Silver is not usually the first allocation priority in most people’s portfolios. It does nonetheless have an important role to play when it’s allocated in the right amount that can both enhance returns and reduce risk.
For precious metals traders, gold is a much more popular market. Big institutions buy gold as a currency hedge when real interest rates and yields on other assets become unacceptably low. Central banks will buy gold, and not silver, as a reserve asset to diversify their currency exposure.
Silver functions more heavily as a commodity than a currency. Because silver is so inextricably linked with gold, it too will also be referenced frequently over the course of this article.
In terms of global reserves above a certain purity, the entire silver market is worth about only $540 billion (compared to around $3.8 trillion for the gold market, ~$100 trillion for the global equities markets, and some ~$350 trillion for the global credit market). It doesn’t take much money flowing into the silver market to move its price. Supply grows by only 1 to 3 percent each year, and about half the market is consumed through industrial use (unlike gold, which is more limited in how it’s used).
As of August 2020, there are 19.2 billion ounces of silver reserves globally (meeting certain purity standards) against 1.83 billion ounces of gold reserves.
Gold is treated much closer to a monetary asset or a currency than a commodity subject to supply and demand considerations.
Silver, on the other hand, is a combination of both.
Silver is both a store of wealth, one of the important characteristics of a currency (the other being a medium of exchange). It is also a commodity, used in medicine (it is non-toxic), LED chips, touchscreens, nuclear reactors, and other industrial applications.
Silver has high thermal and electrical conductivity, making it ideal for electrical applications and hard to replace with less expensive metals. It is also highly malleable and ductile such that it can be flattened into sheets or drawn into wire.
It is non-corrosive and doesn’t oxidize, though not to the same extent as gold.
Relationship with gold and key differences
To illustrate the difference between gold and silver, it helps to look at correlations between gold, silver, and equities.
|Name||Ticker||SLV||GLD||SPY||Annualized Return||Daily Standard Deviation||Monthly Standard Deviation||Annualized Standard Deviation|
|iShares Silver Trust||SLV||–||0.80||0.26||3.53%||1.99%||9.50%||32.90%|
|SPDR Gold Shares||GLD||0.80||–||0.06||7.62%||1.16%||5.04%||17.46%|
|SPDR S&P 500 ETF Trust||SPY||0.26||0.06||–||8.78%||1.28%||4.34%||15.04%|
Gold is primarily used as a reserve asset. Its correlation to stocks is essentially zero.
Given the similarities with gold, silver’s correlation to the yellow metal is quite high at 0.80.
Yet given silver’s industrial uses, it benefits from greater economic activity, as companies use it to help build various goods. Accordingly, it correlates somewhat with stocks. In this case, silver and stocks have a correlation coefficient of 0.26.
Correlations represented as a time series
Silver and gold correlation
Silver and US stocks correlation
Gold and stocks correlation
Correlations are dynamic and backward-looking. So, they shouldn’t be relied on so much as understanding what drives the price of the underlying.
The general takeaway is that silver has a little bit of overlap with stocks (and hence the economic cycle) and quite a bit of overlap with gold, while gold has little overlap with stocks. In Venn diagram terms:
Some traders pay attention to the gold/silver ratio (XAUXAG on Bloomberg, or XAU/XAG on Trading View). This is the value of one ounce of gold versus one ounce of silver.
In July 2020, it reached an all-time high (in modern historical terms) at over 120, before falling down into the mid-70s with silver’s rally.
Given silver’s industrial use and gold’s monetary relevance, it can in part also show the extent to which traders are bearish on the economy.
Since silver is more sensitive to the economy and gold is often more in demand in times of economic or monetary upheaval, the gold/silver ratio spikes higher.
Some use it as a technical or relative value factor, favoring silver when it’s cheap relative to gold (i.e., high gold/silver ratio) and disfavoring silver when it’s expensive in relation to gold (i.e., low gold/silver ratio).
Silver as a reserve asset
Though silver has been used throughout time as a currency directly, or as a backing for government-issued money, it is not widely held by central banks or big institutional funds today.
Much of silver’s demand goes into industrial uses.
Gold’s main long-run valuation, on the other hand, is proportional to fiat reserve and currency growth relative to the global gold stock, with very little of its value tied to industrial applications.
Silver’s role in a portfolio
Silver, when thinking about how to achieve balance (and having a great strategic asset allocation mix that doesn’t strongly expose you to any environment), is less of a component to a portfolio in comparison to gold.
