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How are fund managers responding to gold price slump?

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Traditionally considered a safe haven asset, gold is now becoming a questionable investment after the price saw its largest drop in the past five years.

On 20 July the gold price plunged to $1,090 per ounce from $1,108 per ounce, it’s largest single day drop in five years. It continued falling during the week, marking its biggest weekly decline since September 2008, falling to below $1,078 at its latest point on 24 July. It has since rebounded to $1,102 as at 27 July but remains well below the $1,900 per ounce high reached in 2011.

So what caused the drop in the gold price, and what are fund mangers doing while waiting for a further price rebound?

The yellow metal is traditionally seen as a store of value and a protection policy “against catastrophe”, says Hargreaves Lansdown senior analyst Laith Khalaf.

However, now that worries around markets have mostly receded, this safe haven asset is not as in demand.

“Downwards pressure on gold is mainly the result of higher risk appetite, following the deal by Eurozone leaders on Greece earlier this month,” argues Pictet Wealth Management chief strategist Christophe Donay.

“As fears about Grexit have dissipated, markets have switched their focus back to fundamentals, which are broadly supportive.”

However the dramatic drop in gold price does not come as a very big surprise for many since gold has been trading at low levels for a couple of months already.

Before this most recent selloff gold was already trading at low levels, says CMC Markets chief market strategist Colin Cieszynski, with the price of the precious metal going from $1,200 per ounce in mid-May to $1,140 at the start of July.

This suggests the market was already prepared to see prices falling.

Khalaf says: “Gold has struggled against a backdrop of global economic recovery and a strengthening dollar, and the recent sell-off appears to have come on the back of the Chinese central bank reporting its gold holdings, which disappointed analyst’s expectations.”

In mid-July China announced it had increased its gold reserves by approximately 60 per cent since 2009 to 1,658 tonnes.

“This would have been great for gold except that on a relative basis, gold still only represents about 1.5 per cent of China’s forex reserves,” says Cieszynski.

goldgraph

He adds: “Even worse … gold’s weighting in the People’s Bank of China’s portfolio hasn’t grown in the last six years, pretty much crushing hopes China’s drive to a free floating currency would save the gold price.”

As gold has historically been seen as a hedge against inflation, experts also argue that current low inflation has reduced the need to use it as a hard asset currency.

With oil prices showing no sign of rising imminently, inflation looks unlikely to rebound, says Cieszynski.

“With Iran preparing to return to the oil market amid an ongoing supply war among other producers including the US, Saudi Arabia, Iraq and Russia, the price of oil has tumbled back toward $50 for WTI and $56 for Brent.

“Because energy prices are a significant component of inflation measures, falling oil means that headline inflation looks likely to remain subdued for some time.”

Axa Wealth head of investing Adrian Lowcock says if we see inflation coming back that will be “a big driver” for gold. “Gold is priced in US dollars, so anything that happens to the US is what really matters.”

Interest rate dependency

Clearer signs from the Federal Reserve in the past weeks that a US interest rate rise will come before the end of 2015 were also bearish for gold, experts say.

Khalaf says: “Gold doesn’t pay an income, which isn’t particularly painful while interest rates sit at close to zero. But as they rise the opportunity cost of holding gold instead of cash rises too, and thus it becomes relatively less attractive.”

Anticipating this, many fund managers already reduced their gold exposures to zero “some time ago”.

Columbia Threadneedle commodities portfolio manager Nicolas Robin has been underweight gold for at least 18 months and thinks the price will fall further, to around £1,000 before the end of the year.

He says: “We didn’t like gold for the upcoming interest rate hike as well as the strong dollar.”

He also reduced his silver holdings two months ago and instead went overweight energy and gasoline.

However, not everyone believes a rise in interest rates will have a negative impact on gold as the Fed tightening is likely to be gradual.

After the first rate rise, there may be some kind of relief rally for the gold price, and gold equities in particular, says JP Morgan client portfolio manager James Sutton, who manages the Natural Resources fund.

However, for now, he will not be making any changes.

Sutton says: “At present we have 18 per cent invested in gold equities and this position hasn’t really changed for the past two years. We’re underweight compared to our benchmark, which has 33 per cent in gold equities.”

However, there is still value in holding gold equities as they are a good portfolio diversifier because they have different performance credentials to other asset classes, Sutton says.

“In previous rate hike cycles, gold tends to underperform but as long as the next rate hike is not severe, that wouldn’t cause much of a problem.”

Balancing options

Those choosing to go into gold equities rather than the the physical metal should stay invested in companies that have good fundamentals and business models able to “survive the downturn” and still be around to benefit from higher gold prices in the future, Sutton recommends.

He adds: “We could be in a depressed environment for another two or three years so it’s best for investors to avoid companies that rely on higher gold prices to stay in business.”

Lowcock says in the short to medium term pressure on gold will continue and sophisticated investors might tactically sell their gold holdings in the meantime.

However, there is still a role for gold, he says.

Khalaf says: “Investors who hold gold should do so for some insurance in their portfolio, and as such need to scale their position accordingly.

“Gold should account for no more than 5 per cent of your portfolio, and where investing via exchange traded commodities, always use physically-backed products.”

What’s next?

Debate still remains as to whether the recent big drop in the gold price is the start of a new downleg or the final washout before a rebound.

“Having tested $1,080, gold has now completed a 50 per cent retracement of its 2001-2011 bull markets,” Cieszynski explains. “Should that level drop, gold could fall to retest the $1,000 big round number or perhaps even complete a 62 per cent retracement by testing $880 over time.”

If gold were to rebound, it could bounce back up towards the $1,160 to $1,240 range where it traded previously, he says.

Seasonality may also mean that gold’s sell-off may be close to running its course.

Cieszynski says: “Historically, May to July has been one of the weakest times of the year for gold, however it has then bounced back in August and September ahead of wedding season in India, the peak time of year for physical gold demand.”

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