There are many reasons why pension fund managers, private investors and
even governments are beginning to add bullion to their portfolios. Perhaps
the most important reason for this shift is that bullion provides superior
insurance in times of financial uncertainty such as we are facing today.
Until governments solve their debt problems and no longer need to debase
their currencies through unbridled money creation, a fully diversified
portfolio should include gold, silver and platinum both for wealth protection
and growth.
Portfolios consisting of a mix of stocks, bonds and cash are not protected
or fully diversified as correlations between these three asset classes have
been increasing since 1969. Fortunately, as these three traditional classes
become more correlated, one asset class, precious metals, grows more
negatively correlated. When bonds, stocks and cash fall in value, precious
metals bullion tends to rise and vice versa. Therefore, a modern portfolio
will gain protection as well as growth from an allocation of at least 5-15
percent to precious metals.
Figure 1 shows how gold has outperformed all major asset classes
during the past decade.
Why Gold?
Gold provides wealth protection because it maintains its purchasing power
better than paper currencies. Research shows that throughout history, every
paper currency ever printed has eventually lost purchasing power against
gold. No fiat currency detached from gold has succeeded as a stable store of
value, and yet no gold backed currency has ever failed. At present the
world's major currencies are headed along a well-trodden path to loss of
purchasing power.. As we see in Figure 2, the Japanese yen, the
British pound, the euro and the US and Canadian dollars have lost over 70
percent of their purchasing power against gold in the past 10 years alone.
Figure 3 takes a longer view. It shows how the same currencies,
including the venerable Swiss franc, have performed against gold since President
Nixon removed the US dollar, the world's reserve currency, from its final
international peg with gold. This loss of purchasing power is the direct
consequence of an unprecedented 40-year economic experiment during which none
of the world's major currencies was pegged to gold.
Currencies lose purchasing power against gold for one simple reason:
Currency supplies are expanding faster than gold supplies. Bullion is the one
form of money governments cannot artificially multiply. Since 1980,
above-ground gold bullion supplies have risen, on average, about 3 percent
per year. Figure 4 shows a comparison with the much more rapid rate of
currency creation provided by MZM, one of the most reliable indicators of
money supply.
Like a spinning top must continue spinning or fall, our modern economic
system depends on perpetual growth. This is one of the most fundamental
features of the debt-based fiat currency system. The greatest threat to its
health is slowing growth or deflation. The threat of deflation requires
central banks to create vast amounts of money to compensate for lack of
natural growth. This in turn creates inflation, as the root cause of
inflation is currency debasement. Since there is no historical precedent for
the worldwide levels of debt we currently face, it is impossible to predict
when this cycle will end.
In fact, as we can see by the US debt chart (Figure 5), debt levels
are growing exponentially. In this sort of situation, it is difficult to
predict the outcome.
Currencies Fall While Gold Remains Stable
In truth, gold is not rising in value; currencies are losing purchasing
power against gold. It is an inverse relationship and this implies the price
of gold can rise as far as currencies can fall. In his insightful book, Hard
Money: Taking Gold to a Higher Investment Level, pension fund manager Shayne
McGuire makes an interesting point about this historic pattern Although there
are only 30 recorded cases of hyperinflation (where goods rise at least 50
percent per month), all were caused by currency debasement to compensate for
slowing growth. This debasement (a word derived from the Roman practice of
hollowing out gold coins and filling them with base metals) is happening
worldwide. Currency printing is the only tool central banks have to fight the
deflationary consequences of outsourcing, high unemployment, an aging
population, endless war and the interest payments on the debt they are
creating.
Hyperinflation is therefore a very real possibility. If this were to
happen, how much will an ounce of gold cost when a wheelbarrow of dollars is
required to buy a loaf of bread?
Gold Bullion is No One's Liability
Gold is money that banks and governments cannot expand. Precious metals
bullion is one of the only forms of money that can exist outside of the
world's banking system and beyond the control of bankers and politicians.
Buying gold is therefore portfolio insurance against the failure of the
policies and practices of banks and governments. Buying gold provides an
opportunity for individuals to regain a sense of control or sovereignty over
their financial lives. Gold owned outright is one of the few assets that does
not rely on an issuer's promise to pay. This applies only to gold bullion or
gold coins purchased and held in allocated storage or at home. Gold stocks,
ETF shares, even bank certificates are paper proxies for real ownership and
will likely be difficult to redeem in kind at the time of financial crisis--the
time we will need our gold the most.
Risk Management
Gold bullion is significantly less volatile than gold stocks. Even the
best gold stocks sell off in a stock market decline, as we saw in the fall of
1987 and the fall of 2008.