Gold is an important piece (usually at some ~10 percent of a portfolio’s allocation), but it’s not the best overall investment over time. It tends to perform a little better than cash, but it is still only a cash alternative.
In real terms, it’s performed at about 0.2 percent over inflation since 1850 in US dollar terms.
In Germany, because of two bouts of hyperinflation, it’s returned close to 3 percent annualized in real terms since 1870.
Silver is more volatile and correlates more to the economy (and therefore to equities and other commodities). Accordingly, it doesn’t have the same diversification potential. So, logically, it’s less of a proportion of the portfolio from that angle.
There’s a time where it does well and a time where it does poorly. In a small quantity, it can be both risk-reducing and return-enhancing to have some amount of silver in a portfolio.
Silver as a long-term store of value
Gold and silver have maintained value over thousands of years, unlike fiat currencies, which rise and fall with the empire and/or regime.
People have used gold as a store of wealth and as a way to pass wealth down over generations. To a lesser extent, this has been true with silver. For more than 2,000 years gold and silver have been a form of exchange (though to a lesser extent in modern times).
Throughout history, governments and empires have used commodity-backed currency systems. This has mostly been gold.
Silver has also been used as part of a bimetallic standard and often develops out of a gold standard as a means of getting more money in circulation (i.e., by adding silver reserves as a form of acceptable collateral backing the money).
Being it’s human nature to prefer instant gratification, empires throughout time have run up debts in excess of their ability to pay for them. An easy way to get out of debts is to simply create more money to ease this process.
Given there is only a fixed amount of gold and/or other metal reserves, and stores of it rarely keep in line with the amount of debt being issued (i.e., claims on it), those in charge of the system have a choice.
They can change the convertibility rate and effectively depreciate the currency, adopt new sources of backing for the currency (e.g., add silver reserves to gold reserves), or break the linkage altogether.
In the case of the latter, they go to a fiat system where money creation can be unconstrained. This is always preferred, as liberal money and credit creation provides ample amounts of spending power, but it undermines the value of the currency long-term. Holding all else equal, this is bullish for precious metals as denominated in that currency.
Metals are worth whatever the money purchasing them is worth. Commodities, in general, are priced in currency per a certain unit amount.
Gold is a contra-currency, or essentially a reference point for the value of money, and benefits when money creation goes up over time. It effectively acts as the inverse of money. This is partially true for silver as well.
You also have an environment brought on the Covid-19 pandemic where rates are at zero and a lot of money has to be printed to make up for the shortfall in economic activity to keep incomes and spending at acceptable levels.
Liquidity ends up going into the common stores of wealth. This includes things like gold, silver, and certain equities that can be classified as such.
Companies that produces things like food and basic medicine won’t see their earnings impacted much and will benefit. The same is true for some tech companies that have very long durations in their cash flows (e.g., some tech companies) who aren’t as impacted as incomes being disrupted in the present.
Hard wealth vs. Financial wealth
Cash and bonds
Of all the fiat currencies that have existed within the past five centuries, less than five percent of them still exist.
While it’s natural for investors to build out portfolios where positions are heavily concentrated in their own currency, having diversification in currency exposure can be as important as having diversification across asset classes and geographies.
Companies also come and go.
The most valuable companies today are businesses that are more or less new within the past 15-30 years, or have derived a lot of their valuations from newly invented products or technologies.
For example, Microsoft, while not technically a new company having been founded in the 1970s, derives a lot of its wealth from cloud computing and the future expectations of the company’s role in building it out and capturing a large share of the market.
Similarly, Apple makes most of its money from the iPhone and the ecosystem that came about out of it in 2007.
Amazon, Google, and Facebook are entirely new types of businesses, formed in the 90s and 00s.
IBM didn’t adequately adapt to a changing tech world, largely missing out on trends like cloud computing, social media, mobile computing, and artificial intelligence chips.
An oil conglomerate like ExxonMobil faces growth constraints. Walmart missed the initial shift to online shopping and never became a big player in cloud computing like Amazon (via its AWS product).
The landscape will continue to develop in ways that are hard to predict specific winners and losers.
By the middle of the century, digital technologies will continue to evolve toward artificial intelligence and its related subcategories (i.e., machine learning, deep learning, reinforcement learning) and companies will work to commercially apply them to a host of applications to create value.
Some of the big winners of these trends may not even exist yet, or are being developed (or will be developed) through the venture arm of a large company or fund as an independent idea.
Companies like AMD and Nvidia have taken more market share relative to old chip stalwarts like Intel.
