FWP 1 d530904dfwp.htm GOLD INVESTOR RISK MANAGEMENT AND CAPITAL PRESERVATION

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Registration No. 333-180974

May 3, 2013

world gold council

Gold Investor

Risk management and capital preservation

In this edition:

• Investmentcommentary: first quarter 2013

• Goldandcurrencies: protecting purchasing power

• GoldintheGreat Rotation

• Goldholdings:ampleroom for growth in a broad and liquid market

About the World Gold Council

The World Gold Council is the market development organisation

for the gold industry. Working within the investment, jewellery

and technology sectors, as well as engaging with governments

and central banks, our purpose is to provide industry leadership,

whilst stimulating and sustaining demand for gold.

We develop gold-backed solutions, services and markets based

on true market insight. As a result we create structural shifts in

demand for gold across key market sectors.

We provide insights into international gold markets, helping

people to better understand the wealth preservation qualities of

gold and its role in meeting the social and environmental needs

of society.

Based in the UK, with operations in India, the Far East, Europe

and the US, the World Gold Council is an association whose

members comprise the world’s leading gold mining companies.

For more information

Please contact Investment Research:

Juan Carlos Artigas

juancarlos.artigas@gold.org

+1 212 317 3826

Johan Palmberg

johan.palmberg@gold.org

+44 20 7826 4773

Boris Senderovich

boris.senderovich@gold.org

+1 212 317 3882

Marcus Grubb

Managing Director and Strategist, Investment

marcus.grubb@gold.org

+44 20 7826 4724

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Gold Investor | Risk management and capital preservation

Contents

Foreword 02

I: Investment commentary: first quarter 2013 03

First quarter performance 03

A perspective on gold’s recent pullback 05

A decade shaped by structural changes 06

Two very different bull runs 08

What does the future hold? 09

References 10

II: Gold and currencies: protecting purchasing power 11

Is it not all about consumer price inflation? 13

Measuring purchasing power through exchange rates 16

Focus 1: Real effective exchange rates in summary 16

Holding gold as a strategy for preserving purchasing power 18

Focus 2: Gold and inflation 18

The role of gold in a world of fiat currencies 21

References 22

III: Gold in the Great Rotation 23

Gold and the Great Rotation 24

Focus 1: The Great Rotation debate 25

Gold in the Great Rotation 26

Focus 2. Why gold is a strategic asset 27

Bonds: handle with care 29

Gold’s perennial role 29

References 30

IV: Gold holdings: ample room for growth

in a broad and liquid market 31

Financial assets are growing at a rapid and

unsustainable rate 32

Focus 1: How large is the gold market? 34

A system vulnerable to the increasing frequency

and magnitude of tail events 35

Gold should be a larger share of financial assets 36

Focus 2: Benefits of holding gold in a portfolio 37

Focus 3: The importance of sustainable ownership rates 39

Taking a closer look at gold as a strategic asset 39

References 40

01

Foreword

Welcome to the second edition of Gold Investor, which includes a selection of the latest

investment research from the World Gold Council.

Gold has come under significant pressure over the past months. Following more than a year of

range-bound prices, an exceptional selloff in the middle of April has accentuated concerns that

gold’s bull run has come to an end.

In the short term, a stronger US dollar, fragile sentiment and worries over European central bank

gold sales will create a challenging environment for gold prices. In addition, the concentrated and

violent sell off in the second week of April will shake confidence in gold prices for some time,

but does not damage the long-term fundamental drivers or gold’s long-term strategic value. We

believe that despite the current turbulence, the fundamentals of the gold market remain well in

place. Physical demand for gold remains strong in India and China. Between them, they account

for over half of the annual global demand for gold. Further, irrespective of potential gold sales in

Cyprus, central banks, particularly in emerging markets, have been net buyers of gold for several

years and the conditions and objectives driving these purchases remain in place.

In addition, the continuing economic malaise in the OECD, high levels of accumulated

indebtedness, the ramp up of quantitative easing (QE) in Japan, and the continued effects of the

European sovereign debt crisis serve to remind investors that this economic and credit cycle is

different: the solutions will be protracted and the background level of investment risk is higher

than in the past. In our view, despite the recent and widely followed pullback in its price, gold has

never been more relevant as an investment asset and currency.

In this edition of Gold Investor, we examine the benefits of holding gold in an environment where

expansionary monetary policies and the resultant global imbalances in capital accumulation and

borrowing, imply significant levels of currency debasement and more frequent tail-risk events.

We also explore what a rotation back into equities, in light of improved investor sentiment

surrounding economic recovery in the US, might mean for gold. While there has been some

debate about whether a shift from safe to riskier assets could be negative for gold, its

diversification credentials increase portfolio efficiency in both good and bad economic times. In

addition, we debate why higher portfolio risk – consistent with a rotation out of cash or bonds into

equities – actually warrants a higher strategic gold allocation.

I hope you find this edition of Gold Investor informative and stimulating and would welcome your

views on the papers contained within.

Marcus Grubb

Managing Director and

Strategist, Investment

Gold Investor | Risk management and capital preservation

I: Investment commentary:

first quarter 2013

Gold’s recent price weakness and the sizeable outflows

from gold-backed ETFs have rekindled speculation about

the end of gold’s bull run and generated comparisons to

its 1980s decline. We discuss the limitations of the most

common arguments and contextualise gold’s price pullbacks.

We examine structural shifts that the gold market has

experienced over the last decade resulting in a robust set

of demand factors, very different from that seen during

the 1970s.

First quarter performance

Gold prices fell by 3.6% during the quarter (Chart 1a) alongside traditionally ‘safe’ assets such

as US treasuries, the Swiss franc and Japanese yen amid sizable gains in developed world equity

markets – with US equities alone gaining 11% (Chart 1b). The US dollar appreciated by more

than 4% in the period creating some headwinds for the gold market. Following the quarter’s end,

during an erratic two-day move in mid April, gold prices had dropped a further 10%.

Gold prices fell 3.6% in Q1

amid gains in developed

market equities.

0

8 |  |

16

24

US$/oz Volatility (%)

Chart 1: (a) Gold prices continued to fall, while (b) developed market equities soared during the quarter

Long-term

average

Gold price (lhs) Realised quarterly volatility (rhs)

Reference notes are listed at the end of this article.

Source: Bloomberg, World Gold Council

1,500

1,550

1,600

1,650

1,700

1,750

1,800

04/2012 07/2012 10/2012 01/2013

US equities

DM equities

Trade-weighted US$

Commodities

US Treasuries

Swiss franc

EM equities

Gold (US$/oz)

Japanese yen

-12 -6 0 6 12

Return (%)

-3.6%

10.7%

9.9%

4.2%

0.6%

-0.2%

-0.4%

-0.4%

-7.1%

02_03

During Q1, positive economic developments in the US prompted investors to rotate funds out of

cash into equities, a phenomenon we discuss in Gold in the ‘Great Rotation’. There was also a

slight improvement to European economic confidence early in the quarter, but it did not last long.

News of a proposal to tax bank deposits in Cyprus eroded investor confidence and temporarily

boosted gold prices. While Cyprus was a case of limited contagion, their deposit tax solution set a

precedent and sent shivers throughout Europe. Subsequently, the European Central Bank signaled

that Cyprus could employ central bank gold reserves to cover losses from emergency loans to

commercial banks, putting downward pressure on prices and exacerbating bearish views in the

gold market. While Cyprus’s decision to sell gold has not been confirmed, the announcement

raised concerns about central bank independence and the prospect of sales by other European

nations. However, both the Central Bank Gold Agreement (CBGA)1 and strong emerging market

demand, which accounted for the bulk of 2012 central bank purchases (535 tonnes), should

allay fears.

Elsewhere, the Bank of Japan (BoJ) enacted unprecedented expansionary monetary policies

in early April weakening the yen to almost ¥100 per US dollar – a level not seen since 2009.

Expansionary measures should generally be positive for gold. However, after more than a decade

of deflation, Japanese investors have seen this as an opportunity to increase flows into equities.

Additionally, one unintended consequence of a ballooning monetary base in Japan is the flow of

capital into foreign assets, primarily US-dollar denominated assets, which in the short term can be

negative for gold. Over the longer term, concerns about higher inflation and the sustainability of

BoJ polices are likely to become more apparent and make gold’s role more relevant.

Gold’s volatility marginally dropped to 11.1% during Q1 2013 – its third lowest quarter in the past

decade. Gold volatility typically decreases in a falling price environment in contrast to what is

typically observed in most risk assets. However, a sudden 9% price drop on April 15 has pushed

gold’s volatility higher; despite this gold’s three-month rolling volatility (approximately 20% by

the time of writing) is still within levels seen as recently as Q2 2012. At the same time, gold’s

correlation to other assets fell during Q1 2013 relative to 2012 as macroeconomic drivers that

pushed many risk assets higher, did not have the same effect on gold. Nonetheless, correlation

remains high compared to historical levels (Chart 2).

But what does the current period tell us about gold’s bull run?

Sentiment in the US

may have improved, but

problems in Europe linger.

In Japan, aggressive

inflationary policies

will benefit gold in the

long term.

Gold’s volatility marginally

fell during Q1 and so did

correlations.

Q1 2013 2012 Past 25 years

Reference notes are listed at the end of this article.

Source: Bloomberg, J.P. Morgan, World Gold Council

Global equities

EM equities

Global bonds

Commodities

TW dollar

Chart 2: Gold’s correlation to global assets fell during Q1, but are still high relative to history

Correlation

-1.0 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1.0

1 CBGA prevents signatories from collectively selling more than 400 tonnes of gold in a year and includes all European Union members.

Gold Investor | Risk management and capital preservation

A perspective on gold’s recent pullback

The gold price has appreciated for the past 12 years, with average and year-end prices consistently

rising since 2001. However, gold prices have fallen from their nominal high of US$1,895/oz

(based on the London PM fix) set on 6 September 2011. By the end of Q1 2013, gold traded

near US$1,600/oz – a 16% pullback from its record high. In the first weeks of April, exceptional

conditions pushed the gold prices down further (as much as 27% below the US$1,900/oz level).

As gold prices fell, market participants questioned whether this drop represented the end of the

bull market and many gold analysts revised down their long-term price forecasts. In the past,

analysts’ short-term price predictions have not been without merit despite the difficult task of

forecasting gold. However, gold’s longer-term outlook has consistently been underestimated and

the top of the market called on multiple occasions (Chart 3).2

With gold prices dropping

by 16% in Q1 from their

high, analyst have called the

end of the bull run, but not

for the first time.

It appears that, as a consensus, gold analysts have failed to appreciate the structural changes that

have taken place in the gold market, firmly supporting price increases over more than a decade.

Additionally, most of the analysis tends to focus on US-driven factors neglecting other important

global variables. This leads to a particularly relevant question: is the recent pullback a true sign of

changing dynamics or is it consistent with gold’s 12-year trend?

First, we need to understand the economic environment that pushed gold prices to US$1,900/oz.

During 2011, concerns over the economic health of the US and Europe and the aggressive

monetary policies that followed (Western demand) coupled with strong emerging market growth

(Asian demand) boosted gold prices. Gold prices accelerated from US$1,500/oz in June to

US$1,900/oz in less than two months – an uncharacteristic acceleration. Such sharp increase

proved difficult for long-term demand drivers, such as Asian and central bank demand, to support.

The issue was not the price level itself, but how rapidly prices rose. In this sense, using an

US$1,900/oz as a benchmark for comparison overstates the correction and obscures the

long term trend.

Often, price predictions

exclude the effect of

non-US factors.

In 2011, gold prices rapidly

rose to a record high, not

giving time for organic

demand to adjust.