Supply and Production
Despite gold's rising price, gold production over the past two decades has
averaged an annual increase of only 0.7 percent. Even future growth shows
little chance of increasing significantly. To quote a recent report by
Standard Chartered:
"In our study of 375 global gold mines and projects, we note that
after 10 years of a bull market, the gold mining industry has done little to
bring on new supply. Our base-case scenario puts gold production growth at
only 3.6% CAGR over the next five years." ~ Standard Chartered
There are many reasons for this. The large, multi-million-ounce deposits,
whose signature is visible from aerial magnetic mapping, have likely already
been found. During the past two decades, only a handful of very large
deposits have been discovered, and these are in the far north or in
politically sensitive countries like Ecuador. To quote the same Standard
Chartered report:
"There are few large deposits, and most of the mines have
difficult geological and metallurgical conditions."
Even when gold is discovered, there are many new hurdles to overcome on
the road to production. Environmental restrictions, the threat of
nationalization, heavy taxation and exorbitant infrastructure costs are but a
few.
South Africa led the world in gold production for years. In 1970 South
Africa produced 1,000 tonnes of gold, yet only produced 200 tonnes in 2010.
As we see in Figure 7 this is a global problem.
Because of rising energy costs, the largest component of mining expenses,
new Standard Chartered estimates that, to be economically feasible, new
"greenfield" projects will require $2,000-per-ounce gold, and
existing projects will require $1,400-per-ounce gold.
At the end of 2010, according to the Standard Chartered report, the world
had only 19.2 years of gold production left at the current rate of
production.
Demand
1. Central Banks
After nearly two decades of selling, central bankers are re-allocating to
gold to protect against further loss of currency purchasing power. In 2009,
they began to reverse this generational trend by becoming net buyers of gold.
Central banks will continue to be the largest buyers of gold over the coming
decades.
In Figure 8, the 2010 figure does not include the 454 tonnes that
China admitted to buying secretly over the previous six years.
Most of the emerging economies, whose central banks are the most
aggressive buyers, have a very low percentage of their reserves in gold, and
a much smaller ratio than first-world central banks. To reach parity, they
will need to add thousands of tonnes to their reserves. The Chinese central
bank for example, which has only 1.6 percent of its reserves in gold, plans
to raise its reserves from around 1,100 tonnes, where they stand today, to
6,000 tonnes. This represents over two years of global production.
Unofficially, they have stated a goal of 10,000 tonnes.
2. The Public
Of course, there will be significant competition from the newly affluent
developing world's investing public who wish to protect family wealth. During
the gold mania of 1979-1980, the Chinese public were not allowed to
participate. Today their government encourages them to put 5 percent of their
savings (and China has one of the highest savings rates in the world) into
gold bullion. The Chinese public, like many of the principal buyers of gold
bullion, remember the destruction a currency crisis can cause, as they experienced
over 4,000 percent inflation per month between 1947 and 1949. They will
increase their buying as they see currencies continue to lose purchasing
power. In 2010, Chinese and Indian buying alone accounted for nearly 60
percent of annual global gold production from mines.
3. Large Funds
Central banks and the public will have competition from pension funds,
sovereign wealth funds, insurance funds, mutual funds, hedge funds, private
equity funds and private wealth funds--which have, collectively, over $100 trillion
in assets under management ("AUM"). Pension funds with AUM of
approximately $24 trillion currently have about 0.15 percent of their assets
allocated to gold bullion. In other words, they have not even begun to move
into gold. Fund portfolio managers have avoided gold over the past two
decades, as it pays no interest or dividends. Yet funds invested in stocks
and bonds have lost an average of 24 percent of their value over the past
decade. Had they owned gold during this time, these losses would have been
mitigated or erased. The large funds, the real movers of the financial
markets, are beginning to acknowledge the need to hold gold in their
portfolios. If they allocated only 5 percent of their AUM to gold, it would
trade at between $5,000 and $10,000 per ounce.
Competition will be Fierce
As currencies continue to lose purchasing power worldwide, and more people
come to understand the difference between bullion ownership and proxy gold
ownership, the competition for the world's available gold bullion will be
fierce. Currently there is over $200 trillion in world financial assets, and
about $3 trillion in gold bullion. Most of that is privately held or held by
central banks, and these major holders are highly unlikely to sell at any
price.
Much of what has been discussed about gold applies to silver as well as
platinum, but all three metals have their own unique properties and all have
resumed a position as money.
Why Silver?
Silver is money, but it is also an irreplaceable industrial metal and,
unlike gold, silver is used up in the many processes for which it is
essential. Silver's industrial applications are growing on a daily basis in
order to keep pace with rapid developments in technology.
Geologically, silver occurs in larger quantities than gold, and is
therefore easier to mine: it remains where it is formed, whereas gold travels
through water and seeps into deep veins. Silver also has a lower melting
point than gold and is easier to refine. These are two reasons why silver has
always been less valuable than gold; however, silver shortages are becoming
greater than gold shortages because of a number of unique conditions it faces
today.
In 1980, even with the silver price at a historical high, 4 billion ounces
of above-ground silver existed. Today, because of silver's dual role, only 1
billion ounces exist.
