Silver and Gold in the Modern Portfolio (w/ Ned Naylor-Leyland)
NED NAYLOR-LEYLAND: I'm Ned Leyland. I'm the Portfolio Manager of Merian Global Investors Gold and Silver Fund. The fund is a combination of bullion, held in bullion trusts, and gold and silver mining equities. If you're asking about a forecast for gold prices, you have to think about it in your base currency. And actually, for a lot of investors, because they're not taught about gold-- and gold sort of lives under the table-- it's this kind of strange, esoteric subject-- investors, even professional investors, struggle with this problem. So they, they. So people based in London look at gold in dollars, which is just completely unhelpful. So my outlook for gold is always a 12-month and longer time frame because I think that's the way you need to think about it. And it's based on gold's actual positioning, which is in the cash and bond market. People get very excited about what may or may not be happening in equities. But, of course, gold is a cash-money instrument. And it behaves inversely to dollar real yields. That's to say it's not about inflation on its own, and it's not about rates on its own. But it's about the relationship between the two. And right now, we have-- depending on who you speak to-- three or four hikes, still priced in on a forward-looking basis. And I tend to say that I think it's more likely we're going to get less than we are going to get more than that. But, you know, I look at the Barclays-Bloomberg 7- to 10-year Real Yield index as a key forward-looking measure of what's happening in cash, or rather-- let me rephrase that-- what the bond market thinks is happening in cash. But I think therein lies the investment case for gold, really, which is, there's a huge difference between what the bond market is pricing and what participants actually believe. And I think that that's the way to think about gold. So to dig into that slightly, if you look at that index, it's suggesting that a dollar will be worth between 100 cents and 101 cents seven to ten years in the future. But when I anecdotally poll investors and potential investors in my fund about what they think the purchasing power of $1 will be on that forward-looking -- basis seven to 10 years-- they will, to my surprise, but delight, too, actually come up with an average number of $0.50. So investors seem quite clear that the dollar, and sterling, and anything else is losing purchasing power a lot faster than the screen suggests. But yet, when it comes to actually investing in what the bond market itself says on the screen, it's still at 101. So my thesis for gold here, in terms of dollar pricing, is that there is a big, big problem here between $1.01 and $.50. Now, at what speed are we going to see that $1.01 head to $0.50. It's not, in my view, not going to go the other way. I'm not sure. But at the moment, we're still several hikes priced in, and a very rosy perspective as to what central banks can do in an environment where, clearly, we've had an incredible unleashing of credit through the system consistently for 20 years. I think gold is in a very good place to rally considerably, once the bond market-- the cash-market-- peoples who are holding these instruments-- start to become nervous about their loss of purchasing power. I think there's a flaw because they've been forced in an environment where, really, things have been very, very loose for a very long time. They've been forced to hold the bull markets head up by promising things that they can or can't deliver. So far, they have delivered. They delivered it on a very delayed basis, by the way, because there was about four years where they talked about rate hikes and didn't do anything. But the bull market was a good, compliant puppy, and did what it was told back then, before anything was delivered. So I think the floor is more just a relationship between the bond market and the central bank. It can't be any more compliant than it already is. I suppose that's the way I see it. You know, at some point, the bond market is likely to say-- even if it should gently-- I'm not sure that we can continue to do these hikes or these hikes are actually beneficial-- that there might not be some big macro problem created by doing it. So I think that that's really where the flaw comes from. It's this relationship between the central bank and bull market. It's so tight that I don't really see how it can force real yields any higher than is already priced in. I'm very interested in silver. And silver's a big part of our portfolio. But silver really is just the highbeat version of gold. I mean, its not, people get very confused by silver because it has enormous industrial utility-- in fact, so much so that it can't be replaced in many, many items. But it does still behave as the partner of gold, and it trades on an inverse relationship with real yields. So look, my thing about silver is I think in portfolio-construction terms, it's very sensible to utilize that beater within the portfolio because it actually ends up meaning I can buy larger, larger stocks than I would otherwise need to buy to get that return profile in my portfolio. But the truth is of silver-- at some point, is likely to