UOB ASSET MANAGEMENT
United Gold & General Fund
Commodity prices have been on an upward trend for the past couple of years. Rising demand from rapidly growing economies like China, have been a key driver for commodity prices. There are a few broad categories within the commodity universe, including energy, metals and food. Of these, oil and gold are the most widely traded commodities. Like oil, gold prices have been rising quite rapidly. But this hasn't always the case. Gold prices had been falling for a decade and bottomed in 1998. They started turning around in 2000, and have been on a general upward trend since. As of end May 2005, gold spot prices were at USD 417.25 per ounce (from Bloomberg).
On whether the rally in gold prices will hold up, Alfred Wong, fund manager for the United Gold & General Fund (“UGGF” or “the Fund”), says that, , “On balance, it seems to be positive for gold because it appears that most of these bull factors will still be on the horizon for the next twelve months.” He adds that investors should view gold beyond the obvious price appreciation. He explains it’s because including gold within the portfolio is an important form of portfolio diversification. “The unique thing about gold stocks is that they move in a counter cyclical manner to other asset classes like equities, bonds, currencies, real estate etc. Hence an addition to gold to one’s portfolio improves portfolio efficiency and provided vital diversification during market volatility.”
The United Gold & General Fund aims to achieve long term capital appreciation by investing in companies involved in the exploration of precious metals, energy and base metals. At the point of writing, it is the only fund in Singapore that has an investment mandate to capitalize mainly on opportunities provided through gold. As of 31 May 2005, the fund is 62.23% invested in Gold and precious metals, 37.1% in base metals and a 0.67% cash position. In the 1-year, 2-year and 3-year periods ending 31 May 2005, the Fund returned an annualized -0.1%, 13.6% and 2.2% against a benchmark performance of 1.3%, 9.6% and 2.9% respectively (figures are calculated using offer-to-bid prices, in SGD, with income reinvested).
Source: UOB Asset Management
Turn of Events Supportive For Gold
As stated earlier, gold went into a major slide in the mid 1990s bottoming at around USD 250 per ounce in 1998. The predominant event was undisciplined European Central Bank gold sales, which created an overly bearish, pessimistic sentiment over the sector. The WAG ( Washington Agreement of Gold) instituted in September 1998, saw an end to the gold slide. The agreement involved limiting the amount of gold sold by central banks to 400 tons per year for the next 5 years. Subsequently, this “created stability as well as a floor for the gold price, and since then gold prices actually went up” says Wong. This trend was later re-inforced by the FAG (Frankfurt Agreement of Gold). Since then, gold was re-rated higher against the backdrop of USD weakness and increased market volatility as discussed below.
1) Weakening USD - Historically, gold is known to have a strong negative correlation with the US dollar. The downturn in gold prices throughout the 1990's coincided with a strengthening US dollar. In fact gold is seen as an alternative to USD, in periods of extreme dollar weakness.
2) Shrinking Contango – Because interest rates were so much higher compared to gold lease rates in the past, the wide contango (difference between LIBOR and the Gold lease rate) incentivized speculators to short gold and execute gold-carry trades (similar to the yen-carry trade). This means speculators borrowed gold cheaply and made profits almost instantaneously, by subsequently investing in higher return instruments. This caused gold prices to be artificially depressed. The contango has been shrinking due to the effect of declining interest rates and rising gold prices and gold lease rates. Thus there is now little incentive to use gold carry trades.
3) Reducing Producer Hedging - Some weaker producers’ were also arm-twisted by their financers (bankers) to hedge their gold production. Hedging involves forward sales where gold is sold at a future time based on a price fixed now. This is seen as producers having poor confidence in gold, their own product, and that weakened gold sentiment further. Conversely now, producers are now unwinding their hedges as gold prices strengthen, as they want more upside price participation. The improving sentiment has caused gold to be re-rated.