With that said, all of these companies, the FAAMG + AMD + NVDA contingent, are expensive and high expectations are baked into their prices. Practically everybody wants a piece of these companies because they’re on the frontier of where the economy is going and their prices have been bid up well in excess of what they’re earning.
Like anything there’s execution risk. Developing these technologies is one thing. Commercially applying them, satisfying enough demand, and doing it better than everyone else to stave off competition (like any other high-potential, high-margin business) is another.
Even for companies earnings $20 billion or more per year – e.g., Apple, Google, Facebook – they’re trading at around 35x earnings as this is being written.
The earnings yield is the inverse of that (1/35), or around 3 percent per year for a lot of volatility. They are expected to grow a lot in the future; in theory, this yield should rise. But they are expensive investments.
Moreover, when cash yields are zero and bond yields are around zero (or even negative), that brings the yields of equities down to those levels as well.
When cash and bond yields are zero, you no longer have a discount rate off which the present value of cash flows are calculated. You’re simply left with the risk premium of what people expect to earn on stocks over bonds from taking on the higher risk.
Stocks have historically given about two to three percent over safe mid-duration (e.g., 10-year) bonds. So, that 2-3 percent yield of stocks and earnings multiples in the 30x to 50x range (i.e., the inverse of that 2-3 percent) don’t seem as farfetched.
Because cash and safe bonds have routinely provided yields in the 3-6 percent range in recent history, the earnings multiples of equities were in the 10x to 20x range. When yields go down across the board, applying those historical ranges no longer applies.
Investors increasingly need to go to emerging markets and take on other types of risks (e.g., currency risk, political risk) to find these types of higher yields. Or go to alternatives like precious metals and commodities.
Many tech companies are thought of as the “surest bets” in the market. But when everybody thinks the same way, a lot of it is reflected in the price. Their future performance won’t meet the high expectations set by their recent performance coming out of the Covid-19 bottom.
Anyone trying to put all of their savings into financial wealth, whether that’s cash, bonds, or stocks, is going to have trouble growing their portfolios relative to what those types of portfolios have yielded in the past.
Since 1981, US cash and bond yields have gone from 15-20 percent down to zero percent. That tailwind is gone.
(Source: St. Louis Federal Reserve)
When there’s a contraction in the economy, the stock market has relied on the cash and bond yields going down to offset the fall in cash flows.
Moreover, the diversification effect of bonds helping to offset the drawdown in equities is gone, as bond yields go down in deflationary recessions, causing their prices to go up.
Nominal bond rates can only go so negative, but any normalization in real rates or pickup in inflation can make those yields go back up. In other words, your upside in sovereign developed market bonds isn’t much, though your downside is high. The risk/reward is asymmetric.
Now, monetary policy and offsetting drops in economic activity is all about the monetization of fiscal spending. That’s no longer the interest rate driven monetary policy that’s been the standard. It’s a threat to the currency.
Gold, and to a lesser extent silver, simply reflects the value of the money used to buy it.
The utility of gold hasn’t gone up in recent times. The utility of silver has gone up a little bit with the expansion of electronic devices and other consumer products. But its recent price moves have been a function of its use as a reserve asset, not because its utility has recently gone up by a lot.
The supply of money available to buy silver has increased, so silver has gone up in money terms and money’s value has gone down in silver terms.
So, there is value is having these alternative stores of wealth – e.g., gold, silver, hard assets – as a way to leapfrog the virus situation and its impact on income and spending.
Historically, we’ve seen large currency devaluations following debt crises.
In recent history, since the beginning of the century, the value of money has fallen relative to gold due to:
a) large amounts of money and credit creation, and
b) real interest rates being low (i.e., interest rates being low in relation to inflation rates)
The global monetary system since 1971 (and increasingly since then) has been one of free-floating exchange rates. Most countries have had independent monetary policies and free capital flows.
As a result, the large abrupt breaks of the past – e.g., 1933, 1971 – haven’t transpired and aren’t likely to transpire.
Instead, there’s been a more gradual devaluation of money relative to precious metals in the form of higher prices per ounce.
With a highly indebted environment that has only gotten worse due to Covid-19, real rates can’t rise much in order to keep debt servicing low.
Interest rates have to be kept low in real and nominal terms in order to keep the economy going. Devaluing a currency is always preferable to inducing economic pain.
In developed markets, low and in some cases negative interest rates have not provided enough compensation to make all the new money and credit attractive to own, leading to more of the burden on central banks to buy it themselves.
