A Framework for thinking about Gold and Silver

Gold and silver have become very popular investments in recent years. I’m sure you’ve all seen the ads pitching it. The reaction to this last Fed policy meeting and press conference makes it a good time to go over the main reasons people have had for owning it, and how those factors have been evolving.

Low real rates. Commodities in general tend to do well in environments of low real interest rates. None more so than precious metals. The two reasons are (1) the opportunity cost of holding precious metals is low and (2) periods of low real rates often precede periods of inflation, for which precious metals historically have been used as hedges.

Systemic risk. The US banking system was on the verge of collapse back in 2008, counterparty risk had already broken down, and those living in the bowels of global money markets believed—with good reason—we were hours away from seeing lines of people in pajamas in front of ATM machines hoping there would be cash still in them. And history has seared into our collective memory the role of gold as a time-tested refuge in systemic crises.

Fear of high inflation. Central banks around the world have been expanding their balance sheets. Aggressively. When this started in late 2008, the consensus view was that this would cause inflation, perhaps hyperinflation. This led to a surge in the interest in precious metals, and to many high-profile hedge fund managers buying gold to protect against it. The list is long: John Paulson, David Einhorn, George Soros (though he has reportedly since sold), and countless others.

Fear of fiat currencies/gold as an alternative currency. “All currencies are in a race to zero” seemed the mantra for much of 2010-2011. The belief seemed widespread that in a desperate quest for growth there would be a no-holds-barred currency war, with the US as the instigator. If everyone was going to debauch their currencies, the word was holding gold–which many have come to view as an alternative currency–would be the natural place to go.

Diversification and the Dollar Overhang. The global financial system has been massively dollar centric for the past 60 years. Two things, around 2002, catalyzed a major diversification wave away from the dollar. The first was the plugging-into-the-grid of emerging markets (Brazil came back from the brink; China joined the WTO, etc). The newly found growth and macro-economic stability in these countries  led to them trusting their home currency more, and needing the dollar—in which they were all heavily loaded—a lot less. Dollar-denominated funds joined the BRIC party, intensifying the decline in dollar demand. I’ve written in greater detail on this subject, one of the most misunderstood in global macro investing, here, here, and twice here.

The second was the emergence of the euro. The euro came into existence as an exchange rate regime in 1999, but only in 2002 did it become a deliverable currency. With central banks around the world holding reserves almost exclusively denominated in dollars, a liquid currency that could reduce their concentration in US dollars and better reflect their patterns of trade was a godsend to many. This too put downward pressure on the dollar.

Once the diversification away from the dollar gained momentum, its decline boosted demand for precious metals, first because of the traditional correlations, but second because it also led to fears that something was wrong with the dollar (nothing brings out sellers like lower prices). This further reinforced the diversification bid for precious metals.

Income effects: China and India. China and India have grown spectacularly over the past 10 years. The past decade really was their coming-out party. But these economies have woefully underdeveloped financial systems. Savers and earners have had very few investment vehicles from which to choose. Capital controls have limited choices even further. As a result, Chinese and Indians have resorted to the time-tested investments their grandparents told them about: real estate and precious metals. As their incomes grew, so did demand for both. The fact that precious metals were going up in price only fed the fever. (Nothing brings out buyers like higher prices.)

Where do we stand today?

You can go over each of the above factors, assign weights to them, and decide for yourself if in the aggregate they are waxing or waning. But let’s run through them quickly:

The low real rate environment persists. This, ceteris paribus, will be supportive of precious metal prices. However, the fear that these rates are going to lead to rapid inflation has faded considerably, as investors (and, embarrassingly, many economists) are slowly coming around to a better understanding of the transmission mechanism of modern monetary policy and negative money multipliers. We’ve also seen the serial predictions of those promising that Zimbabwe or Argentina-like inflation was ‘just around the corner’ fall repeatedly flat. Even Peter Schiff must be getting tired by now.

Systemic risk is still an issue, with Europe far from resolved, but with much of global financial system having successfully delevered, it is much less of one. US banks have issues, but the focus is on earnings run-rates in the new environment, not (for most of us) sovlvency. Heavily levered carry-driven investment strategies (remember Peloton and its ilk?) are the exception rather than the rule as risk aversion has pushed aside the pre-crisis go-go mentality. Plus, the EU has a better understanding of the kinds of problems they are likely to run into in crisis, given the Lehman dress-rehearsal, as well as which measures will be required to fix them—even if they are so far reluctant to fully engage them. Lastly, the better understanding of the deleveraging process has led many to conclude deflation may be the greater risk, and it is not clear precious metals will be good hedges for this.

The fever surrounding the currency race to the bottom seems to have broken when the US dollar stopped its decline. As is often the case, the bottom in the US dollar was found exactly when the predictions of its crash became loudest. Investors are coming around to the realization that expanding base money is not the same as expanding the money supply. And, while the link between the money supply and currency rates may tickle investors’ memories of Econ 101, this relationship can’t be found in the data of financially developed countries over the past 20 years. As a result, to the extent the fear of fiat currencies abates, investors who have been holding precious metals on this basis will likely become more nervous and look to reduce (especially when prices go down). Indeed, this explains a lot of the price action in gold and silver over the past year.

The secular diversification away from the dollar should be supportive for precious metals, in theory. In the near term, however, this is somewhat irrelevant: the currency flows related to EU deleveraging and global risk aversion should keep the dollar well supported (NB: irrespective of where funds are domiciled, they are still overwhelmingly denominated in dollars). Longer term, diversification away from the dollar will persist, but whether the main beneficiary of this will be precious metals or other fiat currencies will depend on whether fear of the latter continues to subside.

China and India for their part will continue to grow. And it is unlikely that the development of financial markets there will be fast enough to divert savers, structurally, away from precious metals and real estate for a number of years. But for now, growth rates in both countries are slowing sharply, ahead of expectations, and their real estate markets are under pressure. This, plus declining precious metals prices, is putting China and India off their traditional zeal for gold. (Again, prices and demand are positively correlated. It amazes me we still put so much equilibrating faith in the price mechanism, but that is a post for a future date.)

In short, the reasons for owning precious metals are waning rather than waxing. Some of this is cyclical, but the main reasons for owning precious metals are being revealed as conceptually flawed. And this, to me, is significant. The growing recognition of the impotence of central banks when faced with deleveraging is finally, it seems, driving this point home. More ominously, positioning in gold and silver is still heavy, as macro tourists and retail investors are slow in giving up on their investment theses.

Precious metals are notoriously difficult to trade. Even if I turn out to be right, knowing when to place and press your bets won’t be easy. But I do know this: gold and silver are small, fairly illiquid markets relative to the kinds of positions the biggest macro tourists have on. And when they decide to leave, the escape hatch is going to look very, very narrow.