Silver has a Historic Role as a Monetary Metal
Silver, like gold, is a monetary metal and a safe haven, and it cannot be
debased like modern fiat paper and electronic currencies. Throughout history,
silver has been used as money in more regions and countries than gold. Like
gold, silver meets the criteria for universal money: it can be easily divided
into equal parts, it is found worldwide and it is extremely durable. In times
of extreme economic crisis, silver is more functional as money than gold,
because its lower value makes it more practical as a medium of exchange.
Silver is Undervalued
Silver remains historically undervalued, even more so than gold. In 1980, when
record amounts of silver were stockpiled, the gold:silver ratio was 16:1.
Currently the ratio is fluctuating between 30 and 55. At a 16:1 ratio, silver
today would be $93 an ounce when compared to the price of gold.
Silver's Short Position
One of silver's most unique features is its disproportionately large short
position on the COMEX that has yet to be covered. Although "commercial
traders" in most markets are commercial producers who wish to guarantee
a fixed price for their corn or their copper, in the precious metals markets,
bullion banks hold the largest short positions. Currently, the COMEX short
position of the eight largest traders represents one-third of the total one
billion ounces of above-ground silver bullion in existence.
Figure 10 shows the amount of silver short positions held by the
four largest traders, and compares the days of production it would take to
cover this short with other commodities.
Silver used in Industrial Processes
Silver has industrial uses that no other material can replace. It is
malleable and ductile, and is capable of being formed into fine jewellery,
hammered into thin sheets and extruded into microscopically thin wires. It is
a superior conductor of heat and electricity. It is highly reflective, which
is why it is used in mirrors. It also has anti-microbial properties that make
it ideal for surgical applications, and as an additive to everything from
paint to clothing.
Silver Demand
Because of its dual role, silver has never faced greater demand than it
does today. In 2010, total fabrication demand grew by 12.8 percent to a
10-year high of 878 million ounces, and use in industrial applications grew
by 20.7 percent to 487.4 million ounces.
Compared with gold, we see the consequences of silver's industrial use.
From the beginning of recorded history, 2 billion ounces of the 5 billion
ounces of gold mined remain in bullion form today. Only 1 billion of the 45
billion ounces of silver mined are currently in bullion. As silver's
industrial role is more important than gold's, a silver shortage would have
more negative implications than a gold shortage.
Silver Supply
Although silver mine supply rose by 2.5 percent to 735 million ounces in
2010, the yearly amount of mined silver has been less than its demand for the
last 15 years. There are very few pure silver producers; most silver is mined
as a by-product of other metals. This could be problematic in the event of an
economic slowdown. Currently Mexico leads the world in silver production,
followed by Peru.
Why Platinum?
Including all three precious metals in an investment portfolio provides
greater diversification within the precious metal asset group, and offers
reduced volatility as each metal has unique economic properties.
Platinum is Also Money
In the bull market of the late 1970s, platinum matched the gains of both
gold and silver, which suggests that platinum was acting as a monetary asset
during this inflationary period/dollar crisis. Although platinum coins were
used in Russia in the nineteenth century, the scarcity of platinum, combined
with its much higher cost of production, make it a poor choice for this
purpose. It has served as a store of economic value for 300 years, however.
Rarest Precious Metal
Platinum is the rarest of the precious metals and its price reflects this.
It takes approximately 10 tonnes of ore and six months of mining to produce a
single ounce of platinum. Platinum is 30 times rarer than gold. Unlike gold
and silver, which are mined in almost all areas of the world, most of the
world's platinum comes from only two countries--Russia and South Africa. All
the platinum ever mined would occupy as space of approximately 25 cubic feet.
Record Price
Even though platinum hit a record high of $2,252 per ounce in 2008, it
still has some distance to go to reach its inflation-adjusted high of $2,630.
Since demand for platinum applications keeps growing while mine supply
remains relatively fixed, the price of platinum is likely to continue rising.
Limited Source of Supply
Since 1997, demand for platinum has exceeded mine production and global
platinum demand continues to grow to record highs. Unlike gold, there are no
large above-ground supplies of platinum.
Currently, South Africa accounts for 80 percent of the world's annual
production of platinum and contains 88 percent of the world's platinum
reserves. This is one reason why platinum prices can be more volatile than
either gold or silver prices - they are especially sensitive to political
unrest in South Africa.
Inelastic Demand
Platinum has far more industrial uses than gold or silver. Unlike gold,
over 50 percent of the platinum produced is consumed (destroyed) in
industrial applications. Platinum is indispensable for many industrial uses,
such as catalytic converters in diesel engines. As the oil price increases,
demand for diesel engines increases, and so does demand for platinum.
Leading Inflation Indicator
According to a study by Wainwright Economics, a Boston-based investment
research and strategy firm, platinum is the leading indicator of inflation. While
gold and silver lead inflation by 12 months, platinum leads by 16 months.
This was confirmed in the current bull market; the rise in platinum prices
started in 1999, while gold and silver's rise began in 2001.
Ultimate Portfolio Protection
According to David Ranson, president of Wainwright Economics,
"The only asset class that is better than gold as an inflation
hedge is a basket that includes silver and platinum."
