We are continually being asked these three questions:

1. What do you think are the reasons behind the rise in the price of gold?
2. What is your future outlook for gold?
3. Do you think gold is a good alternative investment?

Here is our response written by Simon Hudson-Peacock, senior portfolio manager at Cadiz Asset Management:

Your questions on Gold are undoubtedly timely as I think we face a tipping point for the metal’s future in the coming months:

Gold is a monetary proxy. It had until 1971 backed most major global currencies. However, due to its scarcity, this rapidly become impractical as money supply growth far exceeded the precious metal’s ability to underwrite its value. The rise in the Gold price in the last few years has come about due to Investors’ concerns with the value of cash, specifically the US$ that has otherwise acted as the World’s reserve currency for many decades.

The global financial crisis has stymied the ability of the world’s largest economy’s to grow itself out of its mounting debt pile. As a result, we have seen two rounds of quantitative easing that is in effect printing money to buy debt. These are extra-ordinary increases in money supply. At the same time, US monetary policy remains very accommodative with the US’s equivalent of the prime interest rate being a mere 0.25%, effectively you can borrow for next to nothing. This over-supply and cheapness obviously combines to negatively impact the perceived value of the US$, witness its 38% fall against the Japanese Yen for example from 124 to 77 JPY/US$ since mid 2007.
Many investors wishing to hedge against the fall in their confidence with the US$ will turn to Gold. It is traditionally a store of value in times of financial crisis because it is a finite, physical, indestructible resource that is uniformly coveted around the world as form of currency. No-one can create Gold out of thin air as they can paper currency although many alchemists have tried over the centuries!

Therefore, so long as the world is in fear of a devaluing US$, global economic and political instability, there will be a underlying demand for Gold.

Sometime in the future, should confidence return to global financial markets, there will be less reason to hold gold. It does not provide an income and it costs money to store and insure, costs that are passed through to investors whether they be holding the physical or securitised form of the metal. As confidence rises, so monetary policy will tighten in order to mitigate against the possible inflationary effects of cheap money in a growth environment. As interest rates rise, so the opportunity cost of holding Gold will increase. When sentiment turns, Gold will find itself in freefall until investor selling is matched by the physical demand from jewellery fabrication. This will be at a level that is significantly below the current price. Investor demand has squeezed physical demand out as Gold has become increasingly more mainstream through the creation of physically backed exchange traded funds that improve liquidity and lower the effective cost of holding the metal.

It is important to note that Gold does not have a reference price. It is not beholden to the marginal cost of supply because there is so much Gold in above ground stocks. Investor holdings are currently at unprecedented levels and when the tide turns, as it ultimately will, its fall could well be precipitous.

Gold does have a place in an investment plan, it is an alternative investment that has defensive qualities that can hedge against economic and financial risks. The time to buy Gold is however when you don’t need it! When everything is calm and the are no stresses to worry about then Gold is priced for fabrication demand and there is no risk premium to be paid. Right now there is a huge risk premium on Gold. Only if an investor believes that things are going to get worse from here would there be a case to buy Gold now. In the short term things can go either way and there may be some trading opportunities. However, I believe that we are in the midst of the crisis and therefore if one take a medium term view then I think the price will fall as the troubles settle.