This article was originally published here in January 2003
Last month I wrote that many investors are choosing to invest in government gilts and corporate bonds. I also explained why I am not; I worry about the risk to capital from a combination of inflation and rising interest rates.
It is always something unexpected that does the real damage. Imagine that we do go to war against Iraq and that it is not the quick walkover that we are being promised. The price of oil is bound to soar, damaging the economy but causing the inflation rate to rise. The Bank of England has an inflation target of 2.5% (±1% ) so they will be forced to raise interest rates, further hurting the economy. Before it came to that I suspect that the government (who sets the inflation goal for the Bank of England to meet) will raise or even drop the target. I believe that the government would greatly prefer inflation to an economy in recession.
In a recession the prices of goods and services generally fall as companies try to entice trade by cutting their prices. The danger comes when the price-cutting becomes a vicious circle of continuous cutting and cutting again. Prices across the entire economy start to decline, the inflation rate turns negative and we have deflation. You may have read that the Japanese economy is in trouble. Prices there are falling by 1% a year and average wages are declining by ½% a year. The Bank of Japan has repeatedly cut interest rates to try to stimulate the economy. The base rate in Japan today is 0.002%. Rates cannot be cut any further and yet the economy is still in recession. Japan is stuck in a deflationary spiral.
You can see what deflation does to anyone who has borrowed money. Their income declines as their employer cuts their wages. Yet the outstanding balance of their loan stays the same. Inflation effectively cuts the value of a loan by reducing the value of money. Deflation increases a loan as money becomes more valuable. The only thing that has saved Japan from total collapse is that most Japanese are net savers, not borrowers. Deflation means that each Yen saved under the mattress (why put money in a bank account paying zero percent, especially if the bank looks to be in financial trouble?) actually increases in value. The goal for the Japanese government has been to persuade people to spend their savings and get the economy moving again. They have not succeeded so far and the Japanese economy seems locked in a downwards spiral.
Deflation in a western economy would be a far greater disaster. People are net borrowers. We have a millstone of debt around our necks with would get progressively heavier in a deflationary environment. Governments know they must do everything in their power to keep inflation alive.
Gold has been used as a currency for over 3,500 years. Although the price fluctuates from day to day and even decade to decade gold has held its value over the long term. History records that two thousand years ago an ounce of gold would buy a Roman a good toga. Today an ounce of gold ($350 or £220) will still buy a nice suit. If inflation takes off gold should hold its value or even rise as people flock to invest in it. Gold has always been a "safe" investment in times of trouble. In tomorrows uncertain world we still need the solidity of such an asset.
Since the removal of VAT on investment gold in 2000 it is once again cost effective to buy gold coins or bullion. However, I would only buy gold coins if I were expecting world war three or a complete collapse in the western economic system - that is something that I am not worrying about. To really profit from a rise in the price of gold you have to leverage your investment by buying shares in gold mining companies for example.
Say that gold is trading at $300 an ounce and it costs a particular gold mine $290 to produce an ounce of gold. Obviously they make a profit of $10 per ounce. Now say that the price of gold increases by 5% so that it trades at $315. Now the mining company makes a profit of $25 per ounce. A 5% increase in the price of gold has increased the profits of the gold mine by 150%. Of course, the reverse is also true. A small decline in the price of gold from $300 wipes out all of the mines profits. However, if you are expecting the price of gold to rise, it makes sense to buy shares in mining companies, as you should make a greater profit.
There is a great problem in buying shares in gold mining companies; there are no large companies listed on the London stock exchange. There are a number of small companies but I ignore them as they are more of a speculative bet on the future of that company, not the price of gold. A large mining company will have mines around the world and their share price will be closely linked to the market price of gold.
A practical way for a UK investor to gain exposure to gold is to invest in the UK’s only gold unit trust, the Merrill Lynch Gold & General fund. This has been a star performer over the last year, rising almost 60%. The fairly steep initial investment fee can be made less painful by buying through a discount broker. It is also possible to set up a monthly saving scheme to take advantage of pound cost averaging.
I started writing this article in early December when gold was then trading at $320. Since then the fear of war with Iraq combined with a fall in the value of the US dollar has pushed up the price of gold to $350. It is a nice short-term gain but I think there is still plenty of mileage in the world’s oldest investment.