500

750

1,000

1,250

12/2007 12/2017

12/2009

12/2011

12/2013

12/2015

1,500

1,750

Gold price

Reference notes are listed at the end of this article.

Source: Bloomberg, World Gold Council

Consensus analyst forecast

2,000

US$/oz

Chart 3: Consensus analyst forecast has consistently been bearish on gold prices

2 This systematic bias is by no means confined to the gold market. Interest rate strategists have consistently had an upward bias to their forecasts of

benchmark interest rates in the US, predicting higher rates even as the 2008-09 financial crisis unfolded.

04_05

Even so, it is not the first time the gold market has experienced a pullback of this magnitude and

will likely not be the last. Asset price pullbacks occur naturally across financial markets and gold is

no exception. Instead, it is important to understand the sustainability of long-term drivers once the

effect of short-term drivers wears off. For gold, price pullbacks have often been linked to investor

profit taking, higher opportunity costs, and less uncertain economic environments, among others.

However, given that only 35% of annual demand is currently driven by investment, many others

factors influence gold’s performance. These factors such as emerging market demand or central

bank activity have little to do with economic conditions in developed markets. Over the course of

its 12-year bull run, gold prices have fallen by more than 10% (peak-to-trough) on seven occasions

and by more than 20% on three (Chart 4).3 The largest correction took place between March and

October 2008, when gold prices fell by 30%. After each of those occasions, gold prices made

new highs supported by healthy demand. In fact, anecdotal evidence suggests that Chinese

and Indian consumers as well as emerging central banks have used price pullbacks as buying

opportunities.4 Such purchases have made the news following gold’s exceptional mid April sell

off, as purchases have been brought forward in response to lower prices.5

So, what has made the gold market been so resilient for such an extended period of time?

However, this pullback has

not been the first. Prices

have fallen by more than

10% seven times and three

times by more than 20%

since 2001.

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

Pullback (%)

393+ days

538 days

369 days

337 days

124 days 120 days

93 days

40

30

20

10

0

50

60

70

80

90

100

29.5%

19.2%

15.7%

Gold (US$/oz)

Chart 4: The gold price has previously fallen by more than 10% seven times since 2001

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Gold price (lhs) Rolling highs (lhs) Pullback (rhs)

*Days shown on the chart are trading days and exclude weekends and holidays.

Notes to go at the back of the document

Note for chart 5

Reference notes are listed at the end of this article.

Source: Bloomberg, World Gold Council

April 15

27%

3 We define a separate pullback as one that occurs for a unique period of a new high. In other words, multiple oscillations around the 10% pullback

level for the same period were not counted.

4 |  | Precious metals daily, UBS, 5 April 2013 and Precious metals daily, HSBC, 25 March 2013.

5 |  | Bloomberg, Gold tumble stokes demand from Indian bazaars to Chinese malls, 18 April 2013.

A decade shaped by structural changes

The gold market has seen a number of positive structural changes since 1999 (see timeline

opposite). These include the launch of gold-backed ETFs, the liberalization of the Chinese gold

market, the Central Bank Gold Agreement, developments in the use of gold as collateral, an

increase in emerging markets disposable income, and the resurgence of investment demand as

a by-product of the 2008-09 financial crisis and its aftermath. The effect of these events was not

felt immediately, but its combined and long-term effects have had significant implications for gold.

The gold market has

seen multiple structural

shifts since the turn of

the century.

Gold Investor | Risk management and capital preservation

The introduction of gold-backed ETFs has made gold investment accessible to a wider audience

through a transparent, regulated and liquid instrument that is backed by physical gold (and thus is

not a derivative contract). While gold-backed ETFs represent only 10% of average annual demand

(and less than one-third of investment demand). As of the end of Q1, there were 2,600 tonnes

of gold held in the form of ETFs, corresponding to just 8% of above-ground stock held by private

investors. The amount held in ETFs is roughly equivalent to one full year of mine production.

The establishment of the Shanghai gold exchange and the legalization of gold investment

purchases were tectonic shifts for the Chinese gold market. In turn, consumer demand has

increased from 200 tonnes per year in 2002 to over 750 tonnes per year in 2011 and 2012.

Chinese demand growth was not only fuelled by accessibility but by higher economic output. In

fact, growth in India, South East Asia and many other emerging economies has been particularly

relevant to the gold price development. As GDP and incomes in these countries increased, so did

demand for gold.

The financial crisis of 2008-09 represented a paradigm shift, structurally changing investors’ risk

management practices. The fallout has led developed market central banks to heavily intervene in

financial markets by implementing aggressive monetary policies. A persistent increase in central

bank balance sheets has motivated many western participants to purchase gold as a hedge

against future inflation and currency debasement. While assets such as US Treasuries, German

bunds, UK gilts, and Japanese Government Bonds are still widely considered ‘safe’, the financial

crisis and its aftermath has exposed some of their weakness, lowered their ratings, and prompted

questions not only on the underlying creditworthiness of government bonds but their excessive

correlation. Even as the economic environment improves, most structural problems in developed

markets have not been properly addressed leading to an increasing frequency of tail risk events as

summarised in Gold holdings: ample room for growth in a broad and liquid market.

Additionally, central banks have become net buyers after two decades of selling. The impact of

central bank activity is driven by two trends. European central banks, that had been the primary

source of central bank sales since the collapse of Bretton Woods and the gold standard, slowed

down their sales. At the same time emerging market central banks started to increase their gold

purchases as they looked to diversify their foreign reserves. As a result, what was close to 500

tonnes of annual supply less than 10 years ago had become over 500 tonnes of demand by 2012.

… such as the advent

of ETFs…

… strong demand from India,

China, and other emerging

markets…

… a reassessment of risk

management practices

by investors in developed

markets…

… and central banks have

turned to net buyers.

European central banks

sign an agreement

limiting gold sales

Gold miners begin

to de-hedge their

operations

Introduction of

gold-backed ETFs

Chinese banks allowed to sell

gold investment products.

Credit crisis spurs

a re-evaluation of

risk management

policies

Central

banks

become

net buyers

Institutions

begin to view

gold as

collateral –

(CME, ICE etc.)

Turkey’s central bank

allows gold to be

used as capital for

commercial banks

Shanghai gold exchange

founded. Chinese gold

market liberalised

Commercial banks

in China begin

trading bullion

Start of QE

monetary

policy

European debt

crisis begins.

Creditworthiness

of developed market

government debt put

into question

Questions

raised about

the safety of

US debt

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Reference notes are listed at the end of this article.

06_07

Two very different bull runs

The recurring comparison between the current gold price trend and the seemingly equivalent

inflation-adjusted price appreciation gold experienced period between 1971 and 1980 is, in fact,

a simplistic and flawed parallel. These two periods have been characterized by different price

performance and remarkably dissimilar fundamental drivers. During the 1970s, the advent of

fiat currencies made gold a free-floating market while private gold ownership was once again

permitted in the US. During that decade, oil prices spiked and tensions in the Middle East rose,

leading to hyperinflation and instability. Gold prices shot up on the back of these tailwinds.

However, speculative flows led the way, not giving enough time for demand to grow organically.

During the 1970s, gold prices rose by an average of 30% per year, with similar levels of volatility.

At their peak, inflation-adjusted prices rose 12-fold to more than US$2,500/oz amid violent

pullbacks of over 40% (Chart 5). A combination of fewer financial assets available, strong gold

investment demand, and a meteoric price increase, substantially increased gold ownership levels

to a 14% share of all financial assets. In comparison, gold represents just 1% of assets today as

discussed in Gold holdings: ample room for growth in a broad and liquid market. At the same time,

the gold market was significantly less diverse. During the 1970s, demand was largely driven by

purchases in the US, UK and Europe which accounted for approximately 60% of demand leading

up to gold’s peak (Chart 6). On the supply side, South Africa greatly dominated mine production

and a flurry of discoveries increased supply in the early 80s, putting further downward pressure

on the gold price.

In contrast, gold demand

during the 1970s was

fuelled by cyclical factors.

Prices quickly rose amid

violent pullbacks and

ownership levels were high.

Price performance 1971 – 1983 2001 – present

CPI inflation 9% 2%

Annual return 30% 16%

Volatility 29% 19%

Maximum price increase 1,065% 465%

Maximum pullback 46% 29%

Number of 20%+ pullbacks 4 2

Reference notes are listed at the end of this article.

Source: Bloomberg, LMBA, IMF, Thomson Reuters GFMS, World Gold Council

1970s gold price performance 2000s gold price performance

Max: US$850/oz

US$2,500 in 2013

0

500

1,000

1,500

2,000

2,500

Index level

Chart 5: Gold’s current bull run has been measured and steady, in stark contrast to

the 1970s price action

1970

2001

1972

2003

1974

2005

1976

2007

1978

2009

1980

2011

1982

2013

Gold Investor | Risk management and capital preservation

In contrast, the bull market in the 2000s, influenced by the structural factors previously discussed,

has been driven by growth in Asian emerging markets and economic problems in developed

markets. Demand and supply are more balanced and geographically diverse resulting in a measured

and less volatile trajectory.

What does the future hold?

Short term factors including market momentum and the concentrated sellof following analysts’

downward gold price forecast revisions along with Cyprus’ gold sales contagion could put

pressure on gold prices in the near future. However, we consider that many of the fundamental

drivers that have supported gold’s 12-year trajectory are still well in place. Data suggests that

some investors in developed markets are betting on a swift economic recovery, and while

economic data may seem encouraging in the US, many of the underlying issues that financial

markets face are still relevant: countries face high level of debt while monetary policies have yet to

unwind. At the same time, gold’s fate does not rely only on uncertainty and malaise in developed

markets. Gold’s performance is also linked to their long-term economic expansion. There is

consensus that emerging market economies will continue growing. Most economists agree that

emerging markets will continue to grow and surpass developed market economies by 2020 in

term of GDP.6 Finally, the US dollar will likely remain a crucial component of the monetary system,

but may have to make room for others. As central banks diversify their foreign reserves, gold will

continue to be one of the most relevant assets.

For the past decade, gold

has been supported by a

robust combination

of factors.

Short term factors can put

pressure on gold, but long

term dynamics remain

healthy.

6 |  | Economist, Power Shift, 4 August 2011.

Source: Thomson Reuters GFMS, World Gold Council Share of demand (%) Chart 6: Geographic composition and source of demand is more diverse today than

it was during the 1970s

0

20

40

60

80

100

USA and Europe Asia Other

Jewellery Technology Investment Central banks

1970s 2000s 1970s 2000s

08_09

References

Chart 1: (a) Gold prices continued to fall, while (b) developed market equities soared during the quarter

(a) |  | Realised volatility is computed using daily returns for each quarter. The wide arrow on the right represents the

long-term volatility computed using return data from December 1987 to December 2012.

Chart 2: Gold’s correlation to global assets fell during Q1, but are still high relative to history

Correlations are computed using daily data over the period referenced in the legend. ‘TW dollar’ is a trade weighted

currency basket for the US. Barclays Global Aggregate, MSCI Emerging Markets and MSCI World are used for

global bonds, emerging market and global equities, respectively.

Chart 3: Consensus analyst forecast has consistently been bearish on gold prices

Analyst forecast is a median of analyst estimate of future gold prices as indicated by the Bloomberg composite.

Gray lines correspond to these forecasts.

Chart 4: The gold price has previously fallen by more than 10% seven times since 2001

The red line labelled rolling high is a rolling maximum price moves up when new a high is reached. The days shown

in the chart represent trading days, not calendar days. Pullback is calculated by taking the percentage difference

between the gold price and the relevant rolling highs.

