The book Intelligent Commodity Indexing identifies three supra-asset categories: capital assets (e.g. bonds and stocks), consumable assets (e.g. copper, oil and soybeans), and store-of-value assets (e.g. gold, art and currencies).
The latter two are a natural portfolio alternative because unlike capital assets their valuation is not based on cash flow streams. Instead their appraisal is dependent on physical supply limitations and sentiment.
Debt, unconstrained by physical limits, has proliferated since 2008, whereas such an expansion would be difficult to envisage with precious metals.
As capital assets swell, alternatives become an increasingly underrepresented asset class in the asset markets. At the end of 2013 financial assets were valued at US$153 trillion of which 47 percent were in fixed income, 43 percent in equities, 6 percent in various alternative investments (including gold and silver), and 5 percent in money markets.
As for sentiment – known by another name as ‘taste’, for which we know there is no accounting for – it is wonderfully unpredictable, uncorrelated to macro-economic activity and a welcome diversifier to a portfolio.
Four appealing macro trends
Future mine supply is being curtailed by a multi-year retrenchment. The trend started in 2012 once it became apparent the downturn in prices was not abating. In response producers made sweeping changes in the executive suite with nearly half of the world’s 40 largest miners replacing their CEO between 2012 and 2014.
The mandate from shareholders was to cut costs and preserve profit margins. But cuts with the largest return to the bottom line and minimal impact on present production hold long-term ramifications for supply: reduced sustaining capital expenditures, eliminated exploration, and forgone expansion of existing projects. By the end of 2013 the top 40 had reduced exploration expenses by 30 percent. Gold producers within the top 40 are on pace to cut capital costs 51 percent from 2012 through 2014.
A review by conultancy GFMS of four primary silver producers showed similar policies: exploration and capital cost reductions year-over-year of 42 percent and 27 percent, respectively, in the first half of 2014. Yet there is still more blood to be squeezed from the stone. The world’s 10 largest mining companies plan to cut capital spending by 10 percent in 2015 while a survey of executives in late 2014 showed that 49 percent deemed “cost management” or “capital expenditures” one of their top two concerns.
Gold and silver mine supply are expected to peak in 2016 because cost control directives from corporate boards and shareholder aversion to greenfield projects are not the only threats to future supply. Geological inflation – shorthand for declining ore grades, worsening recovery grades, and progressively more difficult mine engineering – naturally reduces output. A review of gold producers shows a decline from 0.06 in 2004 to 0.04 by 2013 in gold ounces per tonne of mined ore.
Similarly, silver mining producers have seen their ratio decline from 5.4 to 2.7 between 2009 and 2013. A 15-year review of copper producers shows grades have fallen from a high of more than 0.9 percent to about 0.5 percent recently. These forces – lack of investment and geological inflation – create a predictable supply shortfall just over the horizon.
Over the next decade the base of India’s demographic pyramid will be the foundation for significant gold demand expansion. Already at 15-20 percent of the global total, India’s consumption of jewelry, coin and bullion is used for festivals, surplus savings, investment, births, and anniversaries but most importantly for weddings; by one estimate it is present in 95 percent of ceremonies.
The average age of marriage for women is 20.2 and in 2014 the largest cohort of the population was 5-14 years old. It is estimated that over the next ten years blissful betrothment will grow from 8-10 million to 15-18 million per year. Interestingly, it appears that over the past few decades gold is being purchased earlier in a woman’s life. When asked at what age they received their first gift of gold 55 percent of 18-31 year-old women responded “under 18” while only 36 percent of 32-45 year-olds and 34 percent of 46+ year-olds responded similarly.
Although China’s demographic pyramid is fundamentally different from India’s, the same phenomenon can be found there: the biggest age cohort is transitioning into a phase of elevated gold accumulation.
The coming decade for 40-49 year olds is compelling because the group will volte-face from saving the least to saving the most. As a proportion of income savings will leap from a nadir of 17.7 percent to 26.2 percent (the rate peaks at 27.7 percent for 60-69 year olds). But due to government restrictions there are few options with real returns available: residential real estate, A-share stocks, the shadow banking sector, and gold. All but one of these is a credit-fueled casino; all but one is tied directly to the health of the Chinese economy.
Gold’s diversification away from local options and relative safety will be enticing as 40-49 year-olds transition from accumulation to preservation. Like India, China already accounts for 15-20 percent of world gold demand based on its jewelry, bullion and coin consumption alone (not including industrial or central bank demand). Yet there is room for growth as the overall household allocation to gold – around US$300 billion – is small relative to bank holdings of US$7.5 trillion.
