A Bullion "Moat" for Your Portfolio

Please Note: here the word "moat" means adding safe haven investment characteristics as a way to defend your portfolio.

In the first quarter, precious metals bullion and equities showed strong year-to-date momentum, which began to build in Q4 2022, spurred by significant physical gold buying by global central banks and physical silver buying by Asian countries. Gold has attracted plenty of attention recently since closing above the psychologically important $2,000 per ounce mark. Silver started its move in early March and has reached the $25 ounce level for the first time in over a year. Gold and silver mining stocks have also posted notable gains.

In the recent crisis period, gold has provided a safe haven investment compared to more traditional asset classes, like stocks and bonds. Visit The Case for Gold in Crises to learn more.

A precious metals bull market appears to be underway, although it appears to have many spectators but few investors. The recent price gains for gold and silver bullion have come despite investor outflows from physical bullion exchange traded funds (ETFs). We believe, however, that if prices continue to rise, investor sentiment is likely to shift and re-energize inflows, fueling what has the potential to be a significant bull market for the precious metals complex.

Fed Policy Has Increased Market Risk

It is often said that central bank policies work with a lag. A year ago, the U.S. Federal Reserve (the Fed) started raising interest rates to put the inflation genie back in the bottle. The aim of Fed policy and other central banks worldwide was to increase the cost of borrowing and throttle the creation of easy, low-cost credit. Unfortunately, inflation has remained stubbornly high — although it appears to be rolling over.

The unintended consequence of Fed policy has been a significant increase in market risk. Despite the usual assurances from government officials and status quo cheerleaders that "all is well," the collapses of Silicon Valley Bank and Signature Bank, along with the emergency UBS buyout of Credit Suisse, are canaries in the coal mine of systemic risk. Similar bromides from the usual suspects followed the demise of Bear Stearns in March 2008, months before the full extent of the systemic crisis was fully appreciated.

Higher Rates are Hurting Banks

Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets. Thus far, market risk has made victims out of a few U.S. regional banks, including the highly publicized demise of Silicon Valley Bank and Signature Bank. Across the Atlantic, Credit Suisse, among the 33 institutions deemed to be systematically important, is teetering. Silicon Valley Bank failed because of an asset-liability mismatch. It purchased securities with long duration and low yields whose values were crushed due to high rates, rendering the bank insolvent when depositors demanded their money back.

I suspect that virtually all banks are not only exposed to duration risk but are holding securities that would sell at a steep loss today in a liquidation scenario. This is best visualized when comparing the "Available for Sale" securities (AFS) versus the "High-Quality Liquid Assets" (HQLAs). As Figure 1 shows, the securities available for sale have significantly decreased in recent quarters versus high-quality liquid assets. The reason is simple: increasingly more assets deemed "high quality" are deeply underwater.

Figure 1. U.S. Banks' AFS and HQLAs (2017-2022)

Source: U.S. Bank FR Y-9C filings, @Risk.net graphics. Past performance is no guarantee of future results. For illustrative purposes only.

What we are seeing today is a storm surge in market risk. As a market commentator at Merrion Capital Group pointed out, "The Fed is the systemic risk."

I am willing to bet that this sudden increase in market risk is enough to spook banking institutions of all sizes and across geographies. This, in turn, will likely lead to a reduction in credit that banks extend, which is quite deflationary. Perhaps this is precisely what the Fed and other central banks worldwide wanted to happen.

From Market Risk to Credit Risk

What comes next is even more problematic. A storm surge in market risk, which leads to a reduction in credit extended by banks, is likely to lead to events linked to credit risk.

Credit risk is defined as the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Credit is the lubricant in the modern economy. When banks reduce the amount of credit available, those in debt are most at risk of defaulting on their loans. Today, in many parts of the world, especially in countries like the U.S., Canada, Australia and New Zealand, the amount of private debt far eclipses the total annual GDP (gross domestic product) of these countries. All these countries, in addition to many developed nations, are exposed to credit risk arising from a throttling of bank credit. To look at a country most exposed to credit risk, look no further than north of the 49th parallel, i.e., Canada.

Figure 2. Private Debt as a % of GDP for U.S., AU, CA and NZ (1995-2022)

Source: Bloomberg. Data as of March 16, 2023. Past performance is no guarantee of future results. For illustrative purposes only.

