In recent months, gold has been one beneficiary of the global sovereign debt crisis.
Investors worried about possible government defaults have flocked to the precious metal, helping to drive up its price to record highs and some market watchers believe the rally is likely to continue. In addition, in today’s environment, characterized by low real long-term interest rates, the opportunity cost of holding assets such as commodities that produce no income is low. This is another important factor supporting gold prices.
Investors interested in gaining exposure to gold, and expressing views on it, usually trade the commodity itself, or trade gold producers, which are the companies that operate gold mines. Investors, however, should be aware of less explicit gold exposures in their portfolios that come from trading funds tracking equity indices of countries that are consuming gold and of countries in which gold mines are located. Possibly due to the strong sentiment that has supported the gold rally in recent months, the sensitivity of these country indices to gold price movements has become more pronounced.
The link between gold consuming countries and gold prices is pretty straightforward. The valuations of these countries tend to suffer when gold prices rise, as consumers in such countries face incremental pressure from rising gold prices.
The link between gold prices and countries with gold mines, however, is less direct. Gold producer companies are often listed in countries other than where the mines are located, and any benefits of the mines to the local economy depend on highly idiosyncratic local leasing and labor contracts. But while the valuations of countries with gold mines may not always be fundamentally linked to gold prices, investor perception likely helped drive up the sensitivity of such countries’ valuations to the metal.
In fact, the strength of the relationship between the valuations of gold consuming and gold producing countries and gold prices has almost doubled from January to June. Lately, a 10% increase in gold prices has on average resulted in the valuations of gold consumer countries depreciating by roughly 5.5% as measured by price-to-book value, and the valuations of gold mine countries appreciating by roughly 3.8%. In January, a 10% increase in gold prices would have resulted in roughly half these valuation changes.
Why are valuations for such countries more sensitive to gold prices now? Investor attention has recently been focused on the global sovereign debt crisis and on the eventual possibility of more Federal Reserve stimulus (a Quantitative Easing 3, otherwise known as QE3), which could result in a weaker dollar and inflation. As a result, many investors have been flocking to gold and other physical assets as potential inflation hedges, driving up their prices. In addition, gold prices have also been on the upswing over the last decade for a number of other reasons.
So which countries consume the metal, and which have gold mines, and what are my views on them?
The largest net gold consumer country by far is India, which accounted for more than 30% of world consumption of gold in 2010. I currently advocate an underweight view of the country because of its inflation problems. Elsewhere, European countries such as Germany and Switzerland are also large net consumers of gold. While I hold a neutral view of Switzerland, I continue to hold an overweight view of Germany despite its position as a gold consumer due to the country’s reasonable valuation and strong economic growth.
The largest net producers, meanwhile, are Australia, South Africa and Russia. I hold a neutral view of Australia as it has experienced accelerating inflation recently and its equities no longer look cheap compared to the stocks of other developed markets. I continue to like Russia as a short-term tactical play. The country has a small sovereign debt burden and the challenges it faces appear to be more than adequately reflected in valuations. I don’t, however, have a published view on South Africa.
Peru, meanwhile, accounts for roughly 6% of world gold production and was the largest outperformer in the three days after Federal Reserve Chairman Ben Bernanke floated the possibility of a QE3 last month, rising 5% in valuation terms. Still, that rally may have had more to do with local political issues than gold prices. I advocate an underweight view of Peru because the country looks expensive, its inflation is accelerating and its growth is decelerating. You can read more about my country views in the latest Investment Directions monthly market outlook piece.
While my country views don’t square up exactly with the views one would expect to have if only a country’s gold consumption or mines were considered, I do believe that investors should consider their portfolio exposures to gold by looking beyond just the commodity itself and the stocks of gold producers to all assets, including ETFs that track country-specific equities.
Disclaimer: Past performance does not guarantee future results. Certain sectors and markets perform exceptionally well based on current market conditions and ETFs can benefit from that performance. Achieving such exceptional returns involves the risk of volatility and investors should not expect that such results will be repeated.
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments may be subject to higher volatility.