decouple, I think, because I think that the just-in-time delivery system of the bullion-banking world for silver might start to become a problem for industrial uses. They might become nervous, and they might seek to grab whatever physical imagery they can get hold of. And at some point, I think that will decouple. But for now, it's just a pure way of accessing return profile in the funds. And I think if you're going to invest in gold, you should always think about silver alongside it. We combine bullion-- gold and silver-- with mining equities. One of the reasons for that is I think that gold and silver stocks can be quite liquid. In fact, they can be very liquid, depending on market conditions. And I think that investors are interested in both bullion and mining equities. Mining equities are a real investment. Gold and silver mining equities are an active investment, whereas for me, physical gold and silver is money. It's not an investment. What it is sound money that doesn't degrade, is very important, and it provides like a cash buffer within my portfolio. But I think that the mining equities are the active investment in the space. Now, having said that, they've been horrible for a long time. There have been very short periods they've done very well. But really, they are suffering from a very, very big and very important structural problem, due with the misreporting of inflation. And I think it's a very profound observation that inflation is much higher, in real terms, than the statistics infer. There's plenty of evidence for this if one bothers to dig into it. And I think that if you think about a gold-and-silver mining company as selling something, which is priced of inflation on the screen-- because of course, gold and silver price of real interest rates, and when interest rates take into account the formal data on inflation-- so they're selling something which is pegged to Bloomberg, as it were, whereas their costs are not. Their costs are real. Their costs are rising in a much more secular, structural way, based on the real inflation rate in the real economy. That creates a horrible-investment case for gold and silver equities, which is probably not what I should say, seeing as I invest in them. But that's also where the opportunity lies to me because, you know, we've had 20-plus years of this problem being in place in the sector. And I think that what's happened is we've ended up with now a really profound operational gearing built into the stocks. So long as you buy quality, you don't go chasing racy ones-- there's an enormous amount of operational gearing to rising gold and silver prices available in there. And for me, I don't think physical gold and silver on its own is enough of a hedge against the issues of the structural issues of the monetary system because if you, you know, have a 2%, 3%, 5% position in physical gold, what you're doing is you're saying, I want a 2% 3%, 5% vote no in my capital. Well, that's fine, but that's not going to make up for potential very large write-downs elsewhere in your net-worth pie chart, and wants to explain it like that. So for me, the gold and silver mining equities are a bit like an untimed call option. Now, you want someone to manage it for you because I think it's a very technical industry. It's not somewhere you should just be picking an individual gold stock-- go ahead and go with that one. I think the idiosyncratic risk of individual mining companies is much greater than people realize. The skew is not in your favor buying individual names. So whether one wants to buy an index or a managed fund, the likes of which I manage, I don't really think that that's something I'm going to push someone towards-- but I do think holding individual names is a bad idea. But I also think that this is the finest way to have a really meaningful and geared exposure to a major-trend reversal, which I think everybody is worried about. Lots of people are worried about this, quite rightly, because there's so much herding, so much concentration, so much correlation, inability for people to own things which are going to move fast the other way. And for me, this is what gold-and-silver mining stocks represent. Now they need to be selected carefully. We don't buy companies that are based in Africa, Central Asia, Russia-- anything like that because I don't think you need the additional risks involved in that to capture the return profile. But I do think that, you know, some people believe they can hedge themselves by holding derivatives, holding, basically, a timed short-view on things. For me, that's not the best way to do this because I think the big problem people have is timing this structural issue that we're all talking about. And gold-and-silver mining equities-- so long as they don't go bust in the meantime-- are a very good way of achieving that. The individual gold-and-silver mining stocks are a real problem for most investors. The temptation is to, is to buy them. But you need the knowledge-- not actually even of a geologist, but specifically, of a mine engineer-- in order to be able to integrate the financials and the operating side of mining companies, particularly underground gold-and-silver mining companies. They're very, very technically