedged.”

The argument against using gold as a hedge against inflation is more nuanced. In the past 10 years the price of gold has nearly doubled while inflation has remained more or less the same. This suggests that companies and investors have bought gold with a view to it going up if inflation went up, but inflation (or at least the reported inflation figures massaged by central banks around the world), stayed fairly calm.

"The widespread consensus that gold is an effective inflation hedge is not on the mark," said David Rosenberg, chief economist of Gluskin Sheff in Canada, in a note to clients in June. "Our statistical analysis shows there to be a fairly loose link even if gold is a store of value. We also know that in the deflationary 1930s, the sterling price of gold doubled."

However, the recent upward rise in the price of gold has coincided with a vast increase in global money supply. And when central banks flood the markets with money, inflation tends to follow. Therefore, some argue that a rising gold price is a leading indicator of future inflation, to which end it could protect against its destructive power.

“We find that money supply can have an effect on the price of gold. As the money supply increases, the gold price rises,” says Juan Carlos Artigas, an investment research manager for the World Gold Council (WGC) in New York. “We also find that gold is an indicator of future velocity of money, in particular in the US. In other words, the gold price can be interpreted as a signal that the market expects the velocity of money to increase, thus raising future inflation.”

Whether rising gold prices are a cause or an effect of rising inflation is disputed by others. They say that as gold prices and inflation go through long periods of correlated and uncorrelated movement, it is not correct to look for a causal link. These others point to a bigger issue: namely that when the world seems to be heading to hell in a hand basket, people buy gold. More scientifically speaking, gold will serve as a hedge against increases in global political risk.

Gold was last at the prices it is today back in the 1970s when the oil shock, the cold war, the Cultural Revolution in China and the Islamic revolution in Iran made the world a very risky place. It was also a time of high inflation, and the two are clearly linked. Even though the world seems safer now than it did back then, there are still many geopolitical worries that are affecting the markets.

And yet a close analysis of where the demand for gold is coming from reveals that the price rises are not matched by an increase in demand. In the first quarter of 2010, there was total global demand of 760 tonnes of gold, down from 853 tonnes in the last quarter of 2009 and 1,053 tonnes in the first quarter of 2009. But during this period the gold price actually rose by about 20%. Price and demand are now moving in opposite directions.

Part of this may be because the two biggest demand components in the market – Indian jewellery and Asian industry – are still relatively strong, while other nodes of demand are weak. In 2009, according to the WGC, “India accounted for 25% of gold jewellery consumption, 19% of total net retail investment demand (coins and bars) and 17% of other industrial and decorative demand on a global basis”.

Moreover, industrial demand for gold rose by 31% from the first quarter of 2009 to the first quarter of 2010, driven by an upsurge in demand from the Asian electronics industry. Indeed, the electronics sector accounted for 69.9 tonnes of the 103.3 tonnes that were used by industry in this period, an increase of 40% over the same period last year.

Therefore, given that companies are buying more gold, is it really a hedge against perceived future crises, or is it normal buying for industrial usage? Anecdotal evidence suggests that some Asian and Middle Eastern companies are buying gold and justifying it as a hedge, when in actual fact it is little more than a punt. But given where the global headwinds are taking us, it might not be such a stupid punt. After all, with both inflation and political risk heading higher, gold would seem to offer protection of sorts against both. It might be time for companies to get into that golden hedge.