And because yields are very low and they’re printing more of the currency, more are looking for alternative stores of wealth, like gold and silver.
A secularly weakening US dollar
Low yields and creating more of a currency weakens it.
While for day trading purposes you might not necessarily bet on a weakening US dollar, over the long-term a weaker currency is a necessity.
Precious metals typically benefit from a weaker US dollar. The USD is considered the world’s top reserve currency and gold and silver are most responsive to real USD rates relative to any other currency. (It’s a similar dynamic in oil.)
Things like gold and silver are always denominated in whatever currency is the reference point.
For example, in 2019 gold was making new all-time highs in Australian dollars but still lagged behind its then-2011 all-time high in US dollars. This is because AUD had simply depreciated more in gold terms and relative to many other fiat currencies more than the USD had.
In general, precious metals are an alternative when other currencies don’t work as well. When real interest rates are low, this decreases the incentive to hold interest-bearing currency.
On a technical level, various entities all over the world value the US dollar – reserve managers, sovereign wealth funds, insurance companies, large institutional funds, and so on.
The US is now only 20 percent of global economic activity yet US dollars are 62 percent of foreign exchange reserves, 62 percent of international debt, 57 percent of global import invoicing, 43 percent of FX turnover, and 39 percent of global payments.
Fundamentally, the US will weaken long-term with its balance of payments deficits, namely, a fiscal deficit and a current account deficit.
Its current account deficit (the trade deficit is a component of it) is around 2 percent of GDP.
It also has an unsustainable external debt to GDP of 45 percent. That means the US has to issue a lot of debt to foreign entities to fund its deficits. Those are more claims that will eventually have to be monetized, decreasing the value of money relative to various forms of hard assets.
If the US ran a balanced trade deficit, this would allow the external debt to shrink as a percentage of GDP.
Trade surpluses and trade deficits are zero-sum among countries.
In other words, large surpluses generally create conflict because it means deficits exist somewhere else. Deficits need to be funded by issuing debt and can’t always be done adequately. This is particularly true if a country lacks a reserve currency.
Emerging market countries lack them (i.e., other countries don’t save in them) and have issues with deficits given the need to issue debt that there isn’t a lot of demand for.
Generally speaking, a +/- 3 percent surplus or deficit situation becomes hard to sustain. A surplus country can do it so long as it is not increasing foreign assets relative to GDP. A deficit country can do it so long as it is not decreasing its net foreign assets relative to GDP.
The US dollar provides safety and liquidity and its debt (US Treasury bonds) comprises the world’s top reserve asset. This gives the USD a lot of demand domestically and globally.
But the US is at risk of endangering that with its finances over time. It’s relying more on its reputation than its actual financial health.
The national debt is the very beginning of all the IOUs of the US federal government at not even 10 percent of all liabilities.
Approximate estimates as of August 2020:
– $26.7 trillion national public debt
– $54.2 trillion private sector debt
– $20.7 trillion Social Security liability
– $32.0 trillion Medicare liability
– $153.7 trillion unfunded liabilities
– Total: $287.3 trillion ($871k per person, $2.31 million per taxpayer)
Annual GDP is about $20 trillion. Federal tax-take of around $3.3 trillion; state and local another $3.3 trillion. Annual per-capita income is a bit over $60,000.
The debts and debt-like liabilities will never get paid.
Broadly, there are three ways to rectify problematic debt situations at the sovereign level:
- Cut spending
- Higher tax-take (more revenue does not always mean raising taxes)
- Depreciate the currency
The US can’t cut spending enough and it will never get the tax revenue. Revenue and spending is broadly classified as “wealth transfers” and those rarely do enough during economic turmoil to close imbalances and funding shortfalls. Spending can’t be cut much because people rely on that income. Taxes can’t be raised much because incomes are already depressed and raising tax rates creates capital flight and arbitrage behavior.
It has to go through “door #3”, the currency channel. A lower US dollar over the long-run, as mentioned, is inevitable.
Historically, it always goes through the third option because it’s discreet; it’s stimulative to economies and risk assets, and it’s politically palatable.
Throughout the Covid-19 stimulus debates, you can notice how people on both sides of the aisle are actively encouraging more money printing as any tinkering with the budget is not feasible.
With the US’s financial situation, with large year-to-year deficits that could naturally balloon to around 10 percent of GDP and the debt and debt-like liabilities that are about 15x GDP, there’s going to be a lot more money printing.