The table below shows the relevant dates of highs at each stage, the date of the 10% pullback and the date of the

maximum pullback followed by the maximum gold price for each period, the price at the maximum pullback price

and percentage as well as the length of the pullback period.

Gold market timeline of events since 1999

The events shown in the timeline have a structural influence on the gold price and were not necessarily price

moving events at their announcements.

Chart 5: Gold’s current bull run has been measured and steady, in stark contrast to the 1970s price action

The two price series were normalised (=100) at the beginning of each period: 1970 – 1983 and 2001 – 2013.

Return performance based on daily data. Fundamental drivers computations based on average annual figures.

Chart 6: Geographic composition and source of demand is more diverse today than it was during the 1970s

The 1970s period is computed using the annual demand date from 1973 to 1979. The 2000s period is computing

using annual demand data from 2004 to 2012. Negative values of demand was considered part of supply and

not included in the calculations. Many of these figures have been subsequently revised as a result of changes

in methodology.

Count Date of high

First date

prices fall

more than

10%

Date of

maximum

pullback

Gold price

high

(US$/oz)

Gold price

(US$/oz) at

maximum

pullback

Maximum

pullback

Trading days

to new high

1 |  | 07/02/00 28/03/00 02/04/01 312.70 255.95 -18.1% 538

2 |  | 05/02/03 13/03/03 07/04/03 382.10 319.90 -16.3% 124

3 |  | 01/04/04 07/05/04 10/05/04 427.25 375.00 -12.2% 120

4 |  | 12/05/06 19/05/06 06/10/06 725.00 560.75 -22.7% 337

5 |  | 17/03/08 01/04/08 24/10/08 1,011.25 712.50 -29.5% 369

6 |  | 02/12/09 22/12/09 05/02/10 1,212.50 1,058.00 -12.7% 93

7 |  | 05/09/11 23/09/11 29/12/11 1,895.00 1,531.00 -19.2% -

Source: LBMA, World Gold Council

Gold Investor | Risk management and capital preservation

II: Gold and currencies: protecting

purchasing power

Investors in developed markets face an economic

environment marked by aggressive monetary policies,

high debt-to-GDP ratios, and challenges to the long-term

strength of their currencies. Gold should play an important

role in any strategy adopted to preserve purchasing

power and minimise downside risks in the face of these

inflationary headwinds.

Gold is used today as an inflation-protection tool by many investors as it has been for centuries.

However, its ability to help investors maintain purchasing power is often misunderstood, leading

some market participants to question gold’s usefulness as an inflation hedge. One of their primary

arguments against gold has been that changes in gold prices tend to have a low correlation

to changes in consumer price indices (CPI) in the US and other developed economies. This

argument, however, has three important shortcomings.

Gold is typically used to

protect against inflation,

but this quality is often

misunderstood.

Purchasing

power

Gold

Currency

debasement

and volatility

High inflation

10_11

First, gold should be seen as a barometer of global inflation, one that responds to inflationary

pressures in developed markets as well as in emerging markets. Notably, gold is bought in the

form of bars, coins and jewellery in emerging markets as a way to preserve and transfer wealth.

These markets have accounted for approximately 70% of annual demand over the past decade

and many face high levels of inflation (Chart 1).

Gold should be seen as

a barometer of global

inflation.

Europe (including UK)

US

China

Turkey

South East Asia

India

Chart 1: Gold demand is not limited to countries with current low inflation levels

Reference notes are listed at the end of this article.

Source: Bloomberg, Thomson Reuters GFMS, World Gold Council

2.4%

3.2%

8.2%

8.3%

8.7%

Average annual jewellery demand

Average annual consumer price inflation

Average annual investment demand

53

301

253

119

119

251

147

201

373

123

568

2.3%

98

Demand (tonnes) CPI (% YoY)

Second, consumer price indices can be useful benchmarks in policymaking, but they are not

always perfect gauges for the rate of inflation end-consumers (and investors) face: adjustments,

substitutions, exclusions and weights given to each component may not coincide with what

households experience day-to-day. Additionally, households’ purchasing power is not only

affected by prices for goods and services paid (ie, inflation), but also by their income level. It is

important for investors to have a better sense of ‘true’ inflation through measures complementary

to CPI, including the relative purchasing power reflected in the foreign exchange rates of their

home currencies.

Finally, gold helps to preserve wealth over the long run. While there is evidence that suggests

gold prices rise in periods of high inflation, as discussed in The impact of inflation and deflation

in the case for gold, by Oxford Economics, the relationship between gold, inflation and, more

broadly, purchasing power should be analysed over long periods of time and not on a

monthly basis.

In this study, we analyse gold’s role in preserving long-term wealth, focusing on its relationship

to purchasing power using ‘real effective exchange rates’. We show how gold can be used by

investors as an integral component of their long-term investment strategies.

… evaluated not only against

consumer price baskets,

but broader inflation

measures…

… and over long periods

of time.

Here we analyse the role

gold has protecting longterm

wealth.

Gold Investor | Risk management and capital preservation

Is it not all about consumer price inflation?

Over the past five years, central banks in developed markets have engaged in aggressive

monetary policies designed to steer economies away from an even deeper recession and,

potentially, deflation. With the expansion of the monetary base (partly through quantitative easing

measures) many investors have grown concerned about the spectre of future inflation. So far,

inflation measured via CPI in many developed economies remains low, and inflation expectations

appear well anchored – albeit with a higher degree of uncertainty and less consensus among

economists.1 Yet consumers feel poorer.2 There are multiple reasons why this may be the case,

but two are particularly relevant to investors who rely on inflation measures to make appropriate

financial decisions: consumer price baskets do not always encapsulate all aspects of inflation and

these need to be analysed relative to a broader set of purchasing power measures.

Baskets such as CPI are widely used for setting policy and making business decisions. The

Bank of England and European Central Bank use UK CPI and European harmonised CPI (HCPI),

respectively, as a benchmarks against their inflation targets. The Federal Reserve focuses on

US CPI excluding food and energy (or core CPI) for policy making, despite the impact these two

categories may have on households. The weights that different goods and services have in the

aforementioned indices do not always correspond to what a household may experience.

For example, tuition has been one of the fastest growing expenses for US households but

represents only 3% of CPI (Chart 2). In practice, tuition costs correspond to more than 10% of

annual income even for upper-middle American households3 – and a higher percentage of

their consumption.

With the expansion of

monetary policies, investors

have grown concerned

about the spectre of

inflation, which has yet to

materialise.

This is in part because

consumer price indices

do not always capture all

relevant aspects of inflation

for end-consumers…

Apparel 3.6% 1.6%

Food and beverage 15% 2.4%

17% 2.7%

41% 2.9%

Transportation

Housing

Goods and services 3.4% 3.7%

7.2% 4.2%

3.1% 4.2%

%

Medical care

Tuition

Total CPI

Chart 2: Important expenditures under-represented in US CPI

Reference notes are listed at the end of this article.

Source: Bureau of Labor Statistics, World Gold Council

Current weight Annual growth rate (1976 – 2012)

2.8%

1 |  | Top analysts’ forecasts of the US economic outlook for the year ahead, Blue Chip Economic Indicators, November 2012.

2 A reduction in buying power has been felt developed economies as discussed in: Hard Times, The Economist, October 2011,

and Dropping shopping, The Economist, March 2013.

3 |  | College may become unaffordable for most in US, The New York Times, December 2008.

12_13

Moreover, consumer price baskets are frequently adjusted to incorporate the effect that

advancements in technology (e.g. in computer hardware) have on prices paid. These so-called

hedonic adjustments can overstate reductions in price compared to what consumers pay in

practice. For example, a new computer can have the same nominal price it did five years ago, but

adjusting for processing speed and storage capacity, it appears cheaper.

In addition, there have been periodic substitutions of goods and services as well as other

methodological changes that, while based in well regarded economic theories, in practice do not

always reflect the full erosion of purchasing power. In fact, as shown in Chart 3, the current rate

of inflation calculated using the methodology in use during the 1980s – which foregoes many

of these recent adjustments – is considerably higher than what is currently reflected by today’s

CPI methodology.

… whether for the component

weights chosen, ‘hedonic’

adjustments made…

… or other methodological

considerations.

Chart 3: US CPI inflation rates computed using the current methodology are lower than

indicated by a previous methodology

CPI (YoY %)

0

2 |  |

-2

-4

4 |  |

10

8 |  |

6 |  |

12

14

16

Reference notes are listed at the end of this article.

Source: Bureau of Labor Statistics, Shadowstats

Current methodology 1980s methodology

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012

Gold Investor | Risk management and capital preservation

However, we are not questioning whether CPI or core CPI are valuable measures for policy

makers around the world, their theoretical validity, or whether the methodology used in the

previous decades to construct these baskets is superior to the one used now. Our main argument

is that consumer price baskets do not encapsulate all aspects of inflation and do not necessarily

reflect actual prices paid by a large portion of consumers. Further, even if CPI inflation were

the correct measure, it should be understood relative to household income. Incomes need to

keep pace with inflation in order to maintain purchasing power. However, real incomes in the

US, UK and Europe have been stagnant (and even falling) for the past decade, exacerbating

the effect that tight economic conditions following the 2008-09 financial crisis have had on

households (Chart 4).

While consumer price

baskets are useful for

policymaking, they are

imperfect in measuring

purchasing power…

Chart 4: Inflation-adjusted incomes in the US, UK and Europe have fallen

Index level

80

110

100

90

120

130

140

03/1991 03/1994 03/1997 03/2000 03/2003 03/2006 03/2009

Reference notes are listed at the end of this article.

Source: Thomson Reuters, World Gold Council

UK Europe US

Understanding how to account properly for purchasing power erosion is of particular importance

to investors. Thus, when making long-term asset allocation decisions, investors should focus on

measures that better capture changes in purchasing power. But, if inflation as measured by CPI is

not enough, what else can be added to the decision process?

… which is a more relevant

metric for wealth

preservation.

14_15

Measuring purchasing power through exchange rates

An alternative way to measure the loss of purchasing power is by looking at the effect of currency

depreciation. In theory, exchange rates should incorporate inflation rates differentials between

countries. Over the long run and assuming an open global economic system, real effective

exchange rates (REERs) – which measure exchange rates among currencies adjusting for the

different levels of inflation – should remain in equilibrium (see Focus 1). This is what economists

refer to as purchasing power parity (PPP). Currency intervention, trade restrictions and other

factors may affect PPP.

However, free-floating currencies such as the US dollar, euro and pound sterling, with their fairly

open and efficient markets, should be effective at pricing differences in inflation. When PPP does

not hold for these currencies over the long-run, holding other things constant, the consumer price

basket used to compute the REER may not be capturing ‘true’ inflation. Thus, when a free-floating

currency depreciates in real effective terms, inflation in the country might be higher than what

CPI would suggest. Additionally, research by the Bank of International Settlements suggests that

“keeping the level of the real exchange rate depreciated (appreciated) for an extended period may

lead to a sustained increase (decrease) in inflation”.4 In other words, a structurally weak currency

may fuel inflation over the long run.

As investors focus on

purchasing power,

they ought to consider

the effects of currency

devaluation…

… which can be measured

using ‘real effective

exchange rates’.

4 Kamin, S. A multi-country comparison of the linkage between inflation and exchange rate competitiveness, Bank of International Settlements,

Working Paper No. 45, August 1997.

5 |  | Catao, L. Why real exchange rates? Finance and Development, September 2007.

Focus 1: Real effective exchange rates in summary

Why real exchange rates?, by Luis Catão offers a simple explanation on the importance of real

effective exchange rates.5 Here’s a summary of the main points:

• Nominal exchange rates reflect the domestic price of a foreign currency, but do not encapsulate

fundamental differences in consumer prices vis-à-vis other countries.

