For centuries, gold was considered a primary medium of exchange as it possesses unique qualities that make it ideal for measuring and storing value.
It is rare, has easily discernible quality (hence difficult to falsify), is virtually indestructible, does not rust or fade with time and is stable in its solid form across various ranges of temperatures.
Gold maintained its role as money or a medium of exchange up until 1971, when the Gold Standard was abandoned and paper money was no longer backed by gold.
From the end of the Second World War to 1971, the price of gold was fixed in US dollars while other currencies had fixed exchange rates to the dollar, creating a de facto gold standard. After doing away with the gold standard, government-issued paper (or fiat) currency was backed by the “full faith and credit” of the issuing government, not physical assets.
Currency went from being an asset to being a liability, whereas gold remains the only true global currency that is no one’s liability.
As exchange rates began to vary, the value of gold became a reflection of the value of the US dollar. As the dollar weakened, the value of gold appreciated, and vice versa. Under the current global monetary regime, paper money has no intrinsic value of its own and normally depreciates over time; a dollar today is worth much less than 10 years ago in terms of what it can buy.
Gold, on the other hand, is a tangible asset with perceived intrinsic value that has survived the test of time. One could argue that the real value of gold, expressed in purchasing power, is largely static. The nominal value of gold, however, appears to change over time. In essence, the price of gold in US dollars increases when the purchasing power of the US dollar decreases or is expected to decrease.
World markets have seen a period of considerable volatility since the 2008 global financial crisis, during which the stability of the global financial system was brought into question.
Large financial institutions such as Lehman Brothers and many other banks failed, some governments like Greece effectively defaulted and had to restructure their sovereign debt. It is under these conditions that the value of gold has risen significantly.
Before the crisis, gold traded as low as $604 (Dh2,218) per ounce in 2007, but reached over $1,900 an ounce in September 2011 and is currently trading around $1,200 an ounce.
The stability of the global financial system largely hinges on trust. Lenders have to have faith in their borrowers, and the whole system has to have faith in governments because they regulate the system and issue the currencies which facilitate transactions.
If this faith is undermined, as it has been since 2008, the increased risk drives capital owners to seek refuge in “safe” assets, or “safe haven” assets, and gold is one such safe haven.
The greater the perceived risk, the greater demand there will be for gold and hence it will have a higher price.
Gold is up 16 per cent as of 2016 year-to-date, based on heightened concerns of a slowdown in global growth and higher systemic financial risks coming from Europe and China.
While some traders do speculate on gold prices for short term gains, the true value and best role for gold in a multi-asset class investment portfolio is that of an insurance policy against a number of risks. The most prominent amongst these are risks posed by the global financial system and a weaker US dollar. This is because gold is an asset which is not tied into any sovereign credit rating and is a currency that maintains its stable value, and even appreciates when other paper currencies are depreciating.
In an economic climate where we experience the increased probability and higher frequency of challenging market conditions, particularly emanating from North America, Europe and now China, gold can act as a hedge against such developments. With the continued and considerable uncertainties still facing the world economy, investors need an insurance policy and gold can be one of those strategies.
On the other hand, should the global uncertainly be resolved favourably in the short to medium term and the gold price drops as a result of improved economic conditions and lower financial risks, a well-diversified investment portfolio would not suffer as other asset classes gain in value.
Under such circumstances, the drop in gold prices would represent the insurance premium paid to protect investment portfolios from any potential global economic downturn, even if a downturn does not ocurr.
In my estimation, given the uncertainty surrounding the global economy and financial markets, investors may be well-served by allocating a portion of their portfolios in the 5-7 per cent range to gold as a form of insurance. They would be more secure in the knowledge that a part of their portfolio is denominated in a physical currency that is a tangible asset, and is not dependent on “faith and credit”, or lack thereof.
— Yaser Abu Shaban, CFA, is member of the CFA Society Emirates.