That’s going to undermine the dollar, though it doesn’t mean the USD is in danger of losing its reserve currency status in the near-term. That’s a longer-term issue and relies on the rest of the world developing a better system.
That’s why reserve currency status tends to last with an empire long after its relative decline. This was true with respect to the Dutch and British empires as well. Relative to gold, the Dutch guilder didn’t decline until the late 1700s and the British pound didn’t decline until the lead up to World War II.
The US has encountered these problems before. Though it’s created great losses in the dollar relative to gold, it hasn’t caused the US to lose its reserve currency status.
As to what the next reserve currency is – it could be a metallic standard, it could be a hybrid (e.g., SDRs), it could be another empire like China, or it could remain in US hands for a long time.
Investing in gold or silver means you don’t have to take a specific position on what that “next system” or “next empire” is. You’re not betting on any single fiat currency but rather a different type of monetary system.
In any case, the events that place pressure on currencies – debt crises, pandemics, natural disasters, etc. – brings up a more fundamental question about what is the value of money?
In developed markets, fiat currencies are all fundamentally weak. We know this because they don’t bear any interest or barely any.
In some cases, you have to pay interest to own it (e.g., JPY, CHF, some EUR deposits), which is opposite of the typical borrowing and lending relationship.
It seems very unlikely that nominal interest rates would go down to minus-300bps, for example.
Interest rates can only go so negative before bank profitability dries up, cash hoarding makes more sense. People will turn to monetary alternatives like gold, silver, and certain types of stocks and equity-like assets such as land.
Portfolios are largely under-diversified as it pertains to currencies. Not just to other developed market currencies or emerging market currencies, but to other types of currency systems that countries cycle in and out of over time throughout history.
This is why owning gold, silver, other precious metals, commodities, and other hard assets can be useful to own in some quantity.
Silver as an inflation hedging instrument
Gold commonly serves as the inverse of money, and silver partially plays this role as well. The inverse of money, over the long-run, is inflation.
Monetary inflation nonetheless doesn’t have to happen for gold or silver to do well. As this is being written, silver is up over 100 percent since the March 2020 bottom, yet inflation has been very mild. In fact, it’s likely been negative overall given the contraction in incomes and spending, though that depends on how it’s measured.
Inflation expectations over the next 30 years in the US is at just 1.60 percent.
(Source: Federal Reserve Bank of St. Louis)
However, if asset prices are going to justify their very high levels relative to the level of earnings being produced, it’s probably going to have to come in the form of higher levels of inflation. The deflationary forces could very well win out (e.g., high levels of debt, aging demographics, etc.).
But asset prices won’t be able to sustain such high levels indefinitely unless nominal growth picks up. Real growth isn’t likely to be high given low levels of productivity and low levels of labor force growth. Stagflation is a possibility.
Year by year, most fiat currencies lose their purchasing power due to inflation.
Gold and silver tend to keep their value over time because they’re priced relative to various fiat currencies and thus rise over the long-run (with plenty of short- and medium-term volatility).
Because societies and cultures attribute value to it, it’s used as a store of wealth and usually sees more demand locally when the domestic currency is losing value.
Gold’s relationship with inflation in non-linear over time. Gold tends to not display a very strong correlation with inflation when it’s moderate. But it does begin to strongly correlate when inflation runs above a certain threshold.
The biggest driver of gold is when there’s a deviation from the inflation trend, not necessarily its absolute level.
This makes sense as the biggest determinant of return for any asset is when the expectation of the future changes. All assets compete with each other for available liquidity (i.e., money and credit) in the system. The current environment of economic weakness but liquidity expansion gives a large deviation in the expectation of inflation outcomes in both the financial economy and real economy.
Equities do best in a moderate inflation environment. Inflation increases the odds of the central bank tightening monetary policy, which is bad for equities. Deflation tends to coincide with economic contractions, which is also bad for stocks. When equities do better, that reduces demand for gold and silver among other assets.
Inflation expectations naturally vary over time. In the late 1970s and early 1980s, a 6 percent inflation rate in the US would seem tame. Today, it would be about 4x the magnitude of inflation expectations priced into markets indefinitely.
Gold’s return, and that of other precious metals, best correlates not through the absolute level but when it’s adjusted for its trend.
Silver’s protection against deflation
Precious metals are not only good in times of inflation, but during times of deflation, where it typically goes up moderately.
Deflation is typically when business activity is reduced and debt servicing requirements get worse because of a drop in income. This creates a fall in prices in both financial assets and in goods and services.
