Despite the overnight weakness, it’s been another solid week for precious metal investors, with gold trading just below USD $1230 per troy ounce, whilst in local currency, it is sitting just below AUD $1600 per troy ounce, with the dollar pushing well above $0.76 vs. the USD.

The bigger news has been in silver, with the little cousin of the precious metal complex now trading closer to USD $16.20 per troy ounce, up nearly 9% since the start of the month, when it was trading closer to USD $15.

The outperformance of silver in the last few trading days is giving further encouragement to those who believe the next move in this precious metal cycle will be to the upside, building on the impressive gains seen in Q1 2016.

To that end, this week’s market update is going to start with a detailed technical update on the silver market, written by my colleague Nick Frappell, who recently joined ABC Bullion as global general manager. Nick has over 20 years experience trading precious metals, and ABC Bullion will greatly benefit from his insights into the metals market.

After that, I’ll be talking the investment outlook for the decade ahead, looking at the Australian government bond market, Inflation watch and the ‘logic’ behind buying inflation protected treasury securities, before finishing with a chart of the week to do with foreign investment into Australian property, and the implications for rates, the Australian dollar, and precious metal ownership.

A Silver Special

by Nick Frappell

Silver rallied just over 12% from the beginning of the year to the Q1 high of US$16.14, before falling away after an unsuccessful challenge of the October 2015 spot high of US$16.36. The price hit support right at the base of the Daily Ichimoku Cloud around US$14.80 on April 1st, and bounced aggressively with very positive price action to breach the 2016 highs today, April 14th, with last October’s highs very much in silver’s sights at the time of writing.

What can we say about recent investor behaviour and changes in positioning, and what do technicals tell us about support and resistance levels? Silver is interesting because it looks positive, however there are certain mixed messages – at least in the sense that the price is right at key resistance levels which have served to limit silver’s price rises in recent times.

As usual, there will be a tendency towards a blizzard of numbers; however I hope to surround the discussion with some objectivity, so bear with me.

The Macro Picture

The reasons for favouring silver are approximately those that favour gold, and the adoption of a negative interest rate policy by Japan in January was a powerful trigger in boosting both gold and silver.

In addition, there is still considerable uncertainty in the world with the UK discussing ‘Brexit’, (which may or may not have significant effects on the wider world economy, (although surely those effects are not imminent) the sight of huge migration of people into Europe leading to pressure on incumbent political parties and the spectre of EU dis-unity at an institutional level.

In America, presidential candidates on both the Republican and Democrat sides talk of policies that pose a threat to the existing order with regard to both diplomatic and trade relationships. Trump is an isolationist on the foreign stage, with Cruz appearing to occupy the other end of the spectrum, to the point of belligerence, and right now it is still too early to tell between the pragmatic Clinton and the populist Sanders – he made good progress in Wisconsin and there will be plenty of attention paid to the New York primary on April the 19th.

Correlations

Silver has naturally benefited from the rally in gold, with a positive correlation between the two metals of 0.7441.

The weakening US dollar index has helped silver higher, with silver negatively correlated to the Dollar index (DXY) by 0.29, not quite as strongly as gold is.

There is some degree of correlation with Crude, (0.21) which itself has rallied sharply. Given that the daily correlation between crude and gold over the past 12 months has been negligible, it may be that there is little meaningful to say about a silver-crude link. However if there is a story, it could be along the line that rises in energy costs act as an implicit tax on consumers, particularly in relatively large energy-dependent economies such as America, and that this drag on consumer spending would tend to lessen the willingness of the Fed to raise rates aggressively. However, that is one possible narrative and one that is not mirrored in crude-gold correlation numbers…

Economics

Consumer spending is a little weaker than expected in America right now, which is a paradox considering generally positive employment figures and still low gasoline costs. However generally flat-lining housing prices and the fact that Americans have spent fairly spectacularly on cars over the last couple of years might help to explain the rather wan consumer numbers seen in the first quarter, so spending on silver appears to be a reflection of changed perceptions, rather than a discretionary choice.

