The tradition of hiding gold treasures in the ground is consistent with the observation that gold is the ultimate physical store of value during major disruptions. The mere mention of the word gold steers a feeling of well-being across all cultures. Generally associated with necklaces, rings, bracelets and other jewellery, this yellow metal has also played a very important role in the development of financial systems as we know them today.

Before World War I the world economy operated on a gold standard in which the currency of most countries was convertible directly into gold. American dollar bills, for example, could be turned into US Treasury and exchanged for approximately one-twentieth of an ounce of gold. Likewise the British Treasury would exchange a quarter ounce of gold for £1 sterling. This implied a fixed exchange rate of $5 to the pound. The tying of currency to gold resulted in an international financial system with fixed exchange rates between currencies. With the coming of World War I, which led to massive trade disruptions, countries could no longer convert their currencies to gold; this led to the collapse of the gold standard. Nonetheless, after so many years, gold still managed to retain its status as an ultimate symbol and store of wealth. According to the World Gold Council, central banks around the world still hold around 12 per cent of their reserves in gold.

Over the past eight years the price of gold has rallied by over 225 per cent. No wonder this commodity has recently steered the interest of both institutional and retail investors. Today gold is offered in a wide variety of investment vehicles that can be used in passive (buy and hold) or active (frequent trading) strategies. Gold-linked investments include gold bullion, coins, bonds, mining equity, futures and options on gold and mining equity or bonds. Investment demand for the yellow metal has increased considerably in recent years and has been the main driver of growth. But, with an approximate aggregate of 75 per cent of global demand, jewellery still makes up for the largest share of global demand. Demand from emerging countries like Russia and China has continued to rise over the years, and holds considerable potential for future growth as standards of living continue to improve. Additionally India, the world's largest market for gold by some significant margin, acts as a good support to gold demand given their cultural and religious traditions. Apart from jewellery and investment demand, gold is also used for industrial and dental purposes.

On the supply side of things, mining production has been on a downtrend since 2001, despite the rise in gold price. 2007 saw South Africa lose its spectre as the world's largest producer, ousted by China. Supply of gold is relatively inelastic like most natural resources. Gold production holds a relatively long lead time as new mines often take up to 10 years to come to stream.

For centuries, people have regarded gold as the best possible protection against inflation and social, political or economic crises because it can easily be traded worldwide at any time, and its real value tends to increase during crises. For example, gold kept its real value during the US stock market crash from 1929 to 1932. Rising inflation has become a daily feature in today's media, with mounting oil and food prices. Inflationary pressures and the falling dollar have played a pivotal role in the recent rally of gold prices. During the 1970s oil crisis, the price of the bullion tripled when stock markets worldwide dropped severely. Inflation figures last published for the US, UK and the eurozone all evidenced price data above the respective banks' targets. In the meantime most economists are expecting inflation to remain elevated for the rest of the year.

Gold also holds significant attributes in terms of portfolio diversification. According to statistical analysis from the World Gold Council (Gold Investment Digest - April 2008) the yellow metal holds a negative correlation to the Dow Jones Industrial Average and the S&P 500 over a three-year period ending March 2008. Hence, the inclusion of gold-linked investments in a portfolio that tracks the aforementioned indices would reduce the overall risk of the portfolio, ceteris paribus.

This precious metal has also exhibited a negative correlation against the dollar along the years. In fact the run in the price of gold over the past couple of years has been accompanied by a falling greenback. Market participants have now been predicting some sort of dollar comeback for quite some time. According to Bloomberg estimates the EUR/USD is expected at around 1.54 and 1.50 for the respective third and fourth quarters this year. A dollar appreciation may dent some of the gold's upside potential, although any comeback in the greenback may be capped by excessive US deficits.

Other risks that may be fronted by the price of gold include the decrease of industrial demand especially from the semi-conductor business, as global economic growth rates are expected to slow during 2008. Nonetheless the impact may be somewhat contained as industrial demand for gold does not constitute one of the major sources of demand. Additionally, the precious metal may lose some of its appeal should major economies display an unexpected economic recovery in the short term.

Locally bracelets, necklaces and pendants have always been popular Holy Communion gifts, even though one may have preferred a bicycle at the time. On the other hand, with the current oil prices, a bicycle may be an equally wise investment.

• Mr Polidano is investment analyst, Bank of Valletta plc.

kevin.polidano@bov.com

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