Six reasons why gold still looks good

The new century has brought great years for investors in gold, whose annual average price soared from $271 an ounce in 2001 to $604 in 2006.

However, I think it's interesting that generally speaking they've done no better from getting into gold mining shares than if they simply bought into the metal there was none of the gearing effect that one might have expected from improving margins. That was probably because equities generally suffered over much of the period.

Where next for gold?

As the accompanying chart shows, gold seems to have completed a period of consolidation after rising sharply at the beginning of last year, driven by dollar weakness and strong investor interest in commodities generally.

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If history repeats itself, we could within a few years see the gold price soar to more than $1,500 an ounce, compared to the $673 price when markets closed ahead of Easter. In real terms that is, after adjusting for inflation that would still be no higher than the previous peak reached in early 1980.

Many investors have been surprised by how gold has gone up without traditional drivers such as inflation, dollar collapse, major financial crisis or war.

Undoubtedly that's because the world has been flooded with money by the central banks, inflating prices of all major investment assets.

But that doesn't mean gold will lose its traditional defensive characteristics. It is still, as its bulls have long pointed out, the only kind of money that isn't someone else's liability and dependent on others' financial soundness. The US still keeps 75 per cent of its foreign reserves in gold; the Eurozone's three largest economies keep 61 per cent of theirs in bullion.

GFMS, the independent metals research group, says in its latest annual gold survey that higher gold prices are "the most likely course of events in the short to medium term."

Chairman Philip Klapwijk said at a meeting I attended in London this week that the price floor is now "comfortably" above $600 and any decline into the $620-640 range would probably attract trade buying. Prices could exceed the 2006 high of $725 in the second half of this year. Next year the all-time peak of $850 could be "a target for speculators to go after."

In 2006 the average gold price had to rise 36 per cent in dollar terms to stimulate supply and depress demand to keep them in balance.

Supply of gold traded on world markets fell by 5 per cent to 3,907 tons.

Central banks and other official holders cut their sales by a net 346 tons. Central bankers, having sold off a lot of gold in recent years at huge losses relative to later prices, are less willing to expose themselves to further ridicule. And a handful of smaller nations are even quietly adding to their gold reserves.

This is very good news for the gold price as it means the biggest threat overhanging the market sales from the 30,000 tons held in official reserves has become less of a worry.

Production of newly-mined gold fell by 79 tons last year. To blame were declining grades, mine closures, operational difficulties, and a shortage of new production coming on stream (the legacy of decades of under-investment due to declining prices).

However, higher prices did stimulate greater supply of "scrap" offered for recyling (largely the cashing-in of relatively crude "high-carat" jewellery in Asia). This source provided 1,108 tons, up 222 on 2005.

On the demand side there was a dramatic fall in offtake by the jewellery industry down 427 tons over the year - in reaction to higher gold prices.

However, those elevated prices continued to boost dehedging as mining companies and others who sold forward to lock in prices, usually significantly lower than current ones, unwound their positions.

Investment demand overall actually fell last year as the higher prices encouraged some investors, especially in Asia, to take profits. In the West, momentum investors, who buy assets when their prices are rising, tend to predominate; in Asia it's mainly value investors, who sell high, buy low.

Why the outlook for gold remains good

GFMS remains confident about the outlook for gold for these reasons:

The dollar is likely to continue to weaken;

Slowing economic growth in the US is likely to feed through to produce disappointing returns from major conventional assets;

Rising international political tensions, especially in the Mideast.

On the supply side, official-sector sales are likely to remain subdued, while scrap sales may soften unless the gold price ratches up.

On the demand side, the jewellery market seems to have stabilized after adjusting to higher price levels. Dehedging should remain substantial.

Investment demand looks solid, with ETFs (whose certificates, traded on stock exchanges, give direct ownership of physical metal) generating a third of net new investment.

There is a growing appetite for "safe haven" investments. And the outlook for mainstream investments is questionable, with equity values threatened by a fall-off in earnings growth and bonds and property by rising interest rates.

Klapwijk suggested that if economic slowdown triggers financial turmoil, circumstances could create a "perfect storm" for gold.

Keep 10% of your portfolio in gold

What do I think?

With gold only taking a tiny proportion of new money going into investments of all kinds just $14 billion last year there is clearly huge upside potential should big money decide to move into it for any reason. Even without any particular trigger, we have long-term investors such as pension funds raising their stake in commodities generally, giving gold a ride up with all the others.

Gold should be a core holding in everyone's portfolio. 10 per cent would be a good figure, with a spread across physical metal (bars or bullion coins), ETF certificates providing direct ownership of physical gold, and units in broad-based gold mining funds.

If you're underweight in the yellow metal, this is probably a good time to top up your holdings as the period of consolidation in the price seems to be over.

Gold Survey 2007 can be obtained from GFMS at $495 a copy. Contact the company at laurette.perrard@gfms.co.uk or visit its website at www.gfms.co.uk.