During deflationary periods, people are more likely to save more and keep their assets in a form of cash. This can mean basic currency, safe short-term government debt, or a safe haven like gold and/or silver.
That being said, if people need cash to pay debts, expenses, or need something highly liquid, that could also mean getting out of precious metals. We saw this during the onset of the Covid-19 drawdowny.
(Source: Trading View)
In the depression-era 1930s, gold was considered one of the best places to store wealth. It could be redeemed at any time for a fixed amount of currency. Silver mining had expanded a lot in North America during the 19th century and also had a developed market for it.
Since the US was on the gold standard and not a bimetallic standard (as had been suggested in the late-1800s by some politicians to expand the money supply), silver was not under the same regulatory pressure.
To get more liquidity in the economy to spur the recovery, President Roosevelt banished the ownership of gold through Executive Order 6102 in 1933.
Gold’s bottom over the past 100 years came at $0.28 per ounce in the summer of 1932. This was also at the height of peak monetary tightness. The Federal Reserve would buy Treasury bonds to lower interest rates further in July 1932, which also coincided with the bottom of the stock market.
Silver price chart, past 100 years, log scale, nominal terms
Gold price chart, past 100 years, log scale, nominal terms
The US broke the gold standard from 1933 to 1944. The Bretton Woods monetary system established the US dollar as the world’s top reserve currency and linked it with gold.
That system ran until August 1971, when the claims on gold were too large relative to the amount of gold reserves. The USD was unilaterally taken off the gold standard, characterized by the free price movement observed after that date.
This led to a huge surge in gold and silver prices throughout the decade. Gold was $35 per ounce the day the link was broken and $678 by the end of the decade. Silver was $9.50 per ounce in August 1971 and nearly $120 per ounce by the end of the decade.
Once high inflation was broken in 1981 through a large hike in interest rates by then-Fed chairman Paul Volcker, both gold and silver entered into elongated bear markets from 1981 until around 2000.
The return on currency and bonds (i.e., promise to deliver currency over time) was high in real terms, leading to less demand for alternatives.
Now we’re in the opposite situation where both nominal and real returns are low, feeding the demand for alternative stores of wealth.
Relatively stable gold supply
Since 2000, the global gold stock has increased by only about one percent per year.
For silver, it’s been about 1.7 percent per year.
Money creation has gone up by a lot more, as developed markets combat their high debt to income levels and rising dependency ratios that continue to bloat liabilities in excess of assets coming in.
It will continue that trajectory with all the above-mentioned debt and debt-like flows coming due over time.
That means monetizations or defaults will be in store. It’s not politically palatable to not give people the money they expect, so it’ll go through the currency. Policymakers will do practically anything they can to save the system.
New gold and silver mines can take up to a decade to bring to production. The supply side can be a driver of prices. But because supply doesn’t vary much from year to year the demand side is a much bigger driver.
As of mid-2020, there were about 1.83 billion ounces in global gold reserves and 19.2 billion in global silver reserves.
A hedge against geopolitical tensions
The role of precious metals is not only monetary or financial, but also geopolitical. Like many things, gold serves a better use in this context, though silver can some role as well.
If and when geopolitical and/or social tensions rise or there is less confidence in governments, gold is commonly sought after.
Stocks generally decline while safe bonds and other safe haven stores of wealth increase in value.
For example, we’ve seen higher gold and silver prices in relation to any flare-ups in tensions with North Korea and Iran.
During the coronavirus crisis, the precious metals markets were thrown into a loop as gold and silver supply chains were disrupted and traders sold off all sorts of assets due to cash flow problems.
In the three months from March 2020 to June 2020, the Comex division of the New York Mercantile Exchange increased its gold storage to 30 million troy ounces. About 75 percent of that gold had come in within the past three months.
The dysfunction came largely due to grounding of commercial aircraft.
Most physical gold is stored in London and delivered to NY. Security firms meet air cargo shipments on the tarmac and haul it to certain warehouses.
It’s usually $0.20/ounce to fly gold from London to NY, another $0.20/oz to melt the heavier London bars and get them to match New York delivery standards, and around $0.10/oz for financing.
If there’s a discrepancy of $5/oz in NY and London prices, the net profit is around $400k per shipment minus the costs of chartering the jet. (They will rarely ship more than five tons on any given flight because of the insurance costs and in case anything were to happen.)
At the height of the outbreak in New York in March and April 2020, most airplanes that got off the ground were favored for carrying medical equipment, not gold bullion or other metals.