Positioning

• 44 million Troy ounces of ETF buying since Feb 5th

• 180 million Troy ounces of CME futures buying on a net basis since Jan 4th

• Futures short-covering a dominant feature from mid-January to mid-March

ETF positioning in silver has grown sharply. ETF buyers have purchased about 44 million Troy Ounces since early February, (using data from Bloomberg’s ‘All Known ETFs’ function). ETF positioning had been in secular decline since about July of 2015, shedding about 31 million Troy Ounces between late July 2015 and early February of this year. The burst of buying since the low in February represents a clear shift in investor attitudes to silver.

In New York, CFTC data reveals that futures positioning has changed significantly as well. The ‘Managed Money’ category saw over 171 million Troy ounces of short-covering from those speculating on price drops in silver between the end of the year and mid-March. Over the same period, longs added 43 million Troy ounces to their positions. Subsequently both long and short positions have increased, with silver bears adding more to their futures positioning.

Those short positions were established in November through to early December 2015 at a VWAP (Volume-Weighted Average Price) of around US$14.22, and bought back at an estimated VWAP of around US$15.04.

Overall net positioning is long 211 million Troy ounces in the Managed Money category as of Tuesday the 5th of April, and that represents a net increase of 180 million ounces since the beginning of 2016, a substantial inflow into silver.

However it is worth reflecting on the fact that since the beginning of the year, just over two ounces of every three purchased on the COMEX exchange this year has been from shorts buying their positions back, relative to fresh longs entering the market.

Combined ETF and Comex Flows

Combining both ETF buying and Comex futures activity implies a net inflow of 212 million Tozs since the beginning of January.

Silver Eagle Purchases

Silver Eagle 1 Troy ounce coin sales in the first quarter have outstripped sales of coins in the same period of 2015. Total sales of just over 13 million ounces are higher by 3.923 million Troy ounces, as of yesterday, representing a year-on-year increase of 43 per cent. Whilst total sales are not as significant as the flows seen in the futures and ETF space, they represent a significant message about sentiment towards silver from a particular part of the investor community.

The Technical View

OK, let’s look at the charts, as pictures are usually worth any amount of discussion about numbers. I use Ichimoku Cloud and Point and Figure charts, the former to gain an impression of trend, supports and resistances, and the latter in particular to gauge price targets as well as key support and resistance levels.

The point and figure indicates that there is scope for a strong rally as far as the silver price remains above US$14.80 in the medium term and above the December lows in the long term.

The Weekly Ichimoku Cloud Chart

The weekly chart shows how the price has failed to break above the cloud on a number of occasions since February 2014. Silver is as that critical juncture again. Gold has led the way with a break of the weekly cloud; however there has been relatively more buying on gold via futures since December.

There is also an element of a double-bottom pattern since October 2015 which, if the price breaks above US$16.36, should create a price target to just above US$19, which dovetails nicely with the targets on the Point and Figure charts below.

The Daily Ichimoku Cloud Chart

The Daily Cloud was broken through and subsequently the price decline found support at the Daily Cloud. This cloud shows the price and the Standard and Turning lines above the cloud, and the Turning Line beginning to turn above the Standard line, all of which is bullish.

Daily Point and Figure

This huge chart, which extends back to 2013 on the left–hand side, still has substantial downside price targets, which would be eliminated by a move above US$16.36. The unfulfilled downside targets are relatively remote, and given the demand data from ETFs and Futures, seems less likely to pan out in the medium term compared with the upside targets.

Hourly Point and Figure

An hourly Point and Figure is still a medium-term chart in terms of the guidance it provides for the price moving forward. A quick run on an option calculator shows that at current spot prices and volatilities, the option market is implying a roughly 1 in 5 chance of silver reaching US$19 in 6 months, and roughly a 1 in 8 probability of silver reaching US$21 in the 6-month time horizon.

In contrast, the market currently implies a 1 in 8 chance of the price moving to US$12.80 over the same period. (That level is the nearest unfulfilled price target on the downside based on the Daily Point and Figure chart, hence the choice of level.)

Currently the silver market is pricing call options more expensively than puts, which itself tells you that the market expects the price to move higher. The upside skew is most pronounced out to 6 months, and then weakens. That may be the influence of producer hedging, as there will be some selling of calls and buying of puts from that quarter further down the curve.

