Gold connection now a disconnection

Gold’s rollercoaster ride since April has the market spooked. But, for small investors keen to hold physical gold, the lure of the precious metal is proving too tempting to resist.

Since gold futures prices plunged over $US200 a troy ounce in the space of two days in April, exchange-traded funds (ETFs) around the globe, including Australian-listed ETF Securities, have recorded massive outflows. At the same time, many small investors have pounced on the yellow metal to buy bullion, coins and jewellery, seemingly ignoring the market’s bearish sentiment and emphasising the growing disconnect between the paper gold market and the physical gold market.

Following gold’s dramatic flash crash, it has managed to claw some of its way back, recovering about half the value it lost mid-April. For small investors, it was an opportunity too good to miss. A surge in demand for gold bars and coins, and the increasingly higher premiums investors are willing to pay for physical gold, illustrates the unquenchable thirst consumers have for the precious metal.

But the action in the market tells a completely different story. ETFs are bleeding holdings at an astounding rate, with traders taking an increasingly bearish stance on the precious metal. The world’s largest gold-backed ETF, SPDR Gold Trust, saw record outflows of almost $US12 billion in April, or 143 tonnes. The outflows have continued into May and show no signs of abating. ETF Securities, which listed the world’s first physical gold ETF on the ASX in 2003, saw global outflows of $US323 million in the week before last, the largest weekly outflow in three and a half years. Danny Laidler, head of ETF Securities Australia and New Zealand, says that most of the selling has been by short-term tactical traders, with long-term investors continuing to hold onto the commodity.

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Even before the April sell-off, gold ETF holdings were in a state of decline. Since December, total ETF holdings of gold are estimated to have dropped 13% in the biggest, most prolonged fall since their introduction 10 years ago. ETF Securities has seen global net outflows of $US1.4 billion year-to-date. In Australia, the net outflow year-to-date from ASX-listed GOLD has been a relatively modest $US18 million.

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Source: Bloomberg

At the same time, demand for physical gold from India and China shows no sign of slowing. Chinese imports of gold account for almost 20% of total annual demand. This compares with less than 3% 10 years ago. The trend for increased gold consumption in China is reflected in the first quarter data, rising 26% in the three months to March, to 320.54 tonnes. Gold flowing from Hong Kong to China has increased sharply, surging to 223.52 tonnes in March from 97.11 tonnes in February. The previous monthly record of 114.37 tonnes, reached in December, pales in comparison. Similarly, demand has jumped in India, the world’s number one gold consumer ahead of the country’s wedding season and Akshaya Tritiya festival starting this month.

China and India are without doubt the biggest buyers of physical gold right now, but in the West, demand for gold bars and coins has also surged. The US Mint recorded a 118% rise in demand for one of its gold coins in April, forcing it to suspend sales for a time. Back at home, it’s a similar story. Even before the April price drop, the Perth Mint had experienced a taste of consumers’ growing appetite for gold. In the first three months of the year, demand for gold coins jumped an impressive 49%. But the April figures illustrate that the consumer love affair with the yellow metal is far from over. Last month the mint recorded a 160% rise in gold coin sales and a 74% rise in gold bar sales. Combined bar and gold sales for the month beat all previous records, the Mint said.

What we’re seeing looks to be a growing disconnect between the physical gold market and the paper gold market, with small investors leading the rush to buy “the real thing”, increasingly at a premium to the paper price, despite the market remaining bearish on the yellow metal.

Essentially, the game has changed, in the short term at least. The speculators have taken a step back to reassess the prospects for gold, while small investors have been moving in, buying up physical gold as the attraction of holding a safe haven asset outside the banking system increases.

In the near term, there has been much speculation over the direction the gold price will take. Senior analyst at Thomson Reuters GFMS, Cameron Alexander, expects the gold price to rise back up toward the $US1,700-mark this year, in what he deems to be the yellow metal’s “last hurrah”, before the bullion spot price declines next year and the year after.

At the same time, the fundamental reasons for holding gold haven’t really changed. The Euro zone is still in crisis, the currency wars are heating up, the US recovery is still fragile and global economic growth remains agonisingly slow.

The many critics of gold argue that it has no real value because it doesn’t have the potential to deliver any income, like dividends from stocks or rental yields from property. But it nonetheless offers a hedge against inflation and currency devaluation, and is the go-to investment in times of financial uncertainty.

Historically it has a negative correlation to other investments, including stocks. In a diversified investment portfolio, gold certainly has a role to play. For investors seeking further diversification, a small exposure to gold, say, up to 5% still makes sense for long-term investors.

Tax rules for retail investors

The Australian Tax Office issued a private ruling in 2011 which applies to the popular ASX-listed “GOLD” investment product, which states that any gains or losses incurred by ordinary retail investors in GOLD (and by implication, in physical gold investment) will be taxed as ordinary assessable income (i.e. not as a capital gain, which can be taxed at concessional/discount rates).

The ATO ruling states that any gains from GOLD are ordinary assessable income, and in support of that position it refers to a specific ATO ruling (TR 92/3), which states:

“As an investment, gold has no immediate use since it does not generate income over the life of the investment (e.g. dividends, rent, royalties or interest). In this regard, the only return that can be derived from an investment in gold is the profit generated upon resale.”

Based on that statement, it seems that the ATO would apply ordinary income tax rules to any investor that holds physical gold directly – and the examples given in TR 92/3 cover the usual scenario where gold is purchased as a hedge against other potentially negative movements in the overall investment portfolio.