complicated. So I think that if you don't have that, it's a fool's errand in buying individual stocks because what you're doing is you're saying, oh, I know better than my engineer. I mean, you're not explicitly saying that. But you're inferring this because an index or a fund is going to capture 90%-- 80%, 90% of any upside in an individual name. But what you're doing by investing in an index or a fund is you're avoiding the huge downside risk that can be caused by, well, whether it's geopolitical, whether it's operational-- whatever specific idiosyncratic risk there is-- there are many, many of them-- and they usually do come along when you not expecting it. So I feel strongly that avoiding that problem by layering your exposure is more pertinent in this sector than anywhere else. This idea that gold-and-silver mining companies are brilliant at capital instruction, I think, is just wrong. And it comes from a lack of understanding of this problem of costs versus the gold price. So just to go into that a little bit, gold is money, silver is money. And they're pricing of full stature in the bond market. And I'll say, for me, that, that it's not just the work John Williams of Shadowstats. There are other things as well, which indicate that inflation can be around probably average 9% over the last 20 years. I know that sounds completely shocking. But by the way, in truth, , you know, a lot of the most-interesting investors I meet would agree with me. They want to be up 10% net per year. Otherwise, they feel they're down. So that actually confirms that point. But if you accept that, then there's a huge input-cost problem for these companies. And we see it consistently when you model them out proper. You can see it's there. And they're not able to hedge that away or avoid that problem. If costs are rising at 10, and gold is up 1, it's not a management problem. Now, don't get me wrong. There are issues with corporate governance, renumeration. But I don't think there are any bigger than they are elsewhere in other sectors. I think that there's a narrative here which doesn't really bear out when you really dig into it. The issue is with the way inflation is reported, and thereby, the way real-interest rates price gold. And that's where both the problem has come for a very long time, but also, where the enormousinvestment opportunity lies because if gold does start to break out in a major way, you're going to see massive margin expansion, operational gearing to the upside for these companies. And people can make fantastic returns on that basis. Yeah, the central banks have managed to prolong the cycle hugely, in my view. And I think that they've done that by making the bond market compliant. Or the bond market has willingly been compliant in that. Now what do I do to avoid this problem? Well, stock selection is the obvious one, which is, you don't just pile into the most balance sheet distressed and highly operationally-geared names. You want a good selection of high-quality gold-and-silver mining companies. They do exist, despite what people say. So I think that there's, there's an obvious stock-selection point. But I think that the more interesting question, really, is for the investor and how they allocate towards me, or sector, rather than the other way around. And that, for me, is just a position-sizing point, which is, there is a tendency that once you understand the monetary system, or you feel you understand the problems of the monetary system well, to get particularly fearful or greedy in taking too much of an overweight view. So if we talk about the prolonging of the cycle, you know, I think it's, for me as an investor for myself, rather than necessarily in the fund, what I would say is, I think, it's about, what position do I want directionally hedging this problem? And what is that particular allocation going to do for me in that environment? Now that might seem like a really obvious point. But I don't think that people handle that well. So I think that being in markets, in momentum, in this strange world-- twilight-zone financial markets that we're in-- is, is a compelling and necessary thing to do. But I do think that having an allocation, a 2% to 5% allocation, for example, in a fund like the one I run is a good number. Now, am I at 2% to 5% myself? No. So am I being a hypocrite saying that? Yes. I do take a much bigger view, but then I'm happy to bear the volatility of that. And that's the point. So people say to me, oh, gold's volatile. Silver is really volatile, and gold and silver stocks are crazy volatile. Now, I've been investing in them long enough to be quite sort of immune to that. I don't really feel it, I think, the way other people do. But that's just about position sizing. So if you can't handle the volatility, then you need to down-weight your position. And that doesn't mean you don't have it. It just means you understand what the right quantum is for you. And I think that a good proportion of people's negative perspective on this asset class is because they've understood the structural problem, then they've got their position-sizing wrong. And actually, you know, if gold and silver stocks are down 15% over eight months, and people are moaning, you