• Real exchange rates (RERs) seek to measure the value of goods and services between

countries and in its most simple expression is calculated as: (exchange rate) x (average price of

good in one country) / (average price of good in another country).

• In practice, real effective exchange rates (REERs) are computed using consumer price baskets

and measured against multiple trading partners at a time. The word ‘effective’ refers to this

multi-country view of real exchange rates.

• REERs represent adjusted exchange rates that account for inflation rate differentials between a

country and the rest of the world and whose weights are defined by the proportionate level of

trade (or other relevant relationship) between economies.

• In the short term, REERs can exhibit considerable volatility. However, in equilibrium and over

the long-term, purchasing parity should hold.

• While imperfect, REERs can be useful to identify large exchange rate misalignments and their

negative consequences.

Gold Investor | Risk management and capital preservation

For many developed economies, purchasing power has not remained constant. In nominal (noninflation

adjusted) terms, exchange rates are a zero-sum game. Some currencies appreciate at

the expense of others. However, once inflation rate differentials are taken into consideration

and a stable system is expected, a telling picture arises. Since the beginning of the century, only

Switzerland has maintained purchasing parity with other currencies in real terms, while the US,

the UK, Germany and even Japan have not (Chart 5). For example, US consumers have lost a

cumulative 12% of their purchasing power through real effective currency depreciation alone.

Most developed market

currencies have been

devaluating in real terms

over the past decade…

Chart 5: Most developed currencies have depreciated in real effective terms over

the past decade

Annual depreciation (%)

-1

0

-2

-3

1 |  |

2 |  |

3 |  |

4 |  |

Reference notes are listed at the end of this article.

Source: IMF, J.P. Morgan, World Gold Council

Germany US UK Japan Switzerland

Note: Real exchange rates computed using IMF 1975 – 1999 2000 – 2012

Looking forward, as emerging markets continue their economic expansion and become even

more important contributors to global GDP – and the monetary system as well – their currencies

will strengthen, further challenging the purchasing power of investors in developed regions. In

their paper Gold, the renminbi and the multi-currency reserve system, the Official Monetary and

Financial Institutions Forum (OMFIF) discussed the Chinese renminbi and the likelihood of it

gradually emerging to become genuine international currency as the Chinese government eases

restrictions on its use in transactions and investments abroad. OMFIF further observed how,

during the period of uncertainty and transition from a single to a multiple reserve currency system

and as policy makers undertake alternative reserve asset management strategies, gold will play

an important role.

Likewise, it is particularly relevant for investors in developed markets to look for long-term

strategies that can better maintain purchasing power. While it is unrealistic for US, UK, or

European investors to forgo their domestic currencies, holding gold can protect investors’ wealth

while helping them manage downside risks.

… and this trend is likely to

continue.

Thus, a comprehensive

wealth preservation

strategy is called for.

16_17

Holding gold as a strategy for preserving purchasing power

There is a large body of research that has studied the relationship between gold and inflation,

examples of which are included in Focus 2. However, to fully assess the benefits that gold offers

as a means of preserving wealth, the effect of both traditional inflation measures and currency

depreciation ought to be included. As discussed in Gold and currencies: hedging foreign-exchange

risk, gold not only has a negative correlation to the US dollar – a relation that is particularly

apparent when using real effective exchange rates (Chart 6) – but it also exhibits a negative

correlation to most developed market currencies in periods of systemic risk. Two natural questions

then arise. First, would an investor benefit by using gold to preserve capital? And second, would

gold be needed even if investors already have other currency-denominated assets as part of their

long-term strategy?

Research has shown

gold benefits through

its negative correlation

to developed market

currencies and its

long-term price stability…

Chart 6: Gold is negatively correlated to the US dollar and acts as a hedge

Index log-level

100

95

90

105

115

110

120

IMF US$ REER London PM fix (real)

Reference notes are listed at the end of this article.

Source: Bloomberg, IMF, LBMA, World Gold Council

1975 1979 1983 1987 1991 1995 1999 2003 2007 2011

Focus 2: Gold and inflation

While gold should be seen in the context of global inflation and analysed over the long run,

research suggests that even when linked to inflation in the US and other developed markets, gold

tends to preserve investors’ capital as it typically outperforms sharp increases in consumer prices.

For example, in The impact of inflation and deflation in the case for gold Oxford Economics shows

that gold performs better than most assets under extreme inflation conditions: namely, in periods

of high inflation as well as in periods of deflation. Additionally, in his seminal work The golden

constant, Roy Jastram finds that over long periods of time gold has maintained its value relative to

wholesale (commodities) prices. This finding was extended to a CPI basket in multiple countries

including the US, the UK, France and Japan by Stephen Harmston and the World Gold Council in

Gold as a store of value.

Gold Investor | Risk management and capital preservation

Our analysis shows that investors do benefit by adding gold and, by holding a portion of their cash

portfolio in gold, investors do not only maintain purchasing power but can also reduce volatility.

Even if investors already hold other developed market currencies, gold provides additional (direct

and indirect) advantages that improve the performance of their cash holdings.

Starting from a simple approach in which only cash was held, investors in US dollars would have

lost an average of 0.5% per year for the past 40 years in real effective terms, and experienced

annual volatility on the order of 5.1%. To understand the effect of adding foreign currencies and

gold to the cash portfolio, we considered three alternatives strategies: 1) holding US dollars

and gold; 2) holding US dollars, British pounds, euro, Japanese yen and Swiss francs, with no

allocation to gold and 3) all previously mentioned currencies and gold.

We found that having a diversified set of currencies as part of cash holdings was substantially

better at not only maintaining but increasing purchasing power. Holding gold improved the

performance of a cash portfolio in US dollars as well as in a portfolio containing a basket of

currencies (Chart 7). For example, calculations using data going back to the 1970s (when gold

became free-floating) show that investors with 87% in US dollars and 13% in gold would have

increased their purchasing power by 1% per year while maintaining the same level of volatility.

Further, holding 47% in US dollars, 18% in gold and the rest in foreign currencies (primarily Swiss

franc and yen) would have increased investors’ purchasing power by 2.1% per year without

incurring higher risk.6 In all, allocations to gold between 2% and 20% over the past 40 years have

increased purchasing power for US dollar investors while reducing risk as well as extreme losses

during negative economic environments.

… helping investors in

preserving purchasing

power.

We anlaysed various

strategies comparing

cash, foreign currencies

and gold holdings.

… and found that adding

2% to 18% gold improves

purchasing power with

equal or less risk, even

when foreign currencies

are part of the strategy.

Chart 7: Gold helps to preserve purchasing power by improving the performance of a

basket of currencies

PP increase (%)

0

0.5

-0.5

-1.0

1.0

1.5

2.0

2.5

Reference notes are listed at the end of this article.

Source: Bloomberg, World Gold Council

US$ US$ and gold US$ and FX basket US$, FX basket and gold

Does not include gold Includes gold

6 The optimal weights in the ‘cash’ portfolio were estimated with the objective of maximising purchasing power and computed using the Re-sampled

Efficiency methodology developed by Michaud and Michaud and discussed in more detail in their book Efficiency Asset Management: A practical guide

to stock and portfolio optimisation and asset allocation, 2nd edition, 2008, Oxford Press, New York.

18_19

We also considered the effect that purchasing power has on risk-averse investors who may

focus only on hedging inflation risk as measured by CPI. A natural strategy to such investors

in the US, for example, is to buy Treasury Inflation Protection bonds (TIPs). By holding TIPs only,

US investors would have made 6.6% per year (in CPI inflation-adjusted terms) since 1997 when

TIPs were first issued. However, once the real effective depreciation of the US dollar is taken into

consideration, their return decreases to 4.3% per year. In contrast, by holding 95% in TIPs and

5% in gold, their portfolio return would have increased to 7% without adding volatility.

But cash or inflation-linked bonds are seldom the only assets investors hold. As summarised in

Gold in the ‘Great Rotation’, the case for gold in a multi-asset portfolio is robust across currencies.

Including the effects of inflation and currency depreciation reinforces this view. For US dollarbased

investors holding cash, domestic and international bonds and equities as well as additional

assets such as commodities and real estate, we found that adding gold allocations between

1.7% and 7.8% improved portfolio performance by reducing risk and improving purchasing

power – consistent with previous findings. Additionally, the analysis shows that taking into

consideration the impact that effective exchange rates have on purchasing power substantially

reduces the optimal weights that conservative, moderate and aggressive investors typically assign

to cash and bonds (Chart 8). The rationale is straightforward: when the currency effect is not

taken into consideration, assets such as cash, government bonds and even inflation-linked bonds

appear stable and attractive. However, taking into account the inherent risks any currency has,

exposes the drawbacks of holding large quantities of seemingly ‘safe’ assets. At the same time,

optima allocations to foreign and alternative assets increase. In this case, diversification becomes

paramount and gold stabilises portfolio volatility by counterbalancing risks,

Gold can also benefit

inflation-linked holdings.

… and when analysed in

the context of a broader

portfolio, a strategic

allocation to gold not only

improves purchasing power

but manages risk more

effectively.

Chart 8: Portfolios that take into consideration the effect of inflation and currency

devaluation have more gold and less fixed income

Cash Bonds Equities Alternatives Gold

Source: Barclays, Bloomberg, J.P. Morgan, World Gold Council

Conservative Moderate Aggressive

Risk tolerance

0

10

20

30

40

50

60

70

80

90

100

Weight (%)

FX adjusted Nominal FX adjusted Nominal FX adjusted Nominal

Chart 8: Portfolios that take into consideration the effect of inflation and currency

devaluation have more gold and less fixed income

Cash Bonds Equities Alternatives Gold

Source: Barclays, Bloomberg, J.P. Morgan, World Gold Council

Conservative Moderate Aggressive

Risk tolerance

0

10

20

30

40

50

60

70

80

90

100

Weight (%)

FX and inflation

adjusted

Inflation

adjusted

FX and inflation

adjusted

FX and inflation

adjusted

Inflation

adjusted

Inflation

adjusted

3 |  |

54

23

15

5 |  |

8 |  |

62

16

10

4 |  |

1 |  |

39

31

21

7 |  |

3 |  |

49

26

16

6 |  |

1 |  |

26

40

26

8 |  |

2 |  |

33

36

23

8 |  |

3 |  |

54

23

15

5 |  |

8 |  |

62

16

10

4 |  |

1 |  |

39

31

21

7 |  |

3 |  |

49

26

16

6 |  |

1 |  |

26

40

26

8 |  |

2 |  |

33

36

23

8 |  |

Gold Investor | Risk management and capital preservation

Our analysis used historical asset performance to estimate optimal allocations aimed at

maximising purchasing power by taking into consideration currency inflation and currency

depreciation. Many developed market economies currently face structural issues that increase

their risk and reduce the benefits their currencies have as vehicles for diversification. These issues

range from high levels of debt-to-GDP as seen in the Japanese and US economies, among others,

to the long-term viability of the euro area as a single currency economy. In this case, gold has a

few noteworthy characteristics: 1) it functions as a currency that has no credit or counterparty

risk; 2) it trades in a liquid, global market; 3) new supply can only come from mine production,

increasing the total available stock at low rates; and 4) even under the conservative assumption

for the gold price to increase at the rate of inflation, its optimal weight in a portfolio is linked to its

beneficial correlation to the US dollar and various other assets for investors.

In sum, through a modest allocation to gold, investors are better equipped to protect purchasing

power not only as measured by consumer price inflation, but also by broader measures that

incorporate systemic currency depreciation.