Gold-Silver Ratios

The chart below shows how the recent run of underperformance has ended and that outperformance may extend to the low 70s. There appears to be significant support at 74 on the daily Point and Figure of the ratio.

(Notice how the chart fulfilled the targets to 83.80, and then reversed once the final target was reached. The targets do not imply an average level, but a local high or low from which the value may turn and retreat.)

(Charts courtesy of Updata software – data feeds by Bloomberg LP)

Summary

Silver has seen impressive buying from a number of different sources in an economic and political environment that is much more conducive to higher prices in the medium term. The caveats revolve around the resistance given by the Weekly Cloud, which silver appears to be challenging, and the substantial contribution to buying made by speculators who bet on the price going lower who have been pushed out in the first quarter of the year.

Overall, the stage is (almost) set for silver to extend recent outperformance – but look for a break of US$16.40 to help build confidence in that.

Making Money in the Decade Ahead!

JP Morgan had an interesting report out this week, which despite the global focus, has implications for every Australian in a traditional superannuation fund. Looking at the likely returns for a traditional 60/40 fund (60% of money in growth assets like shares, 40% of money in ‘defensive’ assets like bonds and cash), the author noted that there were two potential problems going forward, the “60” and the “40”.

Commenting on the extraordinary period we are living in, JPM noted that the likely returns for traditional portfolios was likely to be much lower over the next 10-15 years compared to the historical norm. Indeed, for 2016, their “assumption for a static 60% U.S. equity (S&P 500)/40% fixed income (Barclays Aggregate Index) asset allocation is now down to 6.4% annualized. This is a direct reflection of a quicker than expected run-up in equity prices (flattening the trajectory of long-term returns), as well as anticipation of a continued moderate growth, low interest rate environment. Our 6.4% annualized number is well below the whopping 11.9% return the same static 60/40 portfolio delivered for the period March 2009 through December 2015”.

They also included the below chart, which highlights the downshift in return expectations over time, comparing 2006 to 2016.

We actually think that the current return projections, modest though they are, may prove to be optimistic, at least between now and the end of the decade, with equities already looking toppy, and the yield on the US component of the Barclays Global Aggregate Bond index below 2.3%, according to a Schroder’s report we reference in detail below.

What was most interesting though were the comments that JPM made in relation to how they see investors outperforming the market in this market. The three recommendations they made were for investors to:

• Select proven active managers

• Be flexible in managing allocations

• Make prudent use of leverage

For an individual investor, this may well be intelligent and actionable advice, though it is clearly not possible for every investor to select an outperforming asset manager, nor can they all outperform through active asset allocation, dynamically switching between bonds, equities, cash, gold, etc.

The reason we are discussing this is that the average superannuation fund in Australia is also heavily tilted toward equities and fixed income assets, and the managers of these funds will face the same challenges generating returns for their members (including ABC Bullion clients with money in super) in the years ahead.

You can read the JPM report here.

The Australian Bond Market

Regular readers of ABC Bullion market updates will know we often look at the Australian stock market, at a technical, macro, and occasionally sectoral level, as it does help us form our own views on likely precious metal movements, owing to the negative correlation between the markets, and the importance of the ASX to Australian superannuation returns.

But we’ve rarely commented on the Australian bond market, preferring to talk about US Treasuries or Japanese government bonds. This week though we wanted to share some insights from an excellent report written by Schroders, which looks at the composition of the Australian bond market, and some of the risks that are becoming apparent.

First, we will start with a chart from the report, which plots the duration in years (blue line) and the benchmark yield (orange line) for the Bloomberg Australian Composite Bond Index.

What you can see from the chart above is that the duration of the market has increased noticeably, from just over 3.5 years to 4.5 years, whilst yields have plummeted (as they have in cash and property), declining from nearly 8% pre-GFC to just under 3% today.

There are profound implications for investors as a result of these developments, with the author noting that; “Not only is the benchmark becoming more concentrated (and therefore less diversified) as government issuance dominates (government/quasi government now constitutes around 88% of the index), it is also lengthening in duration as issuers (including the government) look to lock in what are historically low yields. For example the Commonwealth Government is now issuing 20 plus year bonds and is looking to further extend its issuance maturity profile. At the same time the prospective returns to investors for providing the funding is historically very low.”