To appreciate the importance of Sino-saving one should consider the often asked question, “Why do the Chinese buy gold?” The answer, “When I buy stocks or real estate in China I have to give my name to the government. When I buy gold, I do not.” The quote given at the 2014 LBMA Precious Metals Conference, perhaps apocryphal, is nevertheless clarifying and in stark contrast with the standard saccharine answer of traditional cultural values. The lack of trust between the government and its citizens is mutual; it is only prudent to store wealth outside of the state-run system.
The modern rise in precautionary savings stems from the 1990s reorganization of state-owned enterprises, which up to that point had been tasked with the social security of their employees. When tens of millions of workers lost their jobs they also lost social insurance and health care payments. In 1990 the Chinese saved 39.2 percent of their income, by 2012 it was 51.4 percent.
Yet that may not be nearly high enough, according to a Cambridge University study that estimated the level of national savings should be 86 percent of GDP based on life expectancy, retirement age, population growth rate, and education. It should not be discounted that gold savings are a liquid, physically portable hedge against the Communist Party.
Silver possesses the highest electrical conductivity of any element, the highest thermal conductivity of any metal, and is the most reflective metal; this positions it well for heavy utilization from trends in electronics, mobile computing and internet connectivity. Already half of world demand is allocated for industrial uses in petrochemical, construction, medical and photovoltaic sectors but its employment in the electrical and electronics segment is especially timely. Its current success in the consumer electronics and automobile sectors gives a hint at future growth.
According to recent research by CRU, a consultancy, “Every single electrical action in automobiles is activated with silver coated contacts. A fully equipped automobile may have over 40 silver-tipped switches to start the engine, activate power steering, brakes, windows, mirrors, locks and other electrical accessories.”
Electronics are plentiful today but the Internet of Things era will make them ubiquitous. Growth in internet connected devices is expected to be exponential with estimates of 25 to 27 billion devices according to research firm Gartner and networking company Cisco Systems.
Each of these devices as well as advancements in flexible electronics, flexible displays, light emitting diodes, interposers, and printed inks will require electrical and thermal conductivity solutions that silver is optimally positioned to solve.
The trends referenced previously will not easily be diverted from their present course. Nevertheless there are risks to contemplate.
Producers, operating in an environment with an artificially low cost of capital, may be able to delay investment required for future production, preserve current margins, and thus continue delivering elevated levels of supply. Assuming producers pursue current policies through 2020, it will have been a biblical seven lean years.
This is just beyond the pale of plausible in a normal business cycle. However, unnaturally low interest rates have created a setting in which a producer could endure.
A review of silver and gold mine-site cost estimates by various consultancies and bullion banks shows expected cost reductions each year to at least 2017 (the furthest forecast).
Perhaps the biggest risk is a socio-economic crisis radiating out of the Middle Kingdom. The event may be triggered because China is in the midst of a wrenching transformation from export-driven and infrastructure-focused growth towards a consumer-oriented economy. Optimists note this conversion will be beneficial to precious metal demand as disposable income and consumption rise. Pragmatists will counter that the political costs to government are too high to allow meaningful reforms.
Neither view is much different from the status quo, which pessimists consider positively Pollyannaish. According to a report from the National Bureau of Economic Research, historic patterns of regression to the mean combined with the government’s authoritarian character and command of the economy are conspiring to make a decline “sudden and large.” A realistic, long-run global average of about 2 percent in real GDP/person is the expectation.
Lastly, pessimists observe that China is the only major economy that promotes an annual GDP target and then infallibly announces success each year. They remember that the Soviet Union officially tripled in size from 1950 to 1973, despite fatal flaws.
They conclude that the economy is built upon profitless industrial projects and vainglorious infrastructure that “make no economic sense beyond supplying temporary bump-ups in GDP growth.” This transformation and its consequences will directly impact disposable income and precious metal demand in difficult to predict ways.
Precious metals have always had a difficult relationship with Western sophisticates and current sentiment has made metal unfashionable again; it is unclear how long this will last. Fighting an intellectual battle against hero economists was hard enough (Keynes referred to the gold standard as a “barbarous relic” while Friedman spurned gold’s currency status, “you might as well use pork bellies”).
But now gold and silver have the added burden of rising interest rates and a strengthening U.S. dollar. Professional investors evaluate gold and silver as non-yielding assets with the opportunity cost of an interest bearing investment. Since 2008 there has been scant opportunity lost but with the Federal Reserve expected to raise rates in 2015 the cost of ownership will increase. Worse still, as the U.S. dollar appreciates the price of gold and silver will naturally decline since both are denominated in dollars.
All of which means the world is a tuxedo, while gold and silver are a pair of brown shoes. Still, this author would rather have a pair of shoes than go barefoot.