The role of gold in a world of fiat currencies

Many developed market currencies face a difficult time ahead. Following the collapse of Bretton

Woods and the end of the gold standard, fiat currencies faced a new world with a new set of

rules, originally devised to give more flexibility to central bankers. However, aggressive monetary

policies developed to stimulate battered economies in the aftermath of the global financial

crisis, coupled with record levels of debt issuance, large budget deficits, and a reassessment

of what a ‘risk-free’ asset is, will likely put further pressure in developed market currencies,

effectively depressing consumer purchasing power. As the global economy expands and the

monetary system evolves into a multi-currency framework, gold is not only a natural participant in

diversification strategies but an effective one.

In addition, gold lacks the

credit risk to which other

currencies are exposed.

… making it a valuable

component of long-term

investment strategies.

As the global economy

migrates to a multicurrency

financial system,

gold will help diversify risk

and preserve wealth.

20_21

References

Chart 1: Gold demand is not limited to countries with current low inflation levels

Average investment demand is the annual average of bar and coin and ETF demand from 2005 to 2012. Average

jewellery demand is the annual average jewellery demand from 2005 to 2012. Annual inflation is the annual average

inflation using the country’s respective consumer price indices. South East Asia includes Indonesia, Vietnam,

Thailand, Malaysia and Singapore. South East Asia annual inflation is a gold demand weighted average of those

country’s inflation rates.

Chart 2: Important expenditures under-represented in US CPI

Categories represent select segments of the CPI basket that comprise the majority of the index. Weights are as of

2012 and annual growth rates are computed using monthly data between 1976 and 2012.

Chart 3: US CPI inflation rates computed using the current methodology are lower than indicated by a

previous methodology

1980s methodology computes the inflation rate using the CPI weights during the 1980s. The data and charts

are taken directly from shadow stats. All questions with regards to construction of yearly inflation using the old

methodology should be directed to shadow stats.

Chart 4: Inflation-adjusted incomes in the US, UK and Europe have fallen

All series are inflation adjusted using the country’s inflation basket. US series is computed using median family

income whereas UK and European series is computed using wage per capita data. Between 2007 and 2011 there

were 2.6 persons per household on average in the US.

Chart 5: Most developed currencies have depreciated in real effective terms over the past decade

The chart shows the annual change in the real effective exchange rate. The effective exchange rate is calculated as

a weighted average of a basket of currencies. For full methodology details please refer to the IMF.

Chart 6: Gold is negatively correlated to the US dollar and acts as a hedge

The chart plots CPI inflation-adjusted gold price against the US dollar’s real effective exchange rate.

Chart 7: Gold helps to preserve purchasing power by improving the performance of a basket of currencies

The chart shows the return of a portfolio consisting of the US$ real effective exchange rate (REER), Gold and US$

REER, basket of currencies and US$ REER and Gold, a basket of currencies and US$ REER.

Chart 8: Portfolios that take into consideration the effect of inflation and currency devaluation have more

gold and less fixed income

Portfolio analysis consistent of 13 assets including cash, US Treasuries, TIPs, global inflation bonds, US credit,

Global treasuries, US large cap, US small cap, developed world equities, emerging market equities, real estate,

commodities and gold. Returns, volatility and correlation were computed using monthly data from December 1987

to December 2012. The TIPS index incepted in March 1997 while the global inflation bond (ex-US) series incepted in

December 1997. Inflation-adjustments using CPI (urban consumers).

Gold Investor | Risk management and capital preservation

2%

10%

1 Bank of America Merrill Lynch, High liquidity, policy traction and the great rotation – The Outlook for 2013, 11 December 2012.

2 |  | FT alphaville, Let’s wait for a fall in stocks before declaring a great rotation, 7 February 2013.

Market observers have positioned the Great Rotation, a term loosely attributed in late 2012 to

an investment bank’s global outlook for the year ahead,1 as the replacement of a multi-year ‘cult

of bonds’ with a new ‘cult of equity’.2 Although by no means a new idea, this perceived shift has

received particular focus of late and is currently hotly debated. Supported by a strong surge

of capital into equity mutual funds and ETFs at the start of 2013, many argue that poor bond

risk/reward profiles, relatively attractive equities and signs of economic recovery will prompt

a large-scale reallocation to a more risk-neutral weighting involving fewer bonds and more

equities (Chart 1).

The ‘Great Rotation’ has

been touted by strategists

as a once-in-a-generation

allocation shift.

III: Gold in the Great Rotation

As the debate surrounding a Great Rotation continues to feed

through both the press and the investment community, we

show why gold has a perennial role in a portfolio regardless

of the asset mix. We also highlight that higher portfolio

risk – consistent with a rotation out of cash or bonds into

equities – warrants a higher strategic gold allocation.

Higher risk

Lower reward 4.0

1990

1994 1998 2002 2006 2010 2012 1990 1994 1998 2002 2006 2010 2012

4.5

5.0

5.5

6.0

6.5

0

2 |  |

4 |  |

6 |  |

8 |  |

10

1.0

1.5

2.0

2.5

3.0

3.5

0

10

20

30 Average

40

50

Yield (lhs) Duration (rhs) P/book (lhs) P/E (cycle adjusted; rhs)

Reference notes are listed at the end of this article.

Source: Bloomberg, Thomson Reuters, World Gold Council

Yield Duration Price/book

Chart 1: (a) Bonds look poor, while (b) equities appear attractive

Price/earnings

Equities unattractive

Equities attractive

22_23

Setting aside the validity of an argument for a rotation (Focus 1), if we are indeed witnessing this

shift, investors would want to know how it might impact gold. There are those who think that

what is good for equities is naturally bad for gold, with gold seen simply as a ‘safe-haven’ asset

that functions like insurance during times of market stress. They view gold as being negatively

correlated to the business cycle and equate this to a negative correlation to equities. To some

investors, a rotation out of bonds into equities might suggest a return to a normalised interest-rate

environment – a theme discussed in the recent Investment Commentary: Q4 and full year 2012

– raising the opportunity cost of holding gold and weakening its appeal.3 These perceptions can

foster the sentiment that a Great Rotation calls for a lower strategic allocation to gold. We do not

share this sentiment. Here’s why.

Strong arguments support the perennial necessity of gold in a portfolio and the rationale that

builds this case. In addition, portfolio optimisation analysis has consistently shown that as portfolio

risk increases, the optimal strategic allocation to gold increases – a scenario synonymous with

a shift from bonds to equities. Current flows suggest not an imminent large shift from bonds to

equities but rather a subtle transition of new incremental income into both bonds and equities and

away from cash. We show that gold’s optimal strategic allocation rises in this scenario, too. We

also question whether long-term assumptions about bond performance are appropriate in setting

allocation strategies, and how a relaxation of these assumptions affects an optimal gold allocation.

So while we do not know how investors will react to a potential shift or to their interpretation of

the current environment, we do know that an extensive body of research suggests that having

gold is optimal, and should a shift occur, increasing gold allocations is warranted.

Gold and the Great Rotation

Before we visit the implications of a historic shift from bonds to equities or safe assets to riskier

assets, we first underline how a strategic allocation to gold is a necessity regardless of asset mix.

In other words, the basic premise is that gold is not part of a rotation but sits apart from it as a

core holding, due to diversification, tail risk and capital preservation credentials. We revisit the

rationale for this assertion in the summary in Focus 2. The supply and demand dynamics of gold

equip it with unique characteristics, visible in its statistical properties and return attributes.

It is through this set of characteristics that gold has consistently been shown to perform a

critical role within a diversified portfolio. Gold’s role will become even more important as the

global economic centre of gravity shifts eastwards and as surplus investment capital risks

generating greater market volatility, as discussed in Gold holdings: ample room for growth in a

deep and liquid market.

As investors ponder whether a lower allocation to gold is warranted, as economic risks appear to

recede in concert with a Great Rotation, we underscore that the opposite is true.

Whether a ‘Great Rotation’

is taking place or not,

investors are right to ask

how it may affect gold.

We address these concerns

by showing that gold is not

a luxury but a necessity.

Gold is a foundation asset

that has shown to always

have an important role in a

diversified portfolio…

… and a rotation to equities

increases its relevance.

3 |  | Goldman Sachs, The turn in the gold cycle is likely underway, 25 February 2013.

4 |  | Buttonwood, Time for the great rotation? The Economist, 9 January 2013.

5 |  | Dolan, M. Awaiting proof of the “Great Rotation”, 15 February 2013.

6 A shift in aggregate, holding the stock of equity and bonds fixed, cannot occur as for every shift out of bonds into equities by an investor,

there must be an equal and opposite shift by someone else.

7 |  | J.P. Morgan, Flows and liquidity: Impediments to the Great Rotation, 8 February 2013.

8 |  | Bloomberg, Bernanke defends asset purchases as benefits outweigh risks, 26 February 2013.

9 Barclays, Equity gilt study, 21 February 2013.

10 CITI Research, QE isn’t working: An equity perspective, 21 November 2012.

Gold Investor | Risk management and capital preservation

Focus 1: The Great Rotation debate

The idea of a Great Rotation surfaced in late 2012 in response

to a number of developments.4 The proponents of this theme,

supported by strong flows into equity funds in early 2013

(Chart 2a), base their arguments partly on a number of factors

including yield differentials, the risk/reward profile of bonds and

signs that economic growth is returning – particularly in the US.

The catalyst for these flows, strategists argue, have been a

number of recent developments.

Equities are relatively attractive, particularly on yield comparisons

with bonds (Chart 3a). There are signs of economic recovery.

In the US, housing and energy sectors show improving

fundamentals.5 Corporate balance sheets are solid. In addition,

global central bank policy is perceived to have ‘insured’ markets,

paving the way for higher risk tolerance. Risk/reward appears to

favour equities.

For fixed income, the outlook is poor (Chart 3b). Bond yields

are at historic lows, with real yields negative across a swathe

of the curve. Duration, which roughly gauges the interest-rate

risk exposure of bonds, is at a multi-year high. Investors are

concerned about credit quality and moral hazard in fiscal policy

as low yields reduce incentives for austerity.

Setting aside the somewhat misleading notion of an ‘aggregate’

shift,6 adherents to the notion of a Great Rotation face a number

of sceptics, and for good reason. The flows evidence that

helped prompt talk of a Great Rotation point to an increase in

bond holdings (Chart 2b), in tandem with equities, and only

moderate reductions in cash.7

Demand for bonds will likely not abate. In the US, the Federal

Reserve has mopped up about 90% of treasury issuance

recently and has no imminent plans of retreating.8 This

should help keep a lid – artificial as it may be – on rising bond

yields. In addition, both banking regulation, through Basel III

requirements, and international reserve management, through

reserve accumulation, are consistent generators of demand for

liquid treasuries.9

The current environment may continue to be equity friendly,

but abundant risks remain. General underlying economic

health continues to be weak in many corners, notwithstanding

a brighter outlook for some core US sectors. A number

of governments continue to walk the tightrope of debt

sustainability. Furthermore, it has been argued that there are

unintended consequences for those seeking ‘bond-like returns’

from equities, as it might incentivise corporate payouts and

buybacks rather than investment in growth and employment.10

Q1’08 Q1’09 Q1’10 Q1’11 Q1’12 Q1’13 Q1’08 Q1’09 Q1’10 Q1’11 Q1’12 Q1’13

Net inflows

Net outflows

Net inflows

Net outflows

-100

-50

0

50

100

150

-100

-50

0

50

100

150

Source: Bloomberg, ICI, World Gold Council

US$mn US$mn

Chart 2: (a) Fund flows into equities are at a multi-year high, but (b) not at the expense of bonds

Global dividend yield Global treasury bond yield 1% inflation 3% inflation

Equities more attractive than

bonds on a yield-basis

Where we are now:

At current yield

level and inflation

1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 -50 -25 0 25 50 75 100

0

8 |  |

6 |  |

4 |  |

2 |  |

10

12

14

16

18

Reference notes are listed at the end of this article.

