Advisory Letter: 13th June, 2019
Another month, another stand off… just two weeks ago we were reminded how quickly things can change, when Trump threatened tariffs upon Mexico (which is basically taxing America itself due to the integration of Mexico into the U.S. supply chain) which led to a sharp risk off moment. We quickly recovered again, but it reminded us in what fragile state the markets are, whether it is viewed from a fundamental or momentum perspective.
This got us thinking about some of the safer asset classes, like precious metals. Gold has generally taken off these past few weeks with Fed rate cut speculation intensifying. There is another driver for precious metal rallying, which is the possible threat of USD weakness on the back of trade war intensifying. 1375 has been a high in Gold that held multiple times over the past 3 years.
A break to the upside would mean decisive new highs. The price of gold is largely determined by the strength (or weakness) of the USD. The odds are stacked towards a weaker dollar once the Fed starts delivering on rate cuts. Trade tattle can also play a role, as China starts to allow (and encourage) settlement of commodity contracts in CNY rather than USD. And while I believe that generally we are in a deflationary world, political gimmicks like helicopter money or forgiveness of student debt would be very inflationary, and hence weaken the USD as well.
Thesis in a nutshell:
Precious metals have always been a safe haven in times of USD weakness, and most people resort to buying Gold these days. I have looked at the price relation of Gold vs. Silver prices, and noticed an extreme position on what I deem to be a mean-reverting relationship. Prices of both precious metals have dislocated for the past 5 years, but this should normalize again.
Observation 1: The ratio of the price of 1oz Gold vs. 1oz Silver is at a 25 year high
After the break in the Gold standard in the early 70’s the ratio quickly climbed from 20 to its all-time high of 98.80 in February 1991, at that time gold in absolute terms traded at around the 370 level.
Silver had its first peak in 1980, when the market got cornered by the Hunt Brothers, which ended in the infamous “Silver Thursday“.
In 2011 in a speculative bubble, Silver also reached a high close to $ 50/oz, driven by speculation about a physical shortage arising from Solar Panel demand, which drove the ratio down to 40 in a quick fashion.
To demonstrate a more longer term view of the price correlation between the two metals, please see below chart.
Observation 2: Demand / Supply story in favour of Silver
Now for the reality check of today, I have been looking at 2 basic indicators that signal Silver could be undervalued at these levels: First the classic supply/demand story. Refer to a report by the Silver Institute which is mapping out supply demand based on Refinitiv data. This shows for 2018 a drop in supply, while demand has risen and is expected to rise.
Silver has a widespread use in the electronics and photovoltaic industry due to its physical properties. For example, solar cells are using silver paste as a conductor material. Batteries and Solar panels account for around 50% of the global silver demand. According to statistics from 2018, the investment demand is only 11%. Therefore, this is not a crowded trade, but it will be driven by ongoing demand growth (solar panel CAGR is at around 20%)
Secondly, a more technical indicator, is the backwardation of the Silver futures contract. This means how much more expensive it is to buy silver further in the future than the most current spot contract. I take this as a ‘true’ indicator of supply demand, and we have seen this indicator starting to turn around, while the spot price is still hovering around the recent lows.
How to implement the trade?
We can offer 2 solutions for our clients:
For private clients, we have recently on-boarded a physical Silver product on our platform. Note that this is not a classic ETF, but rather a trust structure, which invests in physical silver which is held by the custodian on behalf of the trust. I do not recommend miners, since it adds a second dimension into this trade which can work unfavourably to make it wrong even if you are right on the idea itself. The strategy, thus, is to add Silver as a diversification and store of value to the portfolio, which has better upside potential than the classic gold hedge.
Its also a ‘numbers game’ – in the event that the Gold/Silver ratio reverts back to the long term average of 60, from currently 90, and Gold should drop by 10% to say 1,100, the price of 1oz of Silver should then still be around 18.3$, ca. 20% higher than today.
Accredited Investors who don’t want to take a directional view but rather only focus on the spread ratio should look for customized strategies using options or the actual underlying rates for a pair trade.
Please contact us with any questions or comments! You can reach out to our Advisory Desk at firstname.lastname@example.org for any details or queries.
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