Why does Gold shine when Economies don't?

8 Jul 2020 Read 1362 Views

As the Coronavirus pandemic has forced the economies around the world to shut down, uncertainty around the world has been rising, and with the rise of fear and uncertainty, there is another thing that has been on the rise, and that is the price of gold. This global health crisis has also thrown the world into a state of financial and economic crisis, and it has always been seen that it is during these times that the prices of gold reach record highs. Be it the economic crisis in 2001, the financial crisis in 2008, or the recent 2020 pandemic; this yellow metal seems to glitter the most when most economies are plunging to their doom.

It can be seen that there is an inverse relationship between the performance of the stock market and gold prices, especially during recessions and economic crises. This means that when the stock market is crashing, the gold prices move upwards and vice versa. This is because gold is considered to be a reliable and safe investment as the chances of gold losing its worth is very low. We can see this historically.

In the year 2000, some countries of the world were facing a major economic crisis, and this had again led to very volatile stock markets. This volatility of the stock market was due to a variety of factors- the U.S. military actions in the Middle-East, the attack on the World Trade Centre in the U.S., and the moving of the manufacturing processes out of America. The risky stock market made the investors shift to the safer option of gold. Due to this, the gold price rose from an average of $271.04 per ounce in 2001 to around $309.73 in 2002 and $363.38 in 2003.

We can also witness this trend during the 2008 global recession, which rocked the world. This financial crisis that was triggered by the failure of the investment bank, Lehman Brothers in the U.S., led to the collapse of many economies around the world. In this uncertain scenario, people again started buying gold, which led to its rising prices. The prices rose from $700 per ounce to a level of $1900 per ounce in 2011. After 2011, as the stock markets started their recovery, gold prices began falling. In India, the BSE Sensex fell by around 50% during 2008 and 2009, which led to an increase in gold prices.

Coming to the recent years, the gold prices again started increasing in 2018 due to the U.S.- China trade war. The tensions between the two largest economies of the world were bound to impact the gold prices as well. The prices jumped from $1257.12 in 2017 to the average price of $1392.60 in 2019. Gold reached a level of Rs. 48,400 per 10 grams on June 25 and its current price is around Rs. 50,000 per 10 grams. Also, in India, the value of rupee is depreciating against the U.S. dollar, which is encouraging many foreign investors to flee the Indian markets. Foreign outflows, increasing government deficit, and falling interest rates would also escalate the rupee's depreciation. Hence, a depreciating rupee is also pushing up prices of gold in India.

WHY IS GOLD CONSIDERED A SAFE HAVEN?

Gold has been something that is deeply respected throughout the world and also holds a lot of emotional and cultural significance in many countries, like in India and China. Throughout the centuries, gold has been used by people and societies for many different reasons. It is always gold that we fall back on when other currencies do not work, and that is why this commodity acts as insurance in tough times. The different reasons for having gold in one's portfolio are:

  1. Inflation Hedge- It has been seen historically that when inflation rises, gold prices also tend to increase, while the stock markets usually become volatile and tend to fall. So, when the cost of living increases, gold acts as an excellent hedge against inflation. That is why people often say, "When in doubt, buy gold," and people are encouraged to do, especially when they feel that they cannot rely on their currencies.
     
  2. It holds its value- Gold is considered to be a good store of value, and the chances of its value crashing are very low. It also holds a lot of sentimental value for many people, and they see it is a good way to pass on and preserve their wealth from one generation to the other. Gold is a very durable metal in the sense that it is non-corrosive and can be held on to for several years in any form like a coin or a bar.
     
  3. Portfolio Diversification- Holding a relatively diversified portfolio is a good practice. One can diversify their portfolio by investing in different asset classes so that these different asset classes are not perfectly correlated to each other. We have already established earlier that gold has an inverse relationship with stocks, and it has a negative correlation with some other financial instruments as well, and therefore it acts as a good asset class for diversification.
     
  4. Supply constraints- The supply of gold comes from the gold mines that are present. Unlike paper currency, which can be printed, the supply of gold is limited because the mines are limited, and when the supply of something is limited, the prices of such commodities also tend to rise. This is also one of the reasons why it is considered a safe investment.
     
  5. Increasing Demand- In countries like India and China, where gold is so intertwined into the culture, the demand for this metal has always been steady. In these cultures, gold has been used to save and as jewelry for weddings. Due to this reason, people start buying gold during uncertain times because, according to them, it acts as their savings.
     
  6. Deflation Protection- When prices decrease, and the economic activity slows down, people tend to hoard cash, and the most reliable place for them to keep cash is in gold. This could be seen during the Great Depression in 1920 and at the time of the financial crisis of 2008 when people started investing more and more in gold.

These are some of the reasons why gold is considered a haven for investors. It provides the required liquidity and flexibility to investors. If an investor chooses to invest in real estate; instead, he may not be able to sell the holdings when required or may not be able to find suitable buyers. If one chooses a debt instrument, they might not be able to sell their holdings because of the lock-in periods present in the debt instruments.

So, gold is considered the best option during economic crises. Not just people, even central banks, look at adding gold in their coffers during uncertain times for safety, liquidity, and return. Due to the pandemic, gold reserves of central banks grew to 145 trillion in the first quarter of 2020.

Another alternative for holding gold is investing in Gold ETFs. It was in 2007 that the first ETF was launched in India. This has also caught the fancy of investors in India, especially for those investors who do not have sufficient funds to invest in gold.

Exchange-traded funds provide a quick and easy solution to investors who want the benefits of investing in gold but do not want to deal with the hassle of physical possession and storage. Gold-backed ETFs got large inflows, which have pushed the holdings in these products to a value of around 3185 trillion, globally. One could also invest in securities of those companies who mine gold to get exposure to this asset. These methods are getting quite popular, especially for the younger investors who view this as an easier option.

'Gold is a way of going long on fear', Warren Buffet had once said and rightly so. During these uncertain times, we see investors flocking towards the haven of the shiny yellow metal.

About the Author: Vanshika Bagaria | 8 Posts

Vanshika born and brought up in Kolkata, She has done her Graduation from St. Xavier's College, Kolkata with a B.Com (Honours) Degree and will also be joining Narsee Monjee Institue, Mumbai as an MBA student this year. 

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