Source: Bloomberg,Thomson Reuters, World Gold Council

Yield (%) Real gain/loss (%)

Basis points

Chart 3: (a) Equities look attractive on the back of a positive yield gap, while (b) intermediate treasury return payoffs

are not flattering

3 |  |

2 |  |

1 |  |

0

-1

-2

-3

-4

-5

-6

-7

24_25

Gold in the Great Rotation

A simple three-asset scenario shows that as the proportion of risk assets moves up the scale

from low to moderate levels, so does gold’s optimal weighting. Using Re-sampled Efficiency,11

we compute the optimal allocation to gold across a rising risk tolerance as an investment

portfolio rotates from bonds to equities. (It must be noted that these results are not in any way

advocating a simple three-asset portfolio mix but use this mix only for illustrative purposes).

Gold’s diversification benefits, as shown in Chart 4a, become more pronounced as the proportion

allocated to equities increases. Contrary to perceived wisdom, the decision to hold gold is not

merely a choice between risk assets and safe-haven gold. Optimal allocations to gold have been

proven to always be positive (non-zero) in diversified portfolios.

Chart 4b mirrors the current environment more closely. It illustrates how gold’s allocation

increases as cash is reduced and allocations flow into bonds and equities, which occurs as

investors’ risk tolerance moves from low levels to moderate levels.

A simple three-asset case

illustrates how gold optimal

allocation increases in a

bond-to-equity rotation

to compensate for the

additional risk investors

incur.

… and a similar result holds

when funds flow out

of cash.

0 10 20 30 40 50 60

0

0

40

20

60

80

100

Bonds (%) (a)

(b) |  |

Equities (%)

Chart 4: Optimal allocations to gold increase (a) in a bonds-to-equity rotation, and

(b) |  | also when cash moves to both bonds and equities

0 10 20 30 40 50 60 70 80

40

20

60

80

100

Cash (%)

Bonds and equities (%)

Gold’s relative allocation

Reference notes are listed at the end of this article.

Source: World Gold Council

Gold’s relative allocation

11 Methodology explained in Central bank diversification strategies: Rebalancing from the dollar and euro, 2013.

Gold Investor | Risk management and capital preservation

Focus 2: Why gold is a strategic asset

What constitutes a strategic asset? Simply defined, it is an

asset that helps investors achieve long-term goals. Delineating

along the most fundamental strategic lines, equities are owned

for capital growth, debt for income and liability matching,

and gold for capital preservation. Other assets serve some

or all of these roles with varying degrees of success. Gold’s

capital preservation credentials stem from its ability to act as a

diversifier while guarding against a number of risks, including

inflation, currency and tail risk. Why?

These qualities exist because of gold’s unique fundamental

make-up. Gold’s supply and demand composition translates

into statistical qualities that underpin its important role within

investment portfolios.

• Demand and supply enjoy broad and balanced drivers with

each sector, driven by a unique set of macro-economic

drivers. On top of this, demand and supply are geographically

dispersed. As a result, gold’s correlation to traditional assets

remains low and its volatility profile dampened.

• Gold is virtually indestructible, which has led to a large global

stock. It is also a stock that is geographically dispersed and

held in the poorest as well as the wealthiest nations around

the globe. Despite this above-ground supply – which provides

depth, liquidity and buffers against supply shocks, thus

reducing gold’s volatility – gold is geologically scarce relative

to other real assets. Because incremental additions to its

stock are small and constrained by numerous factors, this

scarcity forms the basis for stable value accretion.

• Gold carries no credit or counterparty risk and is no one’s

liability. These credentials lend themselves to gold’s

performance during periods of market stress, when

correlations to risk assets fall. They also ensure that gold acts

as a global currency and an anchor (albeit unofficially) to other

currencies.

Gold’s strategic benefits have been discussed in more detail in

the following research:

Gold as a strategic asset for UK investors

Gold as a strategic asset for European investors

Gold: alternative investment, foundation asset

Gold: a commodity like no other

Gold: hedging against tail risk

26_27

The previous examples oversimplify portfolios investors may hold. To provide a more realistic

and balanced composition, we show how gold allocations change with a shift from cash to

bonds and equities as well as bonds to equities, using the results from our recent publications.

Chart 5 plots allocations sourced from previous research reports: Gold as a strategic asset for UK

investors, Gold: alternative investment, foundation asset, Gold as a strategic asset for European

investors and Gold as a strategic asset for US investors.

Each chart shows, equivalent to a move from very low risk to moderate risk, that an initial shift

from cash to both bonds and equities takes place as the first stage of a shift unfolds. As more

risk is added a rotation out of bonds into equities would materialise. During both of these phases,

gold’s optimal allocation rises, reflecting its increased diversification benefits. These results

were obtained through analysis over periods covering several business cycles across different

geographies. In each case, a shift into riskier assets warrants a higher optimal allocation to gold.

A more complete portfolio

set-up delivers the same

general results: more risks

requires additional gold…

… regardless of investors’

currency or portfolio

composition.

Gold 1.2% 2.9% 5.1% 7.7% 7.0% 6.4%

Cash to

bonds/

equities

Bonds to

equities

Gold 2.1% 4.7% 7.3% 9.6% 10.3% 9.9%

Cash to

bonds/

equities

Bonds to

equities

Gold 1.3% 3.0% 4.5% 5.7% 6.3% 6.0%

Cash to

bonds/

equities

Bonds to

equities

Gold 0.9% 1.4% 2.0% 2.5% 3.1% 3.8%

Cash to

bonds/

equities

Bonds to

equities

20

10

30

40

70

50

60

Bonds (%) (a) US dollar

Equities (%)

0 10 20 30 40 50 60

20

10

30

40

70

50

60

Bonds (%) (b) Euro

Equities (%)

Chart 5: Optimal gold allocations increase with risk, as it has been shown for portfolios in: (a) US dollars, (b) euro, (c) sterling,

as well as those including (d) alternative assets such as hedge funds and private equity

0 10 20 30 40 50 60

20

10

30

40

50

20

10

30

40

50

Bonds (%) (c) Sterling

Equities (%)

0 10 20 30 40 50 60

Bonds (%) (d) Alternatives

Equities, HF and PE (%)

0 10 20

Bond/equity mix Optimal gold allocation

30 40 50 60

Bond/equity mix Optimal gold allocation

Bond/equity mix Optimal gold allocation Bond/equity mix Optimal gold allocation

Reference notes are listed at the end of this article.

Source: New Frontier Advisors, World Gold Council

Gold Investor | Risk management and capital preservation

Bonds: handle with care

The above studies use return, volatility and correlation inputs based on either actual historical

returns over several decades or strategic returns.12 How realistic these are is a subject beyond this

research note. But, using historical returns risks introducing bias into the performance of bonds

going forward. As outlined, current bond yields leave little scope for a continuation of the stellar

and stable returns experienced over the last few decades, despite the suggestion that demand

will not abate quickly. How would amending these assumptions affect the allocation to gold?

Chart 6 shows how a rotation affects the optimal gold weighting in a US portfolio using three

different real return assumptions for bonds (volatility and correlations remain unchanged). Clearly,

gold’s allocation rises regardless of the assumption, but lowering bonds’ expected returns from

25-year historical (highest) to long-term strategic (moderate) to current (lowest) has a significantly

positive impact on the optimal gold weighting.

Further, adjusting return

expectations for fixed

income and cash to reflect

current less rosy market

conditions, results in higher

allocations to gold.

Chart 6: Adjusting bond returns to current market expectations results in higher optimal

allocations to gold

Gold allocation (%)

0

2 |  |

4 |  |

6 |  |

8 |  |

10

12

4 |  | 5 6 7 8 9 10

Historical Strategic

Portfolio volatility (%)

Current

9.9%

7.5%

4.3%

5.7%

3.4%

2.0%

Asset Current real return Strategic real return Historical real return

US cash -1.6% 0.0% 4.4%

US treasuries -1.0% 2.0% 6.9%

US TIPs -0.4% 2.0% 4.5%

US credit 0.7% 3.0% 7.8%

Global treasuries ex US -0.7% 1.4% 6.7%

Reference notes are listed at the end of this article.

Source: Barclays, Credit Suisse, World Gold Council

12 Strategic returns are consistent with very long-term and conservative expected returns and widely accepted risk premia.

Gold’s perennial role

The Great Rotation debate may roll on, and there may be arguments supporting a glacial shift

towards equities – particularly given the risk/reward of many fixed income products. But to the

question of whether a shift from safe assets to riskier assets is negative for gold, we surmise not

to predict how prices may react, but contend that gold’s strategic importance is amplified in such

a scenario. In the long term, gold’s diversification credentials increase portfolio efficiency, both in

good and bad economic times. A shift to riskier assets further promotes gold’s portfolio benefits.

Whether we witness a

‘Great Rotation’ or not,

gold’s importance as a key

portfolio asset remains.

28_29

References

Chart 1: (a) Bonds look poor, while (b) equities appear attractive

(a) |  | Chart is using yield to worst and modified duration statistics for the Barclays Global Aggregate Bond Index.

(b) Shiller PE is a cyclically adjusted price-earnings ratio defined by current price devided by the average of 10 years

of inflation adjusted earnings.

Chart 3: (a) Equities look attractive on the back of a positive yield gap, while (b) intermediate treasury

return payoffs are not flattering

(a) |  | Bond yields are represented by the yield to worst on the Barclays Global Treasuries Index.

(b) |  | Chart represents the total return on a 5 year treasury bond one year from now for numerous interest rate

scenarios. The two series are deflated by a 1% and 3% inflation assumptions.

Chart 4: Optimal allocations to gold increase (a) in a bonds-to-equity rotation, and (b) also when cash

moves to both bonds and equities

(a) |  | The underlying calculations use global bonds (J.P. Morgan), global equities (MSCI) and gold (US$/oz).

The relative increases in the size of the spheres represents a proportionate increase in gold allocations.

(b) |  | The underlying calculations use global bonds (J.P. Morgan), global equities (MSCI), global cash (J.P. Morgan)

and gold (US$/oz). The relative increases in the size of the spheres represents a proportionate increase in

gold allocations.

Chart 5: Optimal gold allocations increase with risk, as it has been shown for portfolios in: (a) US dollars,

(b) |  | euro, (c) sterling, as well as those including (d) alternative assets such as hedge funds and private equity

The chart shows the bond and equity mix of portfolios across the resampled efficient frontier. The figure in

the golden rectangles at the bottom corresponds to gold’s mid-point optimal allocation for a given equity

allocation range.

Chart 6: Adjusting bond returns to current market expectations results in higher optimal allocations to gold

The current real return for bonds is based on yields minus the same maturity breakeven inflation rate – which is the

average inflation expected by market participants derived by subtracting the yield on inflation-protected bonds from

equivalent Treasury securities. Assets included (in addition to the fixed income indices listed in table 1) are US large

and small cap equities (MSCI), Developed world ex-US equities (MSCI), Emerging market equities (MSCI), global

REITs (FTSE), commodities (S&P) and gold (US$/oz).

Table accompanying Chart 6

Current real returns calculated as current yield-to-worst minus aggregate breakeven inflation rates as of

December 31, 2012 across maturities: US breakeven (Barclays) = 1.89%, Global breakeven (Barclays) = 2.2%.

