After a 400% rally in gold and 480% in silver in the past 10 years, we are seeing a pause amid the magnificent rise in precious metals. The price rise started as part of the liquidity-driven rally in all asset classes, and built pace after the credit crisis in the US, supported by safe-haven demand in the aftermath of the European sovereign debt crisis. It is now taking a breather. Low interest rates, high liquidity (stimulusdriven), macro-economic uncertainty and lack of investor confidence in other asset classes were primary drivers of the rally in gold, with a little extra in silver in recent times as gold's cheaper cousin.
The recovery in the US macroeconomic environment and an increasing risk appetite prompted profit-taking in bullion. But larger uncertainties continue and high unemployment rates in developed countries prompt them to keep the easy monetary policy and feed the economy with high liquidity. Both these factors allow investors to chase higher returns in alternative asset classes. The US recovery is seeing some light, but structural issues in Europe are unsolved, posing a significant threat to global-risk appetites. Investors are still bullish on both the metals, and ETF holdings are near all-time highs, indicating that long-term money is still going good in these metals.
There are a few threats to this rally now: better growth in the US could drive investors away and back to equity markets. The greatest strength in precious metals, the launch of ETFs, would also be one of the most important threats, as investors could flee the ETFs and redemption pressures could generate a downward spiral. High prices also increase scrap sales, increasing supply-side pressure. At the same time, fresh physical demand coming from India and China will support these metals on the downside.
According to GFMS, global mine supply of gold has hit an all time record of 2,652 tonnes in 2010 and is certainly expected to increase further as a healthy pipeline of supply has been lined up. On the other hand, a marginal 1% decline in scrap sales was seen, indicating that the price rally in gold is putting off sellers. Though estimated above-ground inventories touched 170,000 tonnes, the impact on prices will be insignificant. Silver mine supply, however, is expected to rise by 3%, while supply from scrap sales is expected to rise by 11%, increasing overall silver supplies by 5% in 2011. On the demand side, fabrication demand for silver is expected to increase by 10% and growth in industrial demand, which was 18% in 2010, will slow down to 4% in 2011 as high prices will compel manufacturers to opt for less expensive alternatives. But key demand growth will come from solar panels and coin demand. The smaller size of the silver market (the value of supply of silver was $19 billion in 2010 compared with $170 billion for gold) makes it vulnerable to huge price swings. So, timing the market is more important in maximising returns in this commodity. Gold, though, would be best in providing stability to a portfolio. So the question is whether the upside continues or not. Long-term investors need not worry about price, as the upsurge in bullion will continue as long as interest rates rise to bring real rates into positive territory in order to discourage investing bullion. But investing in precious metals is more about diversification and reducing portfolio volatility, along with maximising returns.
Many investors believe their portfolios are diversified if they contain a mix of stocks, bonds and cash. Unfortunately, correlations between traditional asset classes have been on the rise, resulting in portfolios that are not adequately diversified. Strategic asset allocation ensures a fully diversified investment portfolio by properly balancing asset classes of different correlations in order to maximise returns and minimise risk. In the past, portfolios diversified into precious metals have produced superior returns to those not diversified. This suggests that the unique risk-reward profile of precious metals renders them as a useful diversification tool in strategic asset allocation, with the potential to improve the reward-to-risk ratio in conservative, moderate, and aggressive asset allocations by including precious metals – with allocations of 7.1%, 12.5%, and 15.7%, respectively.
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