Nicholas Brooks on the Outlook for Silver

Jul.31.09 | About: ETFS Physical (SIVR)

Last week, European ETF titan ETF Securities started trading its first U.S. fund, the bullion- backed ETFS Silver Trust (NYSE Arca: SIVR). But with five products already on the books, does the American silver market have room for another ETF?

That's why we decided to sit down and talk silver fundamentals with Nicholas Brooks, head of research and investment strategy for ETF Securities. With over 15 years' experience as a global economist and strategist, Brooks has worked with Henderson Global Investors, Deutsche Bank and Citibank.

Recently, HAI associate editor Lara Crigger chatted with Brooks about the rise in physical silver investment, the connection between the gold and silver markets and whether the higher prices can be sustained.

Lara Crigger, associate editor, (Crigger): We've really seen an uptick in silver demand recently, especially physical investment. What's driving that?

Nicholas Brooks, head of research and investment strategy, ETF Securities (Brooks): To some degree, what's going on with silver is related to what's going on with gold. Investors view silver as a safe haven asset in the same way they do gold, and as a hedge against inflation and possible paper currency weakness. So silver is benefiting from the still-high uncertainty over the outlook for the global financial system and over what government intentions are, given the aggressive quantitative easing and the rapid run-up in government debt levels.

Crigger: We're starting to see physical investment in silver on the rise, while physical investment in gold is dropping. What's the reason for this? What advantage does silver have over gold?

Brooks: Silver is a very interesting commodity, because it's a hybrid between an industrial metal and a precious metal. About 53% of the end demand for silver is from the industrial sector, compared to around 12% for gold. So silver demand is more sensitive to swings in the business cycle than gold is.

In this environment, silver is in a very fortunate position. There's still lingering uncertainty about structural risks to the global economy, but at the same time, lead indicators of global industrial activity have picked up strongly since late February, early March. We've seen a very strong run in many of the more cyclically oriented commodities, especially industrial metals like copper. So I think silver's been benefitting from that, while at the same time, lingering concerns about the outlook for global financial stability, potential future inflation, rising government debt levels and the long-term outlook for the U.S. dollar are causing investors to increase their weightings in silver.

Crigger: So no matter whether the economy improves or gets worse, silver is poised to take advantage of the situation.

Brooks: That is where the "hybrid" nature of silver makes it quite a unique investment in the current environment. Of course, if the world is really, truly falling apart, I'd probably choose gold first, silver second, since gold still generally acts as the No. 1 safe haven and alternative to paper currency. But silver comes in at a close No. 2 and is a way for investors to diversify their position in "safe haven" precious metals. But if the global macroeconomic picture continues to improve and the industrial cycle continues to pick up, then I think silver will continue to outperform gold.

Price performance over the past 12 months shows this dynamic. In the second half of last year, when it looked like the world was falling apart, gold performed very well on a relative basis. Silver fell pretty sharply, although it didn't fall as sharply as some of the more cyclically oriented commodities, and it held up better than a lot of the industrial metals. When we moved into 2009, we saw relative performance reverse: Gold has held up well but has generally been range-trading. However, once the industrial cycle started to pick up, silver started to really move. We're still in that environment at the moment, with investors still feeling relatively bullish; therefore, silver has been the outperformer.

Crigger: Traditionally, silver has been very volatile compared to gold. But as more investors pile into silver, do you think that volatility may begin to abate?

Brooks: Silver's volatility ties back to its industrial nature: It tends to be more strongly affected than gold by swings in the industrial cycle and perceptions about where the cycle will go. Going forward, I think that will probably remain pretty much the same. Silver's key drivers - investors' desire for a safe haven and industrial demand - are unlikely to change.

Crigger: Can the fundamentals sustain these higher silver prices we've been seeing?

Brooks: We've seen a strong rise in cyclical assets since the beginning of this year, because, first of all, most of the industrially oriented commodities were at panic levels at the end of last year. As governments started to become more aggressively involved in propping up the financial system and investors' confidence came back, the snapback in prices was quite rational. They just dropped too far last year.

Also, we've seen genuine improvement in a number of the key manufacturing lead indicators, which, given silver's exposure to the sector, is another rational reason why prices would've risen.

Whether things have become a bit frothy now, it's difficult to say. I think investors' views on that will really depend on whether you think the worst of the economic crisis is now behind us, or if you think this is a bit of a false dawn, and we're due for some retrenchment. How appropriate the price is now will completely turn on whether the recent upturn in the economic cycle is sustainable or not.

Crigger: Traditionally, silver and gold have been closely correlated. Will this trend continue in the future as the economy starts to pick up (or doesn't)?

Brooks: In late 2008, the gold/silver ratio reached its highest point in almost 14 years. It's come down quite a bit in the past six months or so, and in a lot of ways, that's not so surprising given the dramatic change in investor sentiment over that period. The gold/silver ratio is still high relative to history, so if the industrial growth cycle continues to improve and there is not a near-term relapse towards crisis, there would seem to be scope for further gains in silver relative to gold.

Personally, I'm pretty bullish on the outlook for gold for a medium-term basis, because the debt issues that the U.S. and some of the other developed economies are facing are bigger than anything we've seen since the 1930s, and the problems relating to this debt are going to continue to grow. Digging out of this debt hole is going to be a lot more difficult than perhaps markets are factoring in right now. I think that uncertainty about the global macroenvironment will remain a lot higher over the next few years than it has over the past five. In this environment, I suspect gold will do well, and if gold does well, then I suspect silver will as well.

Crigger: Briefly, let's talk about the new fund. Why launch a bullion-based silver ETF in the States?

Brooks: We've had physically backed gold, silver, platinum and palladium funds in Europe for a number of years now. And what we've found is that with precious metals, investors tend to prefer to hold something backed by the physical metal, rather than futures. Precious metals are a slightly different animal than your typical investment vehicle, in that many people are buying precious metals as a safe haven. So investors like the security of knowing that they're 100% backed by physical metal in a vault. Most investment vehicles aren't, and in the kind of economic and financial environment we are in, it's especially appealing to investors.

Crigger: You also have a third party come in and audit your vaults twice a year.

Brooks: If investors are buying precious metals, they're usually buying them as insurance against worst-case scenarios, or fears of future inflation. So not only do they like the idea of their investments being backed 100% by physical metal, they also want to make sure that metal is actually there, too.

Crigger: Certainly, especially because of alleged manipulation in the gold and silver market. We hear about that quite a bit.

Brooks: For some reason, gold and silver tend to generate more conspiracy theories than any other commodity. So to assure investors that the gold and silver in the HSBC vaults is actually there, these vaults are audited. We also put all our silver metals bars on our Web site, which is updated every day, so investors can go in and see the numbers and what's actually there.

Crigger: This should put those concerned about precious metals manipulation at ease.

Brooks: Exactly. The bars held in the vault at HSBC are not part of their balance sheet. They are completely ring-fenced and they can't be lent out, which is another concern some investors bring up. I think it all comes back to what happened last year, when, in an extremely short space of time, financial systems fell apart, and credit and counterparty risk became serious issues. So now I think more investors are focused on the safety and security of their investments. Being able to see the numbers on the bars and knowing that they're audited gives them peace of mind.