Strategic return methodology is consistent with previous research. Historical returns encompass the period

December 1987 to December 2012 using annualised monthly returns.

Gold Investor | Risk management and capital preservation

Derivatives

Equities

Bonds

Gold as a

foundation

asset

The issuance of equity and debt securities – claims on assets or future cash flows – is driven

by capital markets and, unlike real assets,1 they are not constrained by physical supply. In fact,

corporations and governments routinely issue unsecured debt and equity securities not linked

directly to any forms of collateral. The lack of a physical backing, coupled with a boom in financial

innovation, has allowed financial assets to grow 10-fold over the past 20 years – well in excess of

a three-fold increase in nominal gross domestic product (GDP) over the period. And this trend is

unlikely to subside.

In the current environment of easy monetary policy and record growth in financial assets, gold

has become increasingly relevant as an investment that balances risks in other assets. As a real

asset, one that cannot be debased or devalued, gold is seen by many investors as a valuable risk

management and wealth preservation tool. Gold supply is geologically constrained yet readily

available through a broad and liquid market.

However, some investors and market commentators express concerns that gold may be in

a bubble as a result of 12 years of price appreciation. Emerging-markets growth, economic

uncertainty, central-bank demand and constrained supply are some of the reasons why gold has

risen for more than a decade. Even so, gold remains a widely under-owned asset. Gold holdings

account for 1% of all financial assets – a by-product both of its scarcity and the unprecedented

growth in other financial assets. Further, gold’s low ownership rate stands in stark contrast to

levels seen in past decades, as well as what research suggests optimal gold allocations should be.

Financial assets have grown

at an unprecedented pace

for more than 20 years…

… whereas gold holdings

represent only 1% of all

financial assets, despite a

12-year bull run.

IV: Gold holdings: ample room for

growth in a broad and liquid market

While financial assets have grown at an unprecedented

pace, gold holdings remain low, depriving investors of the

portfolio benefits it offers. The share of gold in portfolios can

sustainably increase and provide balance to a global financial

system likely to experience more frequent tail events.

1 A physical asset that derives its value from its intrinsic properties. Real assets include precious metals, commodities, real estate and raw land.

30_31

Financial assets are growing at a rapid and unsustainable rate

There have been huge fluctuations in asset prices over the past decade. Despite the volatility, the

stock of financial assets has almost tripled during that period. Currently at a striking US$149tn,2

the size of financial assets are a multiple of global GDP (Chart 1). This growth has been primarily

led by fixed income markets. Between 2000 and 2012, debt markets have grown three-fold, from

US$25tn to almost US$90tn,3 as a result of ageing demographics in many developed countries,

heightened risk aversion, low interest-rate policies and record government spending to boost ailing

economies. In particular, outstanding US treasury debt more than doubled from US$4.5tn in 2007

to US$10.5tn in 2012 – a large portion of which is held by foreign investors;4 and further, sovereign

debt issuance was by no means restricted to the US. At the same time, global equity markets

have also grown – at a relatively more modest pace of 67% – from US$31tn in 2000 to US$51tn in

2012, partly driven by economic growth in emerging markets and a subsequent increase in initial

public offerings (IPOs).

Between 2000 and 2012,

debt markets have grown

three-fold, to almost

US$90tn, while equity

markets have increased by

US$20tn to US$51tn.

0

1 |  |

2 |  |

3 |  |

4 |  |

5 |  |

6 |  |

0

20

40

60

80

100

120

140

160

Chart 1: Most financial assets have grown at an unprecedented rate

US$tn GDP/financial assets

1980 1990 2000 2010 June 2012

Fixed income

Reference notes are listed at the end of this article.

Source: Barclay Hedge, BIS, Preqin, World Federation of Exchanges, World Gold Council

Equity Gold Global GDP GDP/asset ratio (rhs)

2 |  | This figure is as of June 2012. See Chart 2 for a detail breakdown of financial assets.

3 |  | Debt outstanding as of June 2012.

4 As of December 2012, foreign central banks owned 48% of outstanding treasuries followed by other holders at 38% and Federal Reserve at 14%.

Gold Investor | Risk management and capital preservation

Still, we are only scratching the surface. Innovation in financial markets and a supportive

regulatory environment saw an explosion of assets managed by hedge funds and private equity

firms, as well as an increase in securitised products. Counting securitised products, financial

assets have grown to more than US$200tn.5 And this figure pales in comparison to the notional

size of the derivatives market, estimated at over US$600tn in 2012 by the International Monetary

Fund (IMF).6

The private investment stock of gold, in contrast, sits at a remarkably smaller US$1.9tn,7

representing just 1% of financial assets (Chart 2), partly driven by gold’s limited supply, which

has been growing at low rates (Focus 1).

Including derivatives and

securitised products brings

total financial assets to an

astronomical US$200tn…

… while gold accounts for only

only US$1.9tn.

Chart 2: Only 1% of US$149tn of financial assets is currently in gold

Money markets 6%

Fixed income 51%

Equities 37%

Alternative investments 4%

Gold 1%

Reference notes are listed at the end of this article.

Source: BIS, Hedge Fund Research, J.P. Morgan, Preqin, Thomson Reuters GFMS,

World Federation of Exchanges, World Gold Council

* |  | As of June 2012.

5 |  | McKinsey Global Institute, Mapping global capital markets, August 2011.

6 IMF, Systemic risk from global financial derivatives, November 2012. Bank of International Settlements (BIS), semi-annual OTC derivative statistics,

November 2012. Notional values may not be the best measure as notional values in most derivative contracts don’t need to be exchanged, but do represent

exposure. A better measure is the gross market value of derivative contracts outstanding, approximately US$27tn for reporting dealers. While a majority

of derivatives are used as a hedging tool, the potential failure of counterparties to service the contract might be disastrous for an institution that thought it

was “de-risking” its operational activities. During the first half of 2012, there were US$3.7 of gross credit exposure amongst just the 55 reporting dealers

participating in the BIS derivatives survey. The notional value of gold derivatives is US$523bn, just 0.1% of the total notional size of the derivatives market.

7 |  | Value based on the average gold price of US$1,651.34/oz during the first half of 2012.

32_33

Focus 1: How large is the gold market?

By the end of 2012, the above-ground stock of gold was

estimated to be approximately 174,100 tonnes,8 representing

all the gold that has ever been mined, worth more than

US$9.3tn (Chart 3). The largest share (almost half) is held in

jewellery form and is worth more than US$4.6tn. Central banks

collectively hold 30,100 tonnes as part of their foreign reserves,

while bars and coins in the hands of investors (including goldbacked

ETFs) account for one fifth of the above ground stock,

worth US$1.9tn. This is the figure we use to estimate the share

of gold as a percentage of global assets.

8 |  | This computation is based on the 2012 stock figures as provded by Thomson Reuters GFMS.

9 According to the US geological survey, below-ground stocks only amount to 50,000 tonnes – less than one-third of the above-ground stock.

10 According to Thomson Reuters GFMS and Bloomberg, gold annual production is lower in tonnage terms than silver, copper, tin, nickel, lead

and zinc as well as other base metals.

11 When gold is used for technological applications, it does not enter the market until that device is scrapped and re-used for its materials.

Other forms of gold however, could be re-sold to other participants.

Gold is geologically scarce and fundamentally constrained by

physical supply.9 Gold mine production – which has averaged

2,600 tonnes over the past 10 years, a small fraction of the

production of some other metals,10 increases the above ground

stock at a rate of 1.7% per year. Because gold is virtually

indestructible with only a fraction lost through technological

and industrial use,11 a large portion of the above ground stocks

is readily available and can be sold on the secondary market.

As a result, liquidity in the gold market is unmatched by most

financial assets (Chart 4).

Chart 3: The stock of gold held in investment form

is worth US$1.9tn

Reference notes are listed at the end of this article.

Source: Thomson Reuters GFMS, US Geological Survey,

World Gold Council

Other

24,800 tonnes

14.2%

*Based on the end-2012 volume and 2012 average gold price.

20.7m

20.7m

Daily trading volume (US$bn)

Chart 4: Gold is one of the most liquid assets

0 200 400 600 800 1,000 1,200

Reference notes are listed at the end of this article.

Source: BIS, CPM Group, German Finance Agency, Japanese MOF,

SIFMA, UK DMO, World Gold Council

US$/euro

US Treasuries

US$/yen

JGBs

US$/sterling

Gold

Euro/yen

S&P 500 stocks

US agencies

UK gilts

German Bunds

Dow Jones (all stocks)

Gold Investor | Risk management and capital preservation

12 Bain & Company, A world awash with money, December 2012.

13 Dudley, William C. Solving the too big to fail problem, Federal Reserve Bank of New York, November 2012.

A system vulnerable to the increasing frequency and magnitude

of tail events

The trend of increasing financial assets, by and large, was the result of two extreme situations:

vast capital accumulation by a set of investors on the one hand and increased borrowing amongst

the indebted on the other. Additionally, financial innovation has produced a greater number of

securitised products to pool and sell risk assets that are seemingly of higher quality than their

underlying components would suggest. An overexposure to these assets – especially by financial

institutions – led to the Great Recession.

The government has subsequently issued debt to subsidise the losses in the banking system

while plugging the spending gap left by a deleveraging private sector. This has led to a spate of

sovereign debt crises and economic turmoil. Unconventional monetary policy, as discussed in

our Investment commentary: Q3 2012 has also allowed central banks to purchase unprecedented

quantities of government bonds and mortgage-backed securities – to achieve their goals of

lowering benchmark borrowing rates to artificially low levels and incentivise borrowing in the

private sector. As a result of these policies, financial assets have continued to grow well in excess

of GDP, reaching what some consider ‘critical levels’.12 The question might thus be: Are there

more financial assets than required to ensure a healthy global GDP growth, and is there enough

global GDP to service these financial assets?

Rapid growth in capital markets leads to more capital chasing lower returns, tempting investors

toward disproportionate levels of risk and increasing the frequency of flight-to-quality episodes.

The implication is that this abundance of capital will likely spur investment activity but, at the same

time, create an unstable growth environment – one characterised by frequent pullbacks in risk

assets and large moves in currency markets. In fact, the number and magnitude of tail events has

already increased over the past three decades (Chart 5). This issue is likely to be exacerbated by

the increased contagion risk from cross-border and cross-holdings of large financial institutions –

an important component of the ‘too-big-to-fail’ problem.13

Imbalances in capital

accumulation and leverage,

coupled with financial

innovation, resulted in a

global crisis…

… and have prompted

unprecedented levels

of financial assets relative

to GDP…

… leading to more frequent

and larger tail-risk events.

-60

-50

-30

-40

-20

-10

0

10

20

30

Chart 5: The frequency and magnitude of negative market events keeps growing

1980–1990 1990–2000 2000–2012

Frequency of monthy returns less than -5%

Reference notes are listed at the end of this article.

Source: Bloomberg, World Gold Council

Average annual negative return during the period

Negative return (%) Count

34_35

In a recent report, Bain & Co. predicted that a prolonged period of capital super-abundance could

lead to persistently low interest rates and an increasing frequency, size and longevity of asset

bubbles. The huge increase in debt has put global economies on a less than stable growth track.

Financial markets have already seen several negative episodes as a result of unbridled deficits and

growing debts in Europe – with potentially more debt-driven collapses on the horizon.14 Of course,

staying on the sidelines is not a viable solution for investors. Holding large quantities of cash will

erode capital over the long term. Investors must look for portfolio risk management strategies

that can help them balance their search for yield with protection against unprecedented financial

conditions.