Credit Risk Can Spread Like Wildfire

Market risk and credit risk are two very different animals. Market risk can be siloed and contained. As we saw in 2008, credit risk spreads like wildfire and often requires a response from the central banks.

It is safe to assume that banks will lend less, given today's environment, to protect their balance sheets. Lower credit creation is deflationary, and this is precisely what central banks want to happen. The big uncertainty is how drastic the tightening of credit will be. If banks hit the brakes, we will likely see a hard landing combined with rapid deflation. If the banks gently tap the brakes, the economy will slow, but less drastically. The latter is the preferred outcome, but the big unknown is how this will impact the inflation picture—which continues to rage. The February 2023 CPI (consumer price index) printed at 6%, which is still uncomfortably high.

The potential impact of a recession on precious metals is a fascinating area to explore. If the economy experiences a moderate to severe recession, central banks may have to become more accommodative by cutting rates. This could create a negative real interest rate environment, which historically has been positive for gold and other real assets. Furthermore, any new rounds of quantitative easing (QE) could push bond yields below the inflation rate, which is likely to increase the risk of fiat currency debasement. The current buoyant price of gold suggests that central banks are anticipating these developments.

Central Banks are Buying Gold

Central banks have also recognized the importance of holding gold as a reserve asset. Central bank gold purchases hit record levels in 2022 (Figure 3), while the U.S. dollar's (USD) share of global reserves declined. It's worth noting, however, that gold accounted for about 70% of global central bank reserves in 1950, and advanced economies held nearly 80% of their reserve assets in gold at that time. Today, gold accounts for less than 20% of reserves, as shown in Figure 4.

Figure 3. Central Bank Gold Buying Hit Record Levels in 2022 (1950-2022)

Source: World Gold Council. Data as of 12/31/2022. Past performance is no guarantee of future results. For illustrative purposes only.

Figure 4. Share of Gold in Official Reserve Assets (1950-2021)

Percent based on the market value of gold.

Source: IMF, International Financial Statistics. Past performance is no guarantee of future results. For illustrative purposes only.

Over the past few years, we have seen central banks emerge as buyers of gold while they rotate out of fiat currencies such as the USD and the Euro. The freezing of all Russian-held USD and Euro-denominated reserves highlighted the importance of holding gold even further to all countries worldwide should they be deemed "unfriendly" by the West. The trend is toward central banks owning more gold and less fiat.

Investors and institutions at large have not been paying attention to gold. It has to be pointed out that the recent run-up in gold has occurred despite investors redeeming their ETF bullion holdings.

Figure 5. Gold Price vs. Gold ETF Holdings (2021-2023)

Source: Bloomberg. Data as of April 18, 2023. Past performance is no guarantee of future results. For illustrative purposes only.

Gold and Silver Sentiment is Likely to Start Shifting

Unlike gold, most of the silver is consumed by industrial use. According to The Silver Institute's World Silver Survey 2023, the supply of silver fell far short of demand. As a result, silver registered a record deficit of nearly 240 million ounces in 2022. More importantly, this deficit is likely to remain in place for the foreseeable future with no new large silver mines coming online and political upheavals in South America impacting mines that currently produce silver.

Figure 6. India Silver Imports in $US Millions (2013-2023)

Source: Bloomberg. Data as of April 18, 2023. Past performance is no guarantee of future results. For illustrative purposes only.

Gold: Barbarous Relic No More?

Individual and institutional investors should be reminded of the importance of owning the "barbarous relic" in their portfolios, not for its cash flows or ability to pay interest, but for the simple fact that gold and silver cannot be debased and are no one else's liability.¹

Ray Dalio of Bridgewater eloquently articulated the current state of the market in a recent article when he said, "With the enormous size of U.S. debt assets and liabilities outstanding, plus lots more to come, there is a high risk that the supply of government debt will be much larger than the demand for it." We posit that the same situation is occurring for ALL debt assets of varying quality. For this reason, the banks are caught holding assets to maturity because a sale of the "high-quality" assets on their books will likely trigger a loss.

We are at an important juncture in the financial markets, where market risk is present and credit risk is nigh. Volatility across asset classes seems like a highly probable outcome, as does the probability of fiat money being worth less. We believe that using volatility to add real assets, especially on dips in bullion and precious metals equities, has the potential to generate glittering returns. We believe that precious metals, one of the most underappreciated and under-owned asset classes, are about to get their day in the sun.