As the market got past the March 23 bottom, the demand for gold and silver by US investors increased.
Monetary policy’s effect on silver
Holding all else equal, the easing of monetary policy is bullish for silver denominated in that currency.
The lowering of real interest rates decreases the return of interest-bearing currency and bonds, leading to the desire to find alternatives.
Moreover, in a world of low rates and exhausted traditional options (i.e., lowering short-term interest rates, purchases of financial assets), investors are gearing up for a return to other policies.
For example, the US Federal Reserve has not tapped yield curve control (YCC; also known as yield caps) since the post-Second World War period.
The basic idea of YCC is that it caps the yields on government bond yields to control borrowing costs. In other words, the Fed would buy an unlimited amount of debt should yields get up to a certain level.
World War II was a very expensive endeavor relative to levels of output in the economy and YCC helped keep borrowing costs low. At the same time, if US medium-term yields are effectively controlled, then the market effectively loses an important benchmark that the rest of the investment universe is measured on. The 10-year US Treasury has already lost much of its traditional signaling effect given the central bank’s control over the market.
Because of very high debt burdens relative to output, all of the world’s major central banks will not be raising interest rates for a very long time. The Fed announced zero rates until 2022, but it will be much longer.
Based on certain metrics like sum of inflation and the ratio of the employed relative to the overall population (the “misery index”), there needs to be a big improvement before the economy is healthy enough.
This will remain a tailwind for silver.
The historical cycle
More or less there’s commodity-based monetary systems and fiat currency systems.
There’s also a hybrid between the two that one could broadly classify as a third. Some have bank notes backed by a commodity (usually gold, and to a lesser extent silver).
Whenever there’s a needed easing of monetary policy, the government can change the convertibility between the commodity and the amount of money it represents.
For example, for a long period leading up to the severing of the gold-dollar tie in March 1933, each ounce of gold was convertible for $20.67. During the lead-up to the next big de-linkage in August 1971, each ounce of gold was convertible for $35.
They can also abandon the use of the commodity altogether to have an unconstrained system, by which it would be a pure fiat system.
We’re in a fiat world currently and all reserve currencies are free floated. (Countries tied to the euro are in a quasi-peg system.)
But over time debt obligations build up that can never be serviced. People don’t want to be paid back in deprecated currency so they lose confidence in it.
Countries get out of their monetary problems by adopting a system with a very hard backing to it. Typically this is gold and/or silver. But it can basically be anything not subject to large swings in supply or demand.
Then they phase out the old currency.
Then the cycle starts again, but eventually money and credit creation is too restrictive under such systems, so they change the convertibility between currency and the quantity of the commodity or abandon the commodity system altogether.
We’re in the part of the cycle where interest rates are at zero in each of the main three reserve currencies (USD, EUR, JPY) and getting there in the world’s other major monetary/credit system (China), and also creating unprecedented amounts of money to relieve excessive debt burdens.
In the meantime, the exchange rates of these currencies can remain elevated relative to others because:
a) they need to print a lot to meet the demand for it so the currency is under-supplied relative to the demand and/or
b) until defaults and restructurings set in, which reduce demand for currency.
The inflection points in currency regimes happen infrequently. Currency systems can work well for decades before a new paradigm comes into place.
Accordingly, because investors become accustomed to events they’ve experienced in the recent past, they tend to underestimate the likelihood of them occurring.
The last big inflection point for the US was in 1971 (half a century ago), when the US went from a gold-linked system to a pure fiat system. This led to a large rise in the price of gold, and its cousin silver, relative to USD as more dollars were printed to satisfy the claims on them. We’re in a similar situation today, which the Covid-19 pandemic has simply exacerbated.
That these changes tend to occur is why smaller amounts of gold, silver, other precious metals, commodities, and other hard assets are important to a portfolio and why it can be useful for portfolios to diversify among many different currencies and currency systems.
The main drawback of silver in a portfolio
Even a well-established store-hold of wealth like silver, which has a track record in some form going back thousands of years, has its own issues.
Silver is not a particularly deep market in terms of size. It is only about 0.5 percent of the size of global equities markets (about $100 trillion deep) and some 0.1 to 0.2 percent of the size of global debt markets (about $350 trillion deep).
It has limited capacity to take in large wealth transfers from more traditional asset markets as a consequence of this smaller size and its relative illiquidity.
However, it can function reasonably well as a reserve asset for smaller amounts of money. It will not always rise in a crisis that’s bad for stocks. Its industrial usage links it to the credit cycle. But it will likely do well compared to equities on a relative basis.