know, it's probably a good sign that things aren't doing that badly. And it is an overall view. And we have to think about it that way. Balance at the moment, the portfolio's 20% bullion and a slightly underweight position in silver miners versus gold miners. But that's purely because silver has underperformed gold for, gosh, nearly two years now. So there's been a negative drift there. And I'm not constantly fighting it by just buying blindly. But broadly, the positioning remains the same. I mean, if the sector really starts to signal very bearish, for me then I would go higher in bullion. And I would sell some of the operating-mining companies and royalty in streaming companies because generally, they do quite well in a difficult environment for dollar-gold prices, mainly because they get to buy more streams and royalties from distressed-operating companies. But for now, I'm still in position-- about 20% in physical, and the rest in the, in the miners. The sector does badly from here if we get even more tightening that's priced in. Now, you know, I don't buy that narrative? Some people do. And it could happen. But I think there's so much bad news priced in. And there are actually some really good-news stories. One of the particularly good-news stories for me, in the gold-and-silver mining equities is the really quite-exciting change in the way mining is happening-- so for example, the introduction of tech. Now don't get me wrong. Gold-and-silver mining companies are about the last people to change what they do, but it is happening. We've seen lots of small, incremental changes to mining processes, whether it's the use of drones in surveying of open pits, whether it's driverless, automated haulage, whether it's improvements in milling, grinding. There are lots and lots of small changes. I think all of these are going to drive big operation improvements over the next two to five years. Now, I will admit, this is at the margin. But I think it's very interesting, and I think it's a big change for the industry. So I think that that's something very positive to look forward to. But overall, we're in an environment now where real yields are where they are. We should see a shift back to the norm-- a closing of the gap between $1.01 and $0.50. I don't know what can be a catalyst to do this. There are many things that are lurking, I think, which can drive people away from this narrative of tightening of central-bank balance sheets. I'm not sure what's going to do it, but I think something is coming at some point over the next 12 months, which will make people question the ability of central banks to continue to do that. So 2008 often gets referred to. But we're not there anymore. And it's not a it's-different-this-time point. It's very, very clear what happened to me. If you look at the Real Yield index I referred to, what you will see is before QE was mentioned, we were in a deflationary collapse. That meant that money on deposit, dollars on deposit, on a forward-looking basis were, according to the bond market, gathering purchasing power just being sat there. Now that is not good for the dollar-gold price. So the dollar-gold price went down nearly 30% in very short order during 2008 before this new, wonderful world of QE was even discussed openly. The moment that happened, it turned. The bond market understood that we are now in an environment where conventional-monetary policy is not around. And we are still in that post-'08 environment, where if we need to, we can go into yet more unconventional environments-- more QE, negative rates-- all these things. We're not where we were in '08 when gold went down 30%. It went down 30% because the bond market-- if you look at the Barclay's-Bloomberg index, it was pricing $1.04. So it was saying, money will be worth 4% more in seven to 10 years' time than it is today. I cannot see any environment of stress where the bond market is going to be pricing that. For me, it's clearly going to go the other way. And people will realize we're going from what is already a tight environment to an extreme-loose one very quickly. It should be the opposite of what we had before. Central banks are very interesting. People talk about their inability to forecast. But I'm not sure that that's really what goes on. I think that, as JP Morgan, said, "gold is money, and everything else is credit," and central banks understand that very well. I also think, by the way, these commercial banks and commercial-bank economists don't understand it at all. Indeed, I had a conversation with a very high-level economist from a big bank recently. And he described what was going on in Asia, respect to de-dollarization, it's just complete nonsense, it's not happening, it's just not interesting. And I brought up gold, and he described it as shiny Bitcoin. And I said to him, but your own central bank has 2/3 of its reserves in shiny Bitcoin. And there was a look of amazement when I made that point. Now, I think central banks are the signal, you know. They hold, really-- leaving aside the equity component that central banks have added-- some have- - let's just leave that aside for a moment. Central banks hold two things. One is money, and the other is credit. Or at least, that's