Stock Watch by Brad Bishop, Butterfield Bank (Cayman) Limited. 

Humans have long had a love affair with gold.  For centuries, it has been cherished by royalty, sought by thieves and desired by central bankers. Aside from its few modern day practical uses (such as in dentistry and electronics) the metal continues to be most popular as a jewel and as a store of value. The price of gold touched an all-time high in October at US $1,381 per troy ounce, representing a 25 per cent increase in 2010 and nearly a 200 per cent increase over the past 5 years. 

What explains this dramatic rise in price? I hear many comments that suggest gold is rising in price because its supply is scarce. If this were the case, then yes economics 101 would dictate a rise in price, all other things being equal. Yet, an analysis of recent statistics compiled by the World Gold Council reveals that the supply of gold is abundant and growing. Unlike stocks of crude or other natural resources that are consumed very quickly, estimates show that current gold stocks could exist for a few centuries given current rates of production and consumption. World central bank assets alone at 30,000 tonnes could meet industrial demand of 3,000 tonnes per annum for 10 years.  

A closer look at demand statistics shows that the demand for gold for use in industrial and jewellery applications has remained somewhat stable (although some regions, such as India and China, have shown notable increases). So if supply is growing and industrial and jewellery demand is stable what gives?  

The answer lies in the demand for gold as an investment. Recent figures highlight this. Total demand for gold (measured in tonnes) increased by 36 per cent from Q2 2009 to Q2 2010 and much of it was for investment purposes. Of particular interest is that ETFs (exchange-traded funds) have been the largest contributor to investment demand growth, showing a 92 per cent increase in 2009, and a 414 per cent increase from Q2 2009 to Q2 2010. However, even with the pickup in investment demand, the numbers show that total new supply is keeping up with total new demand. This suggests to me that the increase in price is mostly a function of investor preferences. In other words, investors are placing a higher value on gold.

Gold, in contrast to many other investments, does not produce income and is primarily sought after as a store of value. And unlike paper money, gold is not a liability of any country and is accepted as a unique asset and medium of exchange the world over. Throughout modern history, dollar-denominated gold has been inversely related with the greenback, making it a useful hedge. In October, this negative correlation was around 0.53, generally in line with its average for the past 15 years. (See Graph ) 

During periods of high inflation, it fundamentally makes sense that the price of gold would increase because the alternatives, fiat currencies, would deteriorate in value quickly when more and more money chases the same amount of goods and services. But why has gold continued to rise of late when the US and most developed countries are battling with extremely low inflation and even fears of deflation?

My hunch is that gold investors are sceptical that governments will be able to make good on their increasing debt levels in an environment where GDP growth is expected to be low for a long time. Think of your personal situation and how very difficult it would be for you to service increased debt levels if your income was not rising significantly. So perhaps gold investors have picked up on the idea that the only way for governments to repay their obligations, absent a growing economy, is to “inflate their way out” and make repayments with a currency that is worth less.  

This fear of future inflation has only gained strength with expectations of further quantitative easing measures by the Fed. To make matters worse, world currency disputes have intensified and raised concern that more volatile exchange rates lie ahead. Both of the above factors have added to the desire for gold as an asset to store wealth.

Thanks to the advent of ETF trackers, investing in gold has become easier than ever for individual investors. One such ETF, the SPDR Gold Trust (Bloomberg ticker: GLD), is backed by physical gold bullion and is the largest such fund in the world. (See Graph 2). Since its creation in 2004, the fund has grown to hold 1298 tonnes of gold at last count, making its holding larger than all but five central banks around the world. It trades just like a stock, has a low expense ratio of 0.40 per cent, and is nearly perfectly correlated with the physical commodity.   

Should you add a gold tracker to your portfolio? The answer to this question depends on your unique circumstances and investment goals and of course your level of confidence in the international monetary system.

The views expressed above are not necessarily those of Butterfield Bank (Cayman) Limited. Financial statistics sourced from Bloomberg. Gold statistics sourced from World Gold Council and Bloomberg.