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Gold as a risk asset
Gary Dugan (CIO Weekly Review) / 20 May 2012
The failure of Greece to agree on a convincing government opens the door to a prolonged period of increased political uncertainty in southern Europe.
It hardly needs stating that the world economy is now two years into a European debt crisis and it doesn’t appear to be anyone in European political circles with a clear plan. The absence of a government in Greece makes it ever more likely that the country will sooner or later be forced to admit that it cannot service its obligations. Default will inevitably follow, and probably exit from the eurozone thereafter. Investors thinking that this is a quick win with little pain on the other side should consider that one default and exit will trail blaze the path that allows others to follow. The road to a permanent solution to Europe’s property, banking and government debt problems is a long one and stretches far into the distance.
It is against this backdrop that markets in both the developed and less-indebted emerging nations are going through another period of risk aversion and the continuation of moderate volatility. Month-to-date developed country equities have fallen 3.9 per cent while in emerging markets equities declines have been much more severe. Ukraine has lost almost 11 per cent, Russia is down 9.5 per cent and Hong Kong’s China H-share market has given up 80 per cent of its year-to-date gains. H-shares have lost almost nine per cent month-to-date. Being cheap, relative to history and relative to EM benchmark valuations has not helped markets avoid the move back out of risk assets.
A number of equity markets have not been helped by recent growth numbers and decisions in taken in political circles. Russia’s imposition of higher taxation on gas companies has hurt the hydrocarbon sector. The drop in Brent crude from $125 per barrel to $110 has also had an impact. In India, fiscal uncertainty and changes to tax laws has increased financial uncertainty into equity markets. The announcement that India’s wholesale price inflation rate has risen from 6.7 per cent y/y in March to 7.2 per cent y/y has undermined calls for the Reserve Bank of India to cut interest rates further and more quickly. India’s capital expenditure has been hurt by high interest rates and tight liquidity. Rising inflation is not a welcome addition for Indian equities and bonds.
Unsurprisingly, rupee continues to face selling pressure, despite measures introduced by the Reserve Bank of India (RBI) last week to increase demand for local currency by forcing traders to convert foreign currency earnings into rupees.
China’s H-share market has been undermined largely due to growth concerns in the world’s second largest economy and fears that the PBOC (People’s Bank of China) will not begin to loosen monetary policy quickly enough to insure against a slowdown. There is no need to repeat at length that China’s property market decline is policy-induced. It is important to repeat that China’s overall data is reasonably encouraging. Exports growth to the European Union has clearly stalled, but exports to the rest of Asia and to the Americas continue to hold up well. The concern gripping markets though loan data, which came in well below market expectations in March. The PBOC responded quickly over the weekend by imposing a further cut in the banking sector’s reserve requirement. Seen as a knee-jerk reaction to bad news, a loss of faith in China’s equity market has been swift.
From a tactical perspective we continue to see reason for holding positions in Russia and China’s H-share markets. Russian equities are trading at less than 5x forward earnings and growth remains well supported by energy prices. Unless there is a sustained downswing in oil prices or the re-emergence of political instability liquidity models continue to point towards higher equity prices. Russia, like all emerging markets, suffers during periods of risk aversion. But the combination of attractive valuations and abundant liquidity makes for a compelling story. China’s H-share market has different dynamics but similarly attractive valuations. Not driven by hydrocarbons, China’s market relies on growth signals and monetary expansion. With the exception of the most recent loans data, much of the recent data from China has pointed towards a bottoming out of its growth profile in Q4. With M3 growing well in excess of real economic activity, there is plentiful funding available for equities.
Lastly, gold’s heavily falls since end-April. Since mid-Q3, when equity markets turned on better US economic data, the price of gold has essentially followed risk appetite.
When markets, particularly equity markets in the emerging world, gained quickly in October and into early November gold rose by $200/oz to $1,800/oz thereafter to give back all its gains by year end. In the market boom of January and February, gold once again rose by $200/oz and has almost given back all of its gains. It is tempting to believe that a continuation of risk-aversion makes for lower gold prices. Here, it is important to re-state the view that gold should form a portion of all portfolios, not as a trading asset but as a store of value and one which is a hedge against inflation or financial distress. Regardless of the purchase price, gold should be in long-term portfolio plans.
The writer is the chief investment officer at Private Banking, Emirates NBD. Views expressed by the author are his own and do not reflect the newspaper’s policy
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