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Gold in your portfolio
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The decline in the price of gold coincided with the period when tail risks within the global economy began to diminish. Rewind to 2011.At that point of time, there was widespread fear that the euro zone might splinter. The US economy too was in the doldrums. But then the central banks intervened. They pumped in so much liquidity that all the risks within the global economy got papered over. As risk appetite returned, money began to flow out of gold and into risky assets like equities. Since then gold, a safe-haven asset, has underperformed while risky assets like equities have surged.
But does gold's current predicament mean that it will remain in the limbo for a long time? Chirag Mehta, fund manager, Quantum Gold Fund, does not think so. Central banks have pumped in so much liquidity that their actions have overshadowed all major concerns: worries related to the economy, and to debasement of currencies and inflation. But the underlying problems of high deficit and debt still persist. It is only a matter of time before these risks show up again. Fundamentally, he argues, the case for investing in gold still remains strong.
Lately, geopolitical upheavals in Ukraine, Iraq, Syria and other parts of the Middle East have prompted some buying of gold. But these concerns have been overshadowed by the US economy's strong performance. The strengthening of the dollar index has also put pressure on the price of gold. The softening of crude oil prices has also played a part. When the price of crude oil falls, it leads to lower inflation in importer countries like India, leading to lower allocation to gold by investors.
Now gold bugs are keenly watching interest rate movements in the US. Tapering, or withdrawal of quantitative easing, will end in October. There is widespread expectation that the first rate hike may happen six months later, say, in March-April 2015. Tightening in the US will, to some extent, be countered by loose monetary policy in Europe and Japan. Nonetheless, any net reduction in liquidity in the global financial system will cause distress in asset markets. If and when interest rates are raised, money will flow out of debt funds due to the capital losses that investors will face there. Rising interest rates will also be negative for equities. In that scenario, investors will move to gold.
Gold - The diversifier
The primary reason why you should still maintain an allocation to gold is that it is the best diversifier available to an Indian equity investor. Look at data between 1980 and now. In most years when equities have given negative returns, gold has done well. Gold is also a good store of value, which means that it tends to do well amid inflationary conditions. Despite the Indian central bank's best efforts, inflation continues to be a major bugbear for the Indian economy.
Gold also tends to rise when the Indian rupee weakens. Whenever foreign institutional investors (FIIs) withdraw money from India--as happened in 2008 after the global financial crisis, and again in mid-2013 after Ben Bernanke first spoke of tapering--the rupee weakens. And when the rupee weakens the price of gold rises.
Hence, investors should continue to have an 8-12% allocation to gold in their portfolios despite its current underperformance.
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