my perspective on it. Now, they're seeking to add this, and they don't want to add any more of that. That tells you we're at a very-important moment, cyclically. It's a difficult thing to pitch because that doesn't show up in pricing because, of course, gold-- and so then people say to me, oh, yeah, but then why doesn't go go up? Why is it not going up? Well, the answer is, the physical market is tiny. But the central banks only participate in the physical market. Now, that's not true what I just said. They only participate as a buyer in the physical market, the tiny physical market. They do participate actively in the paper market, learning, leasing, swapping reserves. But when they want to add, they buy physical. So there's a strange world we live in, where they're buying. They're adding physical reserves and repatriating, of course, which is an important point-- wanting their own gold reserves at home, rather than with other nations. I think this is a huge secular thing. I don't think it's anything anybody should be ignoring. Can the average investor get out to the Bundesbanks? 67% of reserves in gold-- probably not. Do I think that that's something that's flashing at investors that people ignore? Absolutely. I was in Germany a year ago. I asked German investors what, what they thought the Bundesbank's gold holding was. None of them had any idea. They didn't know what that-- and they were surprised they didn't know as well. And when I pointed out that that was the case, they were absolutely amazed. And I think that it's just that simple. Central banks understand, that's money, that's credit. And they need to balance the two out. Now unfortunately, that means some central banks don't have enough money, and they have too much credit. And I think it's very difficult for those ones to do anything about it because if they do, it starts to look a little bit dodgy for them. If they start trying to rush away, then, you know, it's ringing a bell. So I think at the margin, this is the most important thing and the thing that most qualifies why this asset class and a position in this asset class, even if it it's going down while everything else is going up, is there for a reason. And not owning gold and not having exposure to gold, or silver, or the mining equities; for me, is a much bigger risk than a correctly sized position and the fact that it may go down a bit while markets continue to go up. And I suppose that's the point, really. What's the bigger risk-- having some in your portfolio or not having any? And for me, it's very clear. It's definitely not having any at all. In a world where we were awash with credit, and everything is somebody else's obligation, the one thing that isn't is something that really ought to be in everybody's portfolios. Sequencing for a blue-sky scenario for gold, I think is, not how I see it, really. And the reason why I say that is because I do think that gold is the denominator. So all I see, really, is that we're in a situation where we're in the final 1% of purchasing power of the existing monetary system. And it's being degraded very, very fast, despite what central banks may tell you. Now, I think that if you hold a position in physical gold, there can be a big rerating, versus your, your base currency. And it can look very good, and you can do very well. And that will be all about the move from $1.01 in the bond market to $0.50 in reality. So at what point people start to realize that they are shipping purchasing power holding cash-- that's the key driver of everything. I don't know when it happened in the 1970s, it was actually an oil spike and made people realize something that was already there. It was already there. But people, with a big rise in oil, suddenly feared inflation in real terms, and they behaved in a certain way. But for me, still, it's all about the mining companies because that's where the real return comes. If you really want to make a big return here, be one of those people who makes a lot of money in a systemic shift, it's going to be in the mining companies, not in physical, because physical is money. What it's going to do is what it's always done, which is hold your purchasing power against goods and services. There can be one- two-year uplifts and downdrafts. But generally, that's what it does. That's what it's for is money. But the mining equities are not bad. And if you are participating at the right time, when people start to flee cash and bonds, and it's not about equities-- now, by the way, of course, equities going down can, of course, be the trigger that makes the bond market realize we're not getting all these rate hikes. And that can create real yields going down. But it's always through the bond markets. It's about cash and bonds. When do people stop wanting to hold those? I think it's already there, by the way. I think we're seeing what was a very small trickle is it a little bit more than that. At the moment that turns into more than that and turns into a river will be the moment when we get phase change. And gold and silver mining stocks can really start to go at that point. Physical will do well, and people will be very happy they own it. But the opportunity set for me is in the stocks, not in the bullion.