All that glisters is not gold

2010 was a rather remarkable year; it was nearly impossible to lose money. Regardless of whether you invested in bonds, equities, or commodities a year ago, you are probably better off now.

But the most impressive performances were in the precious metals sector. The price of gold rose by 30 per cent, while silver closed 83 per cent higher. Palladium outstripped both, registering a 96 per cent increase over the year.

Precious metals offer a store of value as old as human history. But unlike investments in equities or bonds, they do not in fact generate any income by themselves.

Of late, inflation fears, low interest rates and economic uncertainty have all combined to push investment money into precious metals, forcing up prices. Exchange traded funds (ETF) alone registered a net increase of 331 tonnes of gold last year, helping to lift prices further by making it easier for smaller investors to speculate.

But with the global economy recovering, the gold price dropped by 2.3 per cent on Tuesday and silver dropped by 2.8 per cent. Both registered smaller falls yesterday. Is it about time for speculators to take their treasure and leave?

According to Suki Cooper, a precious metals analyst at Barclays Capital, there is still scope for precious metals to strengthen further. “Investment demand is still positive”, she says “and the factors driving prices up haven’t gone away”.

Unless sovereign debt fears are systematically addressed, confidence restored and quantitative easing policies wound down, many Western investors will keep seeking the security of gold and other precious metals. Meanwhile, high inflation in China in combination with financial liberalisation is creating a whole new class of potential gold investors. Consequently prices ought to keep rising or at least stay stable in 2011.

LOW INTEREST RATES ARE KEY
Cooper argues that low interest rates are a principal force behind price rises, since they imply a low opportunity cost of holding speculative assets like precious metals. As long as the Federal Reserve and other central banks hold down interest rates, more investors will seek out speculative opportunities – including precious metals.

But as confidence returns, many investors may decide to take profits – especially if interest rates seem likely to rise. Given that, it might make more sense to buy precious metals with industrial uses, such as platinum, rather than gold. Platinum is strongly correlated to gold but it has the advantage of being an essential component of catalytic converters, and so is probably less vulnerable to economic recovery and rising interest rates.

Because as Kevin Gardiner, head of global investment strategy at Barclays Wealth, points out: “There remain good reasons for investors to be wary of gold in the long term” he says. “It is not the core inflation-hedging investment that many believe.” As the Roman writer Syrus observed, “everything is only worth what its purchaser will pay for it”. That is more true of precious metals than of anything else. Demand may seem high at the moment, but investors should remember what they are ultimately speculating on.