The fund manager notes that since key events such as the Asian financial crisis and the September 11th terrorist attacks in 2001, sentiment towards gold has shifted. Gold is seen as a hedge against the volatility of markets as it can help to preserve capital during uncertain times. Also as developing countries are able to afford gold, the demand for jewellery is expected to increase. Going forward, Wong thinks that most of the global demand for gold and commodities will come from China and India. “ China does play a very important role. If you look at what happened in the last Asian crisis, China provided a very important buffer in terms of helping the world to suck up all the empty demand. In fact, countries like China and India are lacking in raw materials and energy, be it Alumina, Nickel, Iron ore, Copper, Oil etc. Also, currently China is still very much rural, the country will be moving towards urbanization and industrialization. Given the vast population sizes in these two emerging economies, this structural trend will underpin the robust demand for gold, commodities and oil in the years to come."
Gold Demand From Asian Central Banks
Another factor to note says the fund manager, is activity by Asian Central Banks. In the past when the USD was very strong, it was easier for Asian central bankers to manage their countries’ huge foreign reserves, by investing in US dollar debt. However, Wong says that against the backdrop of a structural decline of the USD, it is now more challenging for them to do so. “It behooves them to then think hard about how to allocate more money towards an asset class or currency that will help them to offset the foreseeable US dollar decline. So I think that going ahead, there will be a very serious rethink by many of the Asian central bankers with huge foreign reserves, to rebalance their portfolio in favour towards a more balanced mix of occupying more euro or more yen or even more gold.”
Wong adds that while Asian Central Banks haven't invested in gold in a big way yet, that could change quite soon. “It has been shown historically that the negative correlation between gold and USD is very strong; the one sure proof way is to buy gold because that offers a very strong natural hedge.”
Higher Commodity Prices Here To Stay
Wong points out that the commodities industries (be it oil, gold, base metals etc.) are facing cost inflation. This is because when demand is high, explorers for these commodities compete for each other for skilled labour, equipment, energy etc. Further more, many of the easily accessible areas for these commodities have been explored or exploited. Going ahead, they have to go into areas that are more unknown or areas that will be very expensive to explore due to difficult geographic conditions.He says these have the overall effect of shifting the cost curve of commodities upwards. Thus the world will have to adjust to higher commodity prices going forward.
Gold & Base Metals Makes UGGF a Hybrid Fund
Although gold and commodities are usually lumped in the same category, they can rally on different or similar reasons. When the world is in a global reflationary mode, it will be positive for both base metals and gold. “The only situation when they can be different is when the world is in global deflationary trend, people want to gravitate towards an asset that they think would be of value, and that should be gold.” The trend for base metals would be negative instead of positive because base metals depend more on global economic indicators like inflation, IP (industrial production), ISM (institute of supply management) and the PMI (purchasing managers’ index). “Gold is entirely different as it operates more on the so called “safety” factor as people are cautious about the global investment environment. It can also depend on your factor of increased affordability.”
As the movements in gold and base metal prices are not necessarily correlated, having both in the fund is a form of diversification notes the fund manager. “I think the United Gold & General Fund is unique because it is can operate like your hybrid bond and equity fund; switch between bullish or bearish environment.” Wong further explains that in a bearish environment, the fund can invest into more gold equities instead of base metals. “In a bullish outlook, you underweight gold, which is seen as a safe haven, but over weight your base metals because that is your leverage to global IP."
Wong says that from a demand angle, the biggest risk is a collapse in demand caused maybe by the hard landing in China. He also adds that the USD sentiment is equally important influencing the direction and magnitude of gold’s price movement. On the supply side, he says that consolidation in the last decade has made the industry more disciplined. On consolidation in the industry, Wong says, “I believe the days of very large scale consolidation may be over. There are just fewer players to go around with. We may have land swapping instead which makes better economic sense. For example, Miner A who has mining activities in Chua Chu Kang and Simei, whilst Miner B has land mining activities in Bukit Timah and Tampines. Miner A and B might swap properties, form a Bukit Timah - Chua Chu Kang block while the others effect Tampines - Simei block. Logically, this would enhance their operational efficiency, effect cost synergies."
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