Like any asset class, there is a time where it will perform well and a time when it will perform poorly in a portfolio.
Blending assets well to generate a portfolio that can perform well in various environments and provide higher return per each unit of risk is one of the best things investors can learn how to do.
Gold vs. Silver across four main factors
Silver is more volatile than gold. From a sizing and balance perspective for the long-term investor, this means silver’s positioning in a portfolio is going to be lower.
For a trader that needs volatility, the additional movement can be a benefit. Larger price swings are available that traders can try to exploit. Options sellers can also benefit from higher relative levels of volatility. These types of market participants will typically sell options (also known as writing options) and delta and/or gamma hedge the underlying position.
From this perspective, silver’s volatility can give an edge over gold from a trading perspective.
Why is silver more volatile?
It largely comes down to the size of the market. A smaller, less liquid market means its price is easier to move when orders come through.
During bull markets, silver tends to rally more than gold. During the 2001 to 2011 bull market in precious metals, silver was up 904 percent against gold’s 636 percent. From 1993 to 1996, silver was up 63 percent versus 28 percent for gold.
But volatility goes both ways. Silver’s bear markets are typically sharper than gold’s. This was also true during the Covid-19 crisis, when prices plunged about 50 percent in a few weeks versus only about 15 percent for gold.
The chart below of gold and silver’s relative price movement over the first 7-1/2 months of 2020 bears out silver’s higher volatility (close to twice that of gold).
(Source: WSJ, Dow Jones Market Data)
The gold market is not particularly liquid, but it is much more liquid than silver given the size of the market and overall volume traded.
The gold market is typically 5x to 8x the size of the silver market.
It is straightforward to move in and out of the gold and silver markets, whether through the futures markets (e.g., GC, MGC, SI futures contracts on NYMEX) or an ETF (e.g., GLD, SLV). But making larger purchases of the metal without moving its price is more difficult to do.
Nonetheless, trading smaller volumes of the metals shouldn’t be a problem.
Storage and security costs
Gold and silver physical holdings come with storage and security costs. Gold is normally placed in vaults and other secure facilities, which involves rent, insurance, and transportation.
Even if one chooses to hold precious metals in the form of a futures contract or ETF, these expenses are still priced in.
Gold and silver are structurally contango markets, meaning the futures price curve is upward sloping to reflect these costs as time goes by.
Taking a set investment, say $1 million of each, silver is going to take up more volume in a secure storage facility than gold. One million dollars will buy you about 35,700 troy ounces of silver if the price is around $28, while it will get you 500 ounces of gold at around $2,000 per ounce. That’s about 2,500 pounds or 1,100 kilograms of silver (versus 35 pounds or about 16 kilograms for gold).
In other words, silver will take up around 70x more space and weight for the same value amount. That increases the storage costs associated with it, and making transportation costlier as well. It will also reflect in the relative steepness of the silver futures curve or the price of an ETF backed by these contracts, holding all else equal.
As mentioned earlier in the article, gold provides a diversification edge on silver given silver’s industrial uses and thus linkage to the business cycle. Gold’s industrial use is small, while silver’s industrial demand can influence prices associated with positive developments for the business cycle.
This gives gold a lower correlation to all other asset classes.
Central banks buy gold to diversify their currency exposure to USD, EUR, JPY, and other systems. They are not, however, buyers in the silver market.
Silver has been part of monetary history going back thousands of years. People have placed value into silver and other precious metals and it has been interwoven in culture and society throughout the world.
Though economics courses haven’t covered gold or silver to much of an extent since the US went off the gold standard in 1971, it remains an important reserve asset.
It remains under-owned by many investors. Because stocks have done relatively well since the financial crisis, people stick to what’s done well and tend to underemphasize other asset classes.
With developed economies in difficult situations financially and monetarily, gold and silver are likely to play more of a role going forward.
Nominal interest rates are at zero or negative throughout the developed world. Real rates are negative. Investors use precious metals as a means to hedge.
With cash and bonds not yielding anything, and stocks yielding not much more, that means more of a place for alternative stores of wealth looking ahead.
Gold is the primary asset economies revert to as a backing of currency when fiat currencies lose their value. Silver has historically held some value in this respect as well.
It acts as a form of diversification to different currency systems that we cycle in and out of throughout history.
In one’s portfolio, having silver at about 1-2 percent of the overall allocation (and some ~10 percent for gold) could be reasonable targets.