Michael Lang: Beware the lure of gold rush

Gold's lack of yield makes it difficult to value. Photo / Supplied

When a new, popular investment class emerges, we tend to see the risks as relatively low compared to the upside.

Take one of the most sought-after investments: gold.

Gold is permanent, indestructible and has been a currency and store of wealth for centuries. Its total above-ground supply is a mere 150,000 tonnes.

Every year, the amount of gold mined increases the total amount of gold in the world by 1.5 per cent, making supply essentially fixed.

So perhaps we should ask why not have everything invested in gold? To answer this, an appreciation of what happened to gold investors last time it was in vogue is essential.

Before 1971 most currencies were either freely convertible into gold or US dollars which, in turn, were convertible into gold.

Central bankers theoretically had to buy additional gold each time a bank note was printed.

Unsurprisingly, the supply of US dollars in circulation remained relatively constant, as did the gold price.

However, in the mid-60s the US became embroiled in a costly war against communism. By the early-70s, America's borrowing had ballooned.

To repay its debts, President Nixon decided to print additional US dollars. To do this he needed to revoke the right to convert US dollars into gold.

The result was an inflationary environment in which gold soared from US$35 to US$850 an ounce.

Meanwhile, the return from alternative investments, such as shares and bonds, collapsed as companies struggled with the ever increasing cost of goods and labour. But the reverse held true.

In the years following the Fed's decision to control inflation, real investments with earnings, innovators, tenants, plant equipment and dividends, rose sharply in value and gold plummeted.

In the 20 years following 1980, US$100 invested in gold was only worth US$32, whereas US$100 invested in global shares had grown to US$1350.

And therein lies the problem with gold. It is a good investment when the printing presses are whirring, or during rare moments of investor panic, which are fleeting.

As gold earns nothing and yields nothing, over the long term it does nothing more than preserve investors' capital from inflation.

Further, its lack of earnings or yield makes it notoriously difficult to value. Nowhere on an ingot does it promise the price will not fall below US$1000 an ounce again.

Neither is it a haven of stability. Since 1971, the price of gold has been more volatile than the sharemarket.

Lastly is the additional complication that gold is valued in US dollars.

For New Zealand investors much of gold's strong returns in 2008 actually came from the New Zealand dollar dropping in value against the US dollar.

Since last year our currency has risen sharply against the greenback, significantly diminishing investors' returns.

The market for gold in the short term is a voting machine requiring money, not intelligence. There is a risk that this short-term voting machine has got ahead of itself, making gold "a crowded trade".

But in the long run all markets are weighing machines.

The more money printed to restart the global economy, or repay government borrowing, the higher gold will levitate. The coming decade will see a rise in inflationary pressures, from which gold stands to benefit.

What we see in gold's price today is the increasing tension between the depreciating value of paper money and term deposits and the scarcity of physical assets, be they listed property or ounces of gold.

There is also the wild card that emerging market central banks such as those of China, Korea and Brazil, which hold less than 2 per cent of their foreign exchange reserves in gold - compared to developed nations' 70 per cent - decide to increase their ownership.

Today's investors are stuck between bullion and a hard place.

Physical assets such as mortgaged property, shares and commodities are likely to be more volatile than most New Zealanders in retirement feel comfortable with.

On the other hand, inflation is an imminent threat to investors who hold their lifetime savings in cash. Gold alone is not the solution.

* Michael Lang is the chief investment officer at NZ Funds.