Fiscal Follies
New York: April 24, 2011
By John Stephenson

Gold advanced to a record close last week and silver touched a 31-year high, as traders reasoned that the fiscal follies going on in Washington were likely to continue. And the strength in precious metals and the oil market helped mask the underlying macroeconomic concerns as stocks shrugged off the cut in the outlook for U.S. credit from stable to negative by Standard & Poor's. But behind the buoyancy in the market, lies a world of financial tumult which has sent investors flocking to gold and silver.

Helping to brighten the fortunes for gold and silver has been the weaker U.S. dollar and the concern over the soaring level of government indebtedness around the world. The U.S. dollar slid against a basket of six major currencies to the lowest level since August of 2008 on speculation that the U.S. Federal Reserve would be slow to raise borrowing costs—a move that would stem the fall in the dollar.

The Fed has kept the benchmark rate steadfastly between zero percent and 0.25 percent since December 2008, while buying billions in Treasury securities in a move widely thought to be inflationary. And with recent CPI data showing that inflation has hit 2.7% in the United States , investors have flocked to precious metals as a safe haven. Topping the list of concerns for investors is the dollar, inflation and the possibility of market shocks emanating from Japan , Europe or the Middle East.

Helping to fuel the surge in precious metal prices has been soaring investment demand from retail investors. Trapped between the ravages of food and fuel inflation and saving rates that are offering negative real returns, retail investors have stampeded into precious metals. Nowhere is this more true than in China and other parts of Asia where the effects of inflation are felt more acutely and scepticism runs high that the U.S. will take seriously its role as a responsible debtor. And that has operators of storage vaults the world over scrambling to find more space to store gold and silver while at the same time, stepping up the hiring of staff to deal with the extra work load.

Demand for gold is also being supported by the Indian festival season which ends with the arrival of the monsoons in June. India , the largest consumer of gold, is an important driver of gold demand. But with endowments and individuals buying up gold bars and coins, total physical gold bullion investment soared 66% in 2010 to 880 metric tons.

But demand for precious metals isn't just relegated to retail investors, big pension funds and university endowments have gotten into the act. The University of Texas Investment Management Company recently converted all of its gold futures holdings into physical bullion, worth about $1 billion, as a hedge against the debasement of the U.S. dollar.

While gold has gained 5.8% so far this year, silver's 154% rise over the last twelve months has been making headlines. And while commodity prices tend to surge when supply is struggling and demand is strong, silver seems to be a market that is defying this logic with consultancy GFMS pointing out that during 2010, the silver market had a surplus of 178 million ounces. And that has many people scratching their heads, suggesting that a conspiracy of some kind must be afoot to explain silver's powerful rise. For some, a Russian billionaire with an eye for silver is behind the metals move, for others, it is central bank buying that is the reason for the metals sudden surge.

The view that silver is in a speculative bubble is so pervasive, that many reason that a powerful correction may not be long in coming. But I beg to differ. A simple analysis seems to throw cold water on the supply/demand balance argued by GFMS. Aggregate investment demand in silver from 2000 to 2009, according to GFMS, was 294 million ounces and yet iShares Silver Trust (SLV) alone had 2009 holdings of 305 million ounces—a difference of 11 million ounces. Adding together the December 31, 2009 holdings of several of the major publicly listed physically backed silver exchanged traded funds (ETFs) implies a total demand of more than 500 million ounces.

So while it can be argued that the size of the gold and silver market is small compared to stocks and bonds and therefore more sensitive to sentiment swings, the demise of the precious metals trade isn't coming any time soon. To unwind your gold and silver positions, investors would have to be convinced that economic growth can be sustained without extraordinary government support. But with the euro zone looking increasingly tattered and the U.S. continuing to debate the debt ceiling and with no visible credible plan to extricate the country from its monumental debts, gold and silver will continue to march higher.

The best way to play both the gold and silver trade is through the gold miners. Some of the largest producers of silver are gold companies that have been trading off the strength in gold prices. But now that silver has staged such a solid upswing, first quarter earnings should be off the charts when miners report revenues supercharged by the potent one-two combination of higher gold and surging silver prices.