WGC analysis asserts gold is not a volatile asset

The World Gold Council suggests that, despite the increase in volatility associated with the rally of recent years, the perception that gold is a volatile asset is not correct.

Author: Rhona O’Connell
Posted: Thursday , 25 Sep 2008

LONDON -

Gold's investment and supply-demand characteristics are a vital part of the tapestry that leads to gold having enjoyed consistently lower levels of volatility over the past twenty years than, for example, silver, oil and other major equity indices.

There is a commonly-held misconception that since the credit crisis' eruption in August 2007, gold has become a volatile asset. Its volatility certainly has increased since then, but gold has remained less volatile than other major asset classes such as the rest of the precious metals sector, oil, the GSCI commodity index and equity markets.

In the 1970s following President Nixon's closing of the gold window in 197, gold was very volatile as prices caught up with the mechanics of a free-float, and then the soaring price of 1979-1980 meant that prices remained volatile for some years thereafter. By the mid-1980s, however this had calmed significantly and this lower volatility has persisted since. The corrections during gold's recent strong bull run have resulted in pockets of increased price volatility, but as the Council points out, they pale in comparison to that experienced during the 1979 - 1980 spike.

The study looks at the 34-year period from 1974 to 2008 and argues that there is a natural shift in market forces that mean that, while it might appear somewhat arbitrary to take the mid-1980s as the starting point for developing the argument for reduced volatility, there are some significant structural economic factors that make the choice a valid one.

The market adjustment of the 1970s speaks for itself, especially as it was a period of high inflation, compounded latterly by a period of high political instability towards the end of the decade.

There followed a period of severe deflation in the early 1980s as the tight monetary policy of the late 1970s fed through into the system with the US, and latterly other economies, falling into recession. This had an adverse effect on commodities in general, while gold suffered the additional factor of deflation, so that by July 1982 gold was at $300/ounce. The Council argues that gold volatility was not surprising during this period, as it was fed by the prevailing economic and policy environment. Average 22-day volatility reached 113% around the time of the $850 peak and in the following two years there were two spikes in which volatility reached 60%.

The transition period from high to low inflation effectively took place in the first half of the 1980s, although it lasted longer in Europe as countries adjusted to the demanding criteria for euro membership. The council points out that it is the linkage between US inflation and the gold price that is the most widely documented and that the second half of the 1980s can e called one of transition.

By the 1990s inflation was under control in the most major economies and although there were recessionary conditions in many parts of the world in the early part of the decade, economic growth rates soon started to improve, led by the US. Inflation was low during the decade, while political uncertainty was relatively benign.

Gold was range trading during this period, although with a downward bias and gold price volatility during the 1990s averaged just 10.6%.

The range-trading period was effectively ended by the announcement on 26th September 1999 of the first Central Bank Gold Agreement, although the price did not really bottom until 2001. Sustained economic uncertainty characterised the first part of the 21st century, but this evolved into a period with economic growth rates improving, with that improvement synchronised across both the developed and the developing nations. This of course set the scene for the subsequent commodity boom, and arguably put the parameters in place for a subsequent surge in inflation.

The Council suggests that, regardless of how persistent the recent higher rates of inflation turn out to be, there are "crucial differences" between the current phase and that of the 1970s.

Inflation is generally well under control in developed economies, with low inflation expectations well-entrenched and despite increasing pressures, the high levels of the 1980s are unlikely to be revisited. The cut-off date for the volatility analysis has therefore been chosen as late 1987, to avoid the spike in equities volatility from the October "crash", following which the equity markets had a series of circuit-breakers implemented, which suggest (although it might not currently feel like it) that levels of extreme volatility in October 1987 are unlikely to return.

The analysis looks at gold's volatility against equities and commodities. The piece presents a series of charts working off 22-day moving average volatility and show that gold is significantly less volatile then these other classes, and that this persists over time.

What lies behind gold's relative stability?

The Council identifies key levels of investment risk: credit risk; liquidity risk; and market risk.

As far as gold is concerned:

· It carries no credit risk and, unlike a currency, its value cannot be affected by economic policies of the issuing country or undermined by inflation in that country.

· Liquidity is more difficult to measure, given the variety of platform on which gold is traded.

· It is, however, deep and liquid and this can be demonstrated by the narrow bid-offer spreads in the market and the speed of trading by comparison with many competing diversifiers "or even mainstream investments".

· Furthermore mine supply is well-dispersed geographically, unlike for example, oil, where production is concentrated in the Middle East. The CBGA's also ensure that official sector selling is generally done on a controlled basis.

Market risk does of course adhere to gold as illustrated by the price performance in the early 1980s. The Council argues, however that many of gold's downside risks are different form those associated with other assets, which enhances its role as a diversifier of risk.

In summary, the Council concludes that the reasons underlying gold's relatively contained volatility are well-entrenched, both in its investment characteristics and those of underlying supply and demand.