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Bitter pill. Bill David Brooks, CC BY-SA

Gold always glitters but better bargains lie beneath

Fears over China’s ability to cope with its debt crisis and renewed doubts over recovery in the US have sent investors running back to old faithful: gold. But markets look as if they are favouring tradition over common sense. There are far better boltholes for their money, even among fellow metals.

The gold price has hit a four-month high as doubts crept in about America’s consumer-led recovery and markets pondered the possibility that Ukraine might default on its debt. A few days ago it was China’s debt burden that grabbed the attention and drove gold demand.

It’s a familiar story. Gold shares this safe haven appeal with only a handful of other asset types and its value peaks and troughs with the macroeconomic winds. But does it actually make sense for investors to rely on it to protect their capital in fragile times – when countries face the risk of being unable to pay their debts? This question prompted a group of us to explore whether there are some better places for investors’ money, among fellow precious metals as silver, platinum and palladium – the rare metal used in catalytic converters – as well as industrial metals like lead, nickel and zinc.

Our study showed that gold is a strong hedge for sovereign bonds of countries with serious debt issues (for example Greece, Italy and Portugal) and that its safe haven status depends on the magnitude of the extreme negative movement in a country’s bond price.

But more importantly, we found that gold is not the most useful metal for seeking safety in turbulent times. Financial institutions – and individuals blessed with means enough to care – should be considering other precious and industrial metals when things start to get ugly. We even found that industrial metals offered a stronger hedge against adverse movements in sovereign debt prices than gold or any other precious metal.

It’s not too hard to see why; the outperformance of industrial metals in managing the risk associated with with the government bond market can be attributed to their increasing global demand as they chart the upswing in the global economic recovery.

My precious …

But it’s not a simple calculation. The safe haven properties of precious metals vary over time. From 1993–2001, our safe haven test indicated that gold is largely a weak safe haven in all markets except Greece. In the period 2001–2006, gold was a strong safe haven for bonds in Finland, France, Germany, Greece, Netherlands, Portugal and the EMU benchmark bond for negative shocks.

Strong, but not the best. A typical portfolio of industrial metals outperforms a portfolio of precious metals and that of all other metals as a hedging instrument against the adverse movement in sovereign bonds.

The simple conclusion is this: all precious metals and many of their more prosaic cousins outperform gold in protecting investors against losses in the sovereign debt market. There is also strong evidence that non-precious metals provide a better compensation for investor losses, particularly in periods of high bond market turmoil. We found that palladium, copper and lead all serve as a strong safe haven as they are able to hedge against a deterioration in credit quality such as that seen during recent financial crises.

So we can still say that gold is a good investment choice during financial crises, but it is evident that there are better alternatives. And more than that, we can say that although all the metals we studied offered protection, investors are actually better off holding industrial rather than precious metals in periods of stormy weather. Maybe it’s not so much a case of following tradition over common sense, but rather a case of sticking with what you know over exploring less popular investment ideas.

Of course, there is some sage investment wisdom about eggs and baskets. And we would say that as the hedging and safe haven performance of gold and other metals vary across bonds, a diversified allocation strategy that manages the bond-metal mix may be necessary to protect investors’ wealth against extreme losses in government bond markets.

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