Is gold a safe haven for your money in these troubled times. Fredrik Nerbrand, Head of Global Strategy at HSBC Private Bank (left) thinks it may not be after all.

Many investors are becoming increasingly conservative in the search for safe havens. Throughout the centuries, gold has often been perceived as the ultimate safe haven and, judging by the markets, today is no different. However, we tend to differ with this consensus view, as we do not believe gold necessarily offers the characteristics of what we would call wealth preserving assets.

Our view primarily focuses on one issue which is often forgotten: volatility. From an overall portfolio perspective, gold is likely to boost rather than reduce portfolio volatility. As such, we do not believe gold is such a safe haven after all.

In our view, gold is so volatile because its price is solely a function of the interaction between supply and demand. There is no intrinsic value to gold itself other than what someone is willing to pay for the commodity. Compare this to other ‘safe’ assets, such as short-term bonds, where price is a function of future cash flows. This demand has, in our view, become much more fickle over the last year as investment into the commodity has become much more popular. To put it bluntly, a buyer of a gold necklace is less likely to sell it compared to someone buying an ETF or gold bar (probably due to relationship issues).

In our view, the reason to buy gold can be split into two categories, either because one believes that demand will increase or because one wants to limit counterparty risk by buying physical gold. Put another way: speculating or hedging. However, both are intrinsically correlated through demand.
 
So, demand is critical. We split the demand into three categories: jewellery consumption, industrial and dental and identifiable investments. The main demand between the three is jewellery, which YTD constitutes 66.5% of demand. However, this has dropped from 68.2% at the end of 2007. In our view, this decline is likely to continue as the ‘wealth effect’ on gold consumption wanes, as individuals feel less wealthy today than they did only nine months ago.

Similarly, we believe industrial demand is likely to wane as the overall industrial cycle moves into a protracted slowdown. That leaves us with the fickle investment demands.
 
According to data from the World Gold Council, demand for physical gold has increased from 29.6 tonnes in Q4 2007 to 72.4 tonnes at the end of Q2 2008, presumably due to the worsening credit crunch. However, due to recent government support of the financial sector, we believe counterparty risks have abated somewhat.

That only leaves pure speculators.  During the sub-prime crisis, particularly during periods of extreme fear, gold volatility has spiked to exceptional levels. 90-day volatility in gold is the highest it has been since the 1998 LTCM crisis. Volatility has traded at these levels only six other times since 1970, and all during political/economic crises.

During these periods, there are short windows of opportunity for significant returns, but there are also significant downside risks. On average since 1970,when 90-day volatility is above 35%, gold tends to decline 15.5%. At present, gold has a 90-day volatility of 33% and despite the potential for safe-haven rallies, the figures suggest far greater risk for downside risk in the price on a 12 month forward basis. This coupled with ample supply, suggests gold is a risky investment.
 

Source: World Gold Council as at October 2008
 
 
Our overall equity view is neutral. We prefer defensive sectors, and global mega caps, particularly in the US.
 
Given the coordinated support from global policy makers, we believe we are getting closer to a bottom. Hence we believe there is more upside than downside. Therefore, we believe investors should increase the pace of allocations into equity markets from available cash positions.

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