Gold and Silver in 2015

By Alasdair Macleod
Head of Research
GoldMoney

It's that time of year again when pundits are asked to look into a crystal ball and divine the future. Gold and silver were the non-performers in the year just ending, while bonds, stocks, fine art and high-end property have been buoyed up by monetary inflation, leaving gold and silver as probably the cheapest assets left to buy in 2015.

An alien visitor from another planet would see that general market prices indicate a world free of risk.

• Interest rates are high at times of risk: today they are zero.
• Bond yields are a measure of financial uncertainty: they are exceptionally low.
• Equity markets reflect the prospects for business: they are close to all-time highs.
• Price inflation reflects loss of purchasing power in currencies: it is remarkably low.
• Gold and silver prices have not risen, which is also consistent with absent financial risk.

What the alien visitor would have missed is that governments through their central banks control market prices, and they are far from free.

Therefore, the answer to what the future holds is to judge if and when governments will lose control over markets. And here one can only express a view; mine is that it is getting increasingly difficult for governments to maintain control over them, and I think 2015 will be a challenging year in this respect.

In making this assessment there are a number of things to consider. Russia and her allies may have it in their power to destabilize the west's financial system. This could happen at any time, given we are still increasing sanctions against Russia and the rapid fall in the oil price is also bringing unintended consequences.

The Eurozone faces growing difficulties, which could lead to major political and economic upheavals in 2015.

Furthermore, if U.S. economic recovery builds to the point where interest rates rise again, a global debt crisis is likely to ensue.

And finally, all this is against a background of deteriorating government finances as welfare costs continue their inexorable rise, adding to national debt burdens at an accelerating rate.

Debt is the underlying problem. The productive private sector in America is approximately two-thirds of total GDP, the rest being government. This productive base ultimately pays for all the debt (government, state, local and private sector) which amounts to six times the private sector's GDP.

Therefore, if interest rates and bond yields were to rise by only 3 per cent, it would require roughly 15% of private sector GDP to service the increase. So there is no way any but the smallest of increases in interest rates can be tolerated because the cost is too high for the economy to bear. It is the classic debt trap.

With accelerating welfare costs, the situation is worsening over time. Importantly it is getting increasingly obvious with every passing year that the cost of welfare is driving western governments towards bankruptcy, which will lead to a crisis of confidence in their currencies. America is by no means the worst case, as the current financial condition of Japan clearly shows.

Little of this is priced into capital markets; because western governments have deliberately kept markets inflated rather than face up to financial and economic realities. So the logic of owning physical gold and silver is becoming increasingly urgent.

Valuing Gold

It stands to reason that if market prices are managed, controlled or distorted by governments, then the current price of gold cannot be taken as its true value, so we must look elsewhere to make an independent assessment.

It was with this in mind that I constructed a new money supply measure, the Fiat Money Quantity (FMQ). The idea behind it is to retrace the steps whereby gold was originally deposited into the banks by our forefathers and then passed on to the Fed when the Fed took on the note issuing monopoly and credited the banks with reserves in return for their customers' gold. FMQ is essentially the total of cash currency, instant access deposits, and reserves held at the Fed.

Ever since the Lehman rescue, FMQ has accelerated alarmingly as shown in the chart below.

The monetary inflation genie is out of the bottle, and given the debt-trap problem it is set to continue to accelerate further from its long-term pre-Lehman crisis path. Putting aside specific details, the only major difference between the finances of the U.S. and Japan is the timing of the same eventual impact on the currency, which will become progressively more difficult to avoid.

It is not impossible to avoid this conclusion: rather it requires actions for which no administration has an electoral mandate. This has left gold cheaper than at any time since the Lehman crisis as shown in the second chart.

The yellow line is the price adjusted by the increase in FMQ (the subject of the first chart) and by the increase in above-ground gold stocks. While the market price has risen from $833 in August 2008 to $1195 today, the price adjusted for monetary inflation has actually fallen to the equivalent of $530 in August 2008 dollars, and if we adjust the price by the increase in FMQ only, the price adjusts further to only $475.

Therefore, while monetary inflation is accelerating out of control, gold in real terms has become exceptionally undervalued. This undervaluation is confirmed by unprecedented public demand for physical metal from Asia, and closer to home record demand for coins (particularly silver) from ordinary Americans. Indeed, the level of known demand for physical gold is considerably greater than total mine and scrap supply, and has been so for the last two, possibly three years.

Silver

I mention silver only briefly, because the underlying argument in its favor is the same sound-money argument behind gold. It is roughly twice as volatile, so if gold is undervalued, silver is doubly so.

The complication is that silver is primarily an industrial metal nowadays. Therefore, if industrial demand declines, investment demand will have to increase to compensate, which is probably why silver has been such a poor performer in 2014.

However, industrial demand is less price-sensitive than for most other metals, and a significant rise in the price, to perhaps over $50, would be needed to force industry to begin abandoning the manufacturing of products with a high silver content. This implies that silver should continue to outperform gold in a financial and economic crisis up to that level, above which new investors would probably absorb all available silver anyway.

Silver has been described as the poor man's gold. I look at it slightly differently: in the event that confidence in fiat money collapses, silver will be just as useful as money as is gold, with the added advantage of practicality for everyday transactions.

There is also the further consideration, that in the event western governments try to confiscate their citizens' gold, they are unlikely to attempt to confiscate or regulate silver as well because of the impracticalities involved. So long as the risk of confiscation of gold exists, silver will be at least as important a monetary metal as gold.