Gold should be a larger share of financial assets

Gold prices increased from US$250/oz to US$1,600/oz between 2001 and 2012. At the same

time, annual investment demand has grown from 348 tonnes to 1,538 tonnes. This has led many

observers to believe that the gold market is saturated with investors,15 that it is an over-owned

asset whose price has risen much more than fundamental drivers would dictate. In other words,

that gold is in a bubble. Refuting this mistaken view, in The 10-year gold bull market in perspective,

published in September 2010, we showed how gold’s performance does not have the same

statistical characteristics of well documented historic bubbles. We also discussed the lasting,

structural shifts the gold market has experienced, including a diverse and robust set of supply and

demand dynamics – emerging market growth, economic uncertainty, central bank demand and

constrained supply – that have supported the price trend.

Further, the rise in gold investment demand, as well as for other real assets, should be seen as a

rational response to a flood of financial instruments linked to the success and credit worthiness of

their issuers. The value and security of government debt is predicated on a country’s willingness

and ability to pay back its debt-holders. Stocks and corporate bond prices are rooted in a

company’s performance and its management’s ability to steer the company forward. While the

private sector has had a good track record of earnings growth and debt repayment, the managerial

risk or ’human element‘ embedded in these investments poses a risk to portfolio managers.

Uncertainty and malaise in developed economies and the accompanying aggressive monetary

policies have accentuated the need for a robust asset allocation, one that is better positioned to

withstand swings and systemic shocks. In the context of today’s market environment – one we

expect to remain in place in the foreseeable future – holding gold diversifies portfolios based on

its qualities as a transparent and real asset that lacks the credit and counterparty risk of other

investments.

To balance these risks,

investors need a more

comprehensive riskmanagement

strategy.

Gold’s price rise in the past

12 years should be partly

seen as a rational response

to the rapid growth of

‘paper’ assets…

… such as bonds and equities,

which naturally carry

credit risk.

14 Gross, William H. Investment outlook: damages, PIMCO, October 2012.

15 Wall Street Journal, Is Gold the next bubble?, May 2010.

Gold Investor | Risk management and capital preservation

Portfolio optimisation studies have shown that a 1% portfolio allocation to gold is generally too

low and that higher long-term allocations are optimal for most investors. As summarised in Gold

in the Great Rotation, research by the World Gold Council, Oxford Economics, New Frontier

Advisors, Mercer and J.P. Morgan, among others, shows that investors can greatly benefit from

a long-term strategic allocation to gold – usually between 2% and 10% across US dollars, euro,

pound sterling and yen denominated portfolios (Focus 2).16

Most investors are underallocated

to gold relative

to what research has

found optimal…

16 J.P. Morgan, Gold in asset allocation, July 2012; Mercer, Gold as an asset class for institutional investors, February 2011; New Frontier Advisors,

Gold as a strategic asset, September 2006; World Gold Council, Gold: hedging against tail risk, October 2010; World Gold Council; Gold: alternative

investment foundation asset; New Frontier Advisors, Gold as a strategic asset for European investors; World Gold Council, December 2011; Gold as

a strategic asset for UK investors, July 2012.

17 See Loco London Survey conducted by the LBMA with the Bank of England.

Focus 2: Benefits of holding gold in a portfolio

Gold’s unique supply and demand fundamentals are largely responsible for its main contribution to

investors’ portfolios, namely, risk management and capital preservation.

Gold as a risk-management vehicle

• Increased portfolio diversification through gold’s lower correlation to other assets

Gold’s correlation to other assets is, on average, 0.1 and, as discussed in Gold: a commodity like

no other, it has a relatively low 0.3 correlation to the broader commodity complex

• Reduction in portfolio losses during tail-risk events

Portfolios containing gold consistently outperform portfolios without it as summarised in

Gold: hedging against tail risk

• Addition of a high quality, liquid asset

Gold trading averaged US$240bn per day in the first quarter of 2011:17 higher than the most

liquid equities, German Bunds, UK gilts, US agencies and certain currency pairs (see Liquidity in

the gold market)

Gold as a source of capital preservation

• Gold hedges extreme inflation scenarios like deflation and hyperinflation

In the paper entitled The impact of inflation and deflation on the case for gold, Oxford

Economics shows that both environments lead to gold’s relative outperformance of

other assets

• Gold hedges against falls in developed market currencies

Gold has a -0.5 correlation against the US dollar and negative correlation against most other

developed market currencies (see Gold as a hedge against the US dollar)

36_37

Even by historical standards, gold’s current share of financial assets is low. The average ratio of

the investable gold stock to the size of financial assets has fluctuated over time (Chart 6). Gold’s

share of financial assets has been as high as 14% in 1980, the last year of the previous bull

market, and as low as 0.4% in 2000, before the beginning of the current one.

… as well as by historical

standards.

Gold ownership rates in 2000 were depressed as a result of various structural factors that have

subsequently changed: investment inaccessibility, central bank sales and large-producer hedge

books, to name a few. This ratio has risen to 1.2% in 2012, a growing but sustainable trend and

the result of increased ownership and an appreciation in the gold price (Focus 3).18 Despite this

growth, gold’s current share of assets sits far below the 1980’s peak, which was driven not

only by the sharp increase in the gold price but incipient rates of growth in many other financial

instruments. So, while a 14% allocation may prove too high as a strategic holding to many

investors, an increase to a more sustainable level is feasible (Chart 7). The gold market is deep

and liquid enough to support higher global allocations and a growing investor base, and it is liquid

enough to facilitate continued acquisitions.19

But the gold market can

easily and sustainably

grow to a higher

percentage of global

assets.

0

600

400

200

800

1,200

1,400

1,600

1,800

0

2 |  |

4 |  |

6 |  |

8 |  |

10

12

14

16

Chart 6: Gold’s share of financial assets has fallen significantly since 1980 despite a

similar inflation-adjusted gold price

Share (%) US$/oz

1980 1980s average 1990s average 2000s average H1 2012

Gold’s share of global investable assets

Reference notes are listed at the end of this article.

Source: Barclay Hedge, BIS, Bloomberg, OECD, Preqin, World Federation of Exchanges, World Gold Council

Inflation adjusted gold price (US$/oz)

Note: Due to data unavailability, gold’s share in 1980 is compared to all non-financial debt.

18 Gold prices increased at a pace of 18.7% per annum (between 2001 and 2011) while private investment stock grew at 3% per annum.

19 The London OTC market clears US$240bn of gold per day with an average transfer size of 7,400oz of gold. This calculation is based on LBMA

estimates of 2012 average of gold transfers and the monthly average amount of gold transferred.

Gold Investor | Risk management and capital preservation

Focus 3: The importance of sustainable ownership rates

Ownership rates are an important consideration for the sustainability of asset prices. For

example, in 1995, at the start of the dot-com bubble, US equities comprised just 33% of US

investor portfolios but grew to 50% of investor portfolios in just five short years, representing an

unsustainable rate of new investment. The underlying demographic composition or investor risk

tolerance had not sufficiently changed to justify such a rise in equity ownership rates. Instead,

it is clear that equity risk was mispriced, and the market was likely fuelled by momentum and

an exceedingly overoptimistic expectation around earnings growth in the technology sector.20

Today, we are seeing a similar but less dramatic shift in fixed income ownership, as debt’s share

of assets has increased between 1999 and 2012 from approximately 40% to approximately 60%

of financial assets. Investors will likely rebalance their portfolios once the asset mix is deemed

inappropriate for their investment goals.

20 The technology sector became an over-sized portion of US market capitalisation. NASDAQ market capitalisation as a share of total US market

capitalisation grew from 15% in 1994 to 31% in 1999.

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

Chart 7: Demand would surge if investors re-allocate to a 2% gold allocation

while financial assets grew by 10%

Tonnes

Reference notes are listed at the end of this article.

Source: Thomson Reuters GFMS, World Gold Council

Gold holdings (2012) Gold demand Potential gold holdings

(2% allocation)

Gold demand

(10% financial asset growth)

*2% is the minimum optimal allocation for most investors. 10% growth is approximately This analysis assumes that the gold price remains at US$1,650/oz.

34,582

21,478

5,606

61,666

Taking a closer look at gold as a strategic asset

Despite a consistent bull market for more than a decade, gold holdings currently represent a small,

sub-optimal portion of financial assets. This ratio is depressed as financial assets have exploded

over the past two decades, fuelled by financial innovation, expansionary monetary policies and

global imbalances in capital accumulation and borrowing. In a globalised economy characterised

by increased cross-border flows, such an expansion of ‘paper’ assets has increased the

frequency and magnitude of tail-risk events. As such, a closer look into strategic gold allocations

is warranted. Gold is a hard asset with a deep and liquid physical market capable of absorbing

considerably higher average allocations. Gold provides a foundation to portfolios, helping investors

protect capital and manage risk more effectively.

In an increasingly risky

world, investors should

consider gold as a strategic

and necessary portfolio

allocation.

38_39

References

Chart 1: Most financial assets have grown at a unsustainable rate

Equity market capitalisation encompasses publically traded REIT securities. Fixed income represents domestic and

international bonds, notes and money market instruments. The value of gold holdings is computed using average gold

price and end of year stock figures. GDP to asset ratio uses end of 2011 global GDP as the World Bank series has only

been updated through the end of 2011.

Chart 2: Only 1% of US$149tn of financial assets is currently in gold

The chart values are as of June 2012. Estimates include the global market capitalisation of all publicly traded stocks

and REITs; the total value of outstanding bonds and money market instruments; total open interest on major

commodity futures plus above ground stocks of precious metals; the assets under management of private equity and

hedge funds; and private holdings of gold bullion. Central bank holdings of gold and bonds were excluded.

Chart 3: The stock of held in investment for is worth US$1.9tn

The stock of gold is based on end of 2012 volume and values are based on 2012 average gold prices. Thomson

Reuters GFMS has not officially update the gold stock figures but 2012 demand figures were used to compute end

of 2012 stock figures. For example, end of 2012 jewellery demand is approximately equal to 2011 stock of jewellery

plus 2012 jewellery demand net of 2012 recycling activity. All other categories were computed by adding 2011 stock

numbers and 2012 demand numbers.

Chart 4: Gold is one of the most liquid assets

Foreign exchange liquidity is based on the BIS tri-annual foreign exchange survey. Government bond liquidity is based

on statistics published by country’s respective debt offices. Daily trading value of gold is based on the loco London

survey conducted by the LBMA and the Bank of England in Q1 2011.

Chart 5: The frequency and magnitude of negative market events keeps growing

The count of monthly returns less than -5% is based on data from a spliced index of the MSCI World (1980 – 1987)

and MSCI AC World (1988 – 2012) indices. Average annual negative return is based on the average negative monthly

return over the period.

Chart 6: Gold’s share of financial assets has fallen significantly since 1980 despite a similar inflationadjusted

gold price

Due to data unavailability, gold’s share of financial assets in 1980 is compared to all non-financial debt or debt that

wasn’t issued by a financial institution. The bars labelled ‘1980’ and ‘H1 2012’ represent gold’s share of assets at the

end of the decade, while the ‘1980s average’, ‘1990s average’, and ‘2000s average’ represent gold’s average share of

assets during the period.

Chart 7: Demand would surge if investors re-allocate to a 2% gold allocation while financial assets

grew by 10%

The 2% re-allocation is based on the minimum bound of the optimal allocation range for most investors. 10% growth

is approximately equal to current growth in financial assets. The analysis assumes that the gold price remains at

US$1650/oz. To maintain the current share, gold holdings need to keep pace with the growth in financial assets.

Gold Investor | Risk management and capital preservation

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including without limitation, any advice to the effect that any gold related

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Published: April 2013

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