IAU - CEF: How To Invest In Gold And Silver As They Rise In 2023

2023-03-25 02:13:29 ET

Summary

• The Sprott Physical Gold and Silver Trust is a closed-end fund with strong appeal as an efficient and safe vehicle for exposure to these two precious metals.
• Numerous tailwinds are already in place that see us likely to be at the early stages of a structural bull market in gold and silver.
• The gold and silver bullish run has been contained by the USD holding up ok and a relatively hawkish Federal Reserve. Such trends look increasingly likely to end soon.
• This fund on average trades at a 3-4% discount to the NAV. With increasing economic turmoil in the world, expect it to trade in line with NAV in the future.

Introduction

The Sprott Physical Gold and Silver Trust ( CEF ) is a closed end fund (“CEF”) that invests in gold and silver. The metals are fully allocated for and held at The Royal Canadian Mint. Currently the mix is around 2/3 in gold and 1/3 in silver. Based on their history I would not expect this to change significantly in the foreseeable future. For gold bulls or who also are of the belief that silver is cheap versus gold on a long-term historical basis this CEF may be ideal. If one was to take an outright bet on silver that can be a volatile ride.

The structure enables an investor to redeem units in exchange for the physical assets, however subject to very high minimum amounts and fees are involved. It is worth mentioning though, as this feature assists in ensuring CEF does not trade at a material discount to NAV like other closed end funds. This is evident when one examines the very long histories of other Sprott closed end funds such as The Sprott Physical Gold Trust (NYSEARCA: PHYS ) and The Sprott Physical Silver Trust (NYSEARCA: PSLV ).

The MER of CEF is only 0.49%, so it still compares very competitively against various gold and silver ETFs. CEF is large and liquid with AUMs of circa $3.8 billion.

Is silver cheap versus gold?

Silver looks primed to mean revert with the historical relationship to the gold price, implying silver is cheap in comparison.

It is not too difficult to imagine the gold / silver ratio moving towards the 65 area on the below chart. That would imply a silver price of some 30% higher than current levels, in a scenario that the gold price was unchanged.

At the start of the pandemic, it was noticeable that silver was positively correlated with the gold price increase and tended to move by more. We have seen far less of this dynamic play out with the latest surge in the gold price over the last five months. As a result, silver looks to have more upside potential for the remainder of this year.

CEF will capture a significant part of such a trend, with its current approximate 32% silver exposure. Of course the obvious question is why not take direct exposure to silver, such as via the Sprott Physical Silver Trust? That may well suit many investors, I happen to prefer the likely less volatile ride with CEF, even though I am still bullish on the silver price. CEF does have a slightly lower MER, and the 5-year average discount to NAV is slightly larger compared to the Sprott Physical Silver Trust.

Reasons to own silver in 2023

For those wanting to dive deeper into the bullish silver arguments, this article from Sprott themselves expands on 10 reasons to own silver . To quote one reason directly “ silver plays an integral role in technology, especially innovations critical to fostering a more environmentally-friendly future ”. I find this quite interesting with all the attention this area is getting. At the same time though the silver price is not that strong compared to gold in recent months like we saw at times during 2020.

Gold supply is being limited in the last decade

The top gold miners of the world are simply not spending anywhere near as much on capex given that we see the gold price reach the same heights again as 2012.

Decade long trends such as above act as a powerful potential catalyst for a major gold bull market in the 2020s. The 1990s saw investors fall in love with technology, and investing in commodities was shunned and the sector under supplied. This dynamic helped set up many powerful bullish moves in various commodities including gold over the following decade.

With 2022 having been an awfully tough time for technology investors some similarities are evident now. Gold has also been relatively unpopular over the last decade until it has come to life a bit this year.

Another limiting effect on the supply of gold in recent years has been the popularity of gold companies using share buybacks rather than pursuing organic growth plans. To quote directly from this S&P Global article last year “ With gold production plateauing in the near term and expected to decline over the next five to six years, the industry is not making enough new, high-quality discoveries to support the long-term pipeline,” said Commodity Insights analyst Kevin Murphy.

