Will Coronavirus Propel Silver Higher?

In my recent series on gold, I provided an investment framework and valuation methodology based on the opportunity cost and demand function for gold as a form of insurance against the risks inherent in financial assets. Here, I extend this methodology to silver but also incorporate several other important factors specific to gold’s sister. In brief, the outlook for silver is strongly positive at present both vis-à-vis gold and base metals, and versus financial assets. One surprising reason could be the recent global COVID-19 scare.

A Brief Monetary History of Silver

Silver has a long monetary history, at least as long as gold’s and spread just as broadly around the world. Indeed, in some Asian languages, the words for ‘money’ and ‘silver’ share etymological roots. And silver has been more frequently circulated as coinage, whereas gold has often been hoarded by the wealthy, or by religious orders, for use in ceremonial art or for storing unusually large amounts of wealth in bullion form.

Silver was the first official money of the United States, with the US dollar specified in the Coinage Act of 1792 as ‘three-hundred and seventy-one grains of four sixteenth parts of pure, or four hundred and sixteen grains of standard silver,’ which corresponded to the world’s most widely circulating silver coin of the time, the Spanish milled dollar – or ‘piece of eight’ as it was commonly known. The Act also specified an official exchange ratio of 15:1 between silver and gold by weight. (This ratio would be subsequently increased to 16:1 by a future amendment.)

However, beginning in the 19^th century, silver was gradually demonetised, at first unofficially, but later also de jure. One reason among many was that, as the European and international banking systems evolved, the use of banknotes—or ‘real bills’ if you prefer—became commoner as a means to transact, lend or borrow.

With circulating paper claims on specie gradually replacing specie itself (in particular for larger transactions), there was less demand for the actual metallic circulating medium. Yet there was as great a demand as ever for a stable, reliable store of value. Due to its more stable supply, lower reactivity, and higher density of value, gold’s properties ensured that when a choice was to be made between which of the two made the superior money, silver lost out, and the 15:1 ratio specified in the coinage act has not been seen since.

While silver coinage was still common well into the 20^th century, it represented an ever-declining portion of monetary reserves. By the time the Bretton-Woods system was formalised in 1944, silver’s official monetary role was essentially over. The US dollar was fixed to gold, at $35/ozt, but the price of silver fluctuated, and central banks gradually liquidated their remaining holdings.

Following the breakdown of Bretton-Woods in 1971-73, silver and gold both soared in value. Although notwithstanding occasionally sharp fluctuations, the long-term trend of gold outperformance continued. Most recently, the ratio has reached a historic high of around 100:1. Silver has thus never been so affordable vs gold as it is today.

Chart 1: Gold/Silver Ratio at Historic High

Source: Bloomberg, Macro Hive

So will the trend continue? Or is silver due a comeback? I believe that a comeback is on, for a variety of reasons including both supply-side and demand-side factors.

Silver’s Supply Side

Historically, silver was acquired from mines specifically developed to extract silver ores. But today, most silver is mined as a by-product of other production, in particular copper, lead, zinc and gold. This means in practice that the supply of silver is a function of that for primarily industrial metals. (This would change if the price of silver were to rise sufficiently, making some old mines economic to operate once again, but as it stands now there is not a meaningful independent silver supply function.) Hence silver supply is largely a function of those macro factors driving the industrial demand cycle. And as such, the price of silver tends to have a higher price correlation to base metals than does gold.

Silver’s Demand Side

The demand side is more complex. Silver has a wide range of industrial uses, some of which are highly cyclical, others less so. Among the largest source of demand is electric and photovoltaic products such as solar panels because silver is, of the metals, the best conductor of electricity and also the most reflective of sunlight. Such demand for silver represents around 15% of annual production.

While silver is still used in photographic film, the rise of digital photography has seen this source of demand decline sharply over the past two decades to under 10% of annual production. However, the photovoltaic applications noted above have taken up this slack. Silver’s antimicrobial properties have also boosted medical demand, for example in clinical masks, dressings, gloves and other garments.

Given the current coronavirus scare, it would seem reasonable to expect a fresh surge in medical demand for silver, especially when silver has been shown to be effective not only as an antibacterial but also an antiviral agent. Research is ongoing, but scientists believe that silver’s high electrostatic charge interferes with the ability of both bacteria and viruses to replicate and multiply. This also helps to explain the popularity of silverware throughout history, as silver’s natural antiseptic properties were ideal in lieu of bleach, detergents and other strong modern cleaning agents.

Overall industrial demand for silver takes up about half of annual production. The other half comprises jewellery, other decorative and artistic applications, and finally the residual monetary demand for silver. While not the same order of magnitude as gold, silver’s monetary (bullion) demand fluctuates in much the same way; that is, it is sensitive to long-term real interest rates and other factors known to drive the price of gold, as described in detail in Part II of my gold series.

A Price Framework for Silver

Pulling the supply and demand factors together, it is possible to construct a fair-value model for silver that incorporates real interest rates, the price of gold, and industrial demand, achieving an overall medium-term predictive fit of some 70%. However, there is substantial short-term noise and silver tends to be roughly twice as volatile as gold to the upside and closer to three times as volatile to the downside.

This higher volatility and price asymmetry is probably best explained by the fact that the silver market is not only affected by both industrial and monetary demand but also that it is a much thinner, less liquid market than gold, with above-ground stocks only a tiny fraction of the value of those for gold. In other words, silver has a lower stock-to-flow ratio than gold. Moreover, many of silver’s industrial uses make recycling prohibitively uneconomic—at anywhere near current silver prices at least—and so once consumed by such processes, it is no longer accessible. Gold, on the other hand, is much easier to recycle and has proportionately far less industrial demand in the first place.

The Silver Price Outlook

Although it would be unusual, I believe silver has much potential to outperform not only gold but also industrial metals over the coming months. Stocks are low, and there is likely to be a surge in medical demand for silver. Yet with industrial metals demand probably declining in the same time frame due to weaker base demand, mine production may slow, implying less silver supply arriving on the market.

Given how relatively tight the silver market is when compared with that of gold, only a sharp rise in price is likely to clear the market going forward. While a rising price might be met with some selling of silver bullion, it is worth pointing out that those investors holding monetary silver generally do so because they believe that it is historically deeply undervalued versus gold at a ratio of some 100:1, far, far higher than the post-Bretton-Woods average ratio of closer to 60:1.

If I am right that monetary precious metals demand in general is likely to re-rate over the coming months, then silver is perhaps the better speculative play than gold. But it is important to note that silver’s much higher volatility with asymmetric downside and its weak claim to a modern monetary role—e.g. it no longer comprises central bank reserves— imply that silver should be understood as a speculative way to combine the monetary properties of gold with demand for silver’s numerous industrial applications, including meditech listed above, rather than as a core, long-term holding within a conservative, well-diversified portfolio of both financial assets and precious metals. In my opinion, only gold can satisfy that latter role.

John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)