Gold – a hedge against uncertainty

Analysis of a commodity is a reasonably straightforward matter. Production is reviewed to see what changes have taken place, similarly with consumption. An adjustment is then made for global economic conditions and whether there is likely to be a shortfall/surplus in demand or supply compared with previous years. On that basis a forecast is delivered. A currency differs in that interest rates are taken into account and consideration of governmental policy is thrown into the mix. This is clearly a gross simplification of the process otherwise we could expect all estimates to be 100% correct -- something that is rarely, if ever, achieved.

However, what do you do about a product that is a hybrid of the two? Where some investors focus on its commodity aspects and others on its currency features. That is the problem with gold. Roughly some 2,450 tonnes of the metal is produced each year but since gold is not destroyed in the "consumption" process all that really happens is that the stocks of the metal are being added to each year.

A generally accepted estimate is that there are now some 165,000 tonnes of gold that have been mined in the history of the world. Some of that is in museums, some held as "sentimental" jewellery that will never be sold, 30,000 tonnes still sits with central banks but much of it is being hoarded in bars, coins and "investment" jewellery. So if supply and demand are the key determinants then it is obvious that gold should simply fall each and every year as global stocks increase.

Similarly, a key driver of currencies is often cited as interest rates: the greater the yield, the more attractive that currency becomes to investors and hence its exchange rate will tend to rise. So what about a "currency" that has no yield for the majority of investors? True it can become attractive if nothing else produces a return but that simply puts it in a category along with everything else -- indistinguishable from the general morass.

What then of an investment that has increased five-fold in value over the past 10 years despite global stocks increasing from 140,000 tonnes to 165,000 tonnes and where six month interest rates have collapsed from 2% to 2 basis points over the same period? Clearly neither the currency nor the commodity component are in the ascendency yet equally obviously a major change has taken place to account for this seemingly nonsensical contradiction.

While there are a number of theories looking to account for this, my view is altogether more straightforward and encapsulated in the accompanying chart which I have dubbed the "trust gap".