China re-opening and central bank buying are positive for gold demand

With gold jewelry demand representing circa 50% of total gold demand, it is well worth still paying attention to this demand source. China and India are the major buyers in this regard, and in China February saw the strongest wholesale gold demand since 2014. Notably this article also discusses strong Chinese central bank buying interest continuing from late last year.

It is not only the Chinese central bank that are showing more appetite for gold. Collectively we saw central bank net purchases of gold surge in 2022, with reports that 2023 demand is off to a strong start.

Negative US real rates persisting is bullish for gold

There are various inflationary pressures that are to some degree structural and will struggle to be contained successfully like prior decades.

• Earlier I discussed the under investment in gold and that can also be seen in other commodities including agricultural.
• In a world of rising geopolitical tension, onshoring is becoming more of a trending story these days than offshoring.
• Despite the heightened risks of recessions across the globe, surprisingly unemployment has not risen substantially, so labor markets are relatively tight.

The first two points above involve factors that may continue to see inflation remain high despite the efforts of the Federal Reserve’s rate hikes.

Whilst the last point about wage inflation pressures could more likely be solved by rate hikes, doing so may be a very negative scenario for other assets such as equities. Gold may still be a better alternative.

With somewhat sticky structural inflation due to factors such as above, the risk is that we continue to be in a negative real rates environment.

Whilst the Fed surprised many with their hawkish stance last year, such a stance will be awfully harder to maintain in the back half of this year. With the lagged effects of monetary policy, we are likely to see more broader economic weakness and outside pressures for them to change course. It will become easier to point to this and cut rates because forward indicators suggest inflation can come down. At present this is not quite so palatable as they don’t want to be seen as being too reactive to a banking crisis.

Inflation pressures may well ease later this year, but perhaps not enough to remove the negative real rates environment we are in that is helpful for gold.

US dollar risks mounting to provide further catalyst to the gold bull market

Aside from potential Fed rate cuts as being negative for the USD, there are other downside risks.

The nation’s growing debt is becoming more of a discussion point yet again. The cost of servicing such debt has been increasing and having social security payments linked to the high CPI do not help.

Other large players in the global economy such as China and Russia are looking for ways to reduce their reliance on US dollars. I touched on central bank buying of gold earlier which is a related point. There is also the increasing desire from a large part of the world to seek alternative ways to trade.

The USD held up better than many expected for much of 2022 which limited the degree to which a new gold bull market could be formed. Increasingly the signs such as above are negative for the USD and bullish for gold.

A limiting factor to gold’s performance when the pandemic took hold was also the popularity of bitcoin. The factors that would normally lead some investors to buy gold in some cases steered them towards bitcoin instead. Whilst bitcoin has bounced back strongly in 2023, I would note its disappointing performance since inflation risks became a major issue at the start of 2022.

Risks

I see the future performance risks for CEF mainly revolve around the chance that we see much of the structural supply side inflationary pressures I discussed earlier come to an end. That could happen at the same time we see a US recession. Yet in such a scenario CEF may suffer less badly than equities as an asset class. Longer dated US treasuries would likely perform better in such an environment.

If supply side inflationary pressures ease in a “soft landing” type scenario, CEF may well underperform equities markets.

Conclusion

Numerous tailwinds currently exist for gold and silver to continue to outperform this year. Some factors that held back the precious metals rally since the pandemic are I believe coming to an end. I refer to the USD initially holding up well, and the Federal Reserve tightening aggressively from last year.

CEF is a good way to play the continuation of what is likely a structural bull market in gold and silver. It often trades at a discount to NAV of 3-4% which hasn’t varied much in the past five years. With the competitive MER of less than 50bps, it is appealing to those that like the structure of fully accounted for physically backed precious metals held at The Royal Canadian Mint. These attributes may well see that usual discount close in the future.

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