Commenting on the implications, Schroders went on to note that “The changes to the characteristics of the benchmark have significant implications. For example, in 2010 benchmark duration was around 3.5 years and the benchmark yield around 5.5%. This meant that for an investor holding the benchmark portfolio, a 1% rise in yields would result in their 1 year return declining to 2% (5.5%-3.5%). In contrast a 1% rise in yields today would result in returns for the equivalent period declining from 2.7% to -2.0% (2.7%-4.7%). Another way to think about this is that for an index investor to see a negative return over a 12 month period, yields would only have to rise by around 0.5%. In 2010, a negative return would have required yields to rise by 1.6% (over 3 times as much).”

Another observation that caught the eye from this excellent read was the following, which effectively discussed indexing a bond portfolio, and whether it makes sense for an investor to make their bond exposure reflect the market for bonds itself. There is clearly a problem with this approach, as by definition the more an issuer borrows, the bigger a part of the ‘market’ they become, even though that borrowing may (and in many cases can) reflect lower credit quality from the borrower of funds. A good way of picturing this is to recognize that the Japanese government bond market dwarfs the Australian one, and offers much lower yields, despite the Japanese government being horribly over-indebted and being a far less secure bet than Canberra.

In a local context, Schroders discuss this phenomenon, and the implications for investors, noting that they’d “argue that owning the market portfolio in fixed income is intuitively flawed. This is because the market portfolio in a debt context is defined by the preferences and behaviors of borrowers (the bigger the borrowers, the bigger the exposure), both in terms of composition and characteristics. It is logical that as a borrower I want low borrowing costs, limited caveats and typically extended terms (long duration). However, as a lender it is logical for me to want adequate compensation, strong protections and my money back in a time frame commensurate with my investment goals. In other words, the link between the market (or benchmark) portfolio and my objectives as a defensive investor is tenuous.

The conclusion from the article also included a particularly eye opening comment, with the author stating that (bolded emphasis mine); “While it would be relatively easy to recognize the uncertainty of prevailing conditions and reduce risk, it is not completely clear what a less risky position is.”

There is only one asset class that is a truly defensive, highly liquid asset class with zero counter party risk, and that is gold.

Inflation Watch

The strong performance of all sectors precious metals related in the first quarter of 2016 is evidence (as opposed to proof) that monetary dynamics are changing, and the inflation may well be on the way back.

Leading asset managers PIMCO and Blackrock have even gone so far as to suggest that investors should buy inflation protected treasury securities (TIPS), as a way of hedging against this risk in their portfolios.

Livewire markets, a financial news service targeting Australian investors interviewed a range of contributors (including ABC Bullion) on our thoughts on the latest inflation dynamics.

Our thoughts, where we liken buying TIPS to buying fire insurance from an arsonist, as well as those of Saxo Capital Markets, Aimed Capital, Betashares and Spectrum Asset Management can all be found here.

Chart of the week

The chart of the week is undoubtedly this one below, which is drawn using data from the 2014-15 annual report from the Foreign Investment Review board, which you can download here.

The chart highlights approved foreign purchases of Australian housing, both existing and new dwellings.  As you can see, there has been a veritable explosion in money pouring into the country, with a large component of this directed towards new dwelling construction.

Undoubtedly, this has helped the economy ‘transition’ from the unwinding mining boom, and has helped keep a lid on rising unemployment. To help visualize how important it has been in supporting the economy in the last few years, consider the following chart, which comes direct from the FIRB report. As you can see, since 2010-11, investment approvals for real estate have risen from circa AUD $40bn to almost AUD $100bn, now neck and neck with “other sectors”, which are declining due to decline in mining investment.

Having said that, we’ve long warned of overvaluation in Australian property, and remain largely unconvinced about the supposed Australian housing shortage. As such, we think a lot of these proposed investments will end up being seen as gross capital misallocations, with the country jumping out of the frying pan (commodity bubble) and into the fire (housing bubble).

Callam Pickering, a local economist well worth paying attention to, discussed these latest trends in a well-written piece over at his blog, CP economics. Commenting on the implications of this influx of capital at this point in the cycle, Pickering stated that; “I view the risks in this sector to be at, or at the very least near, their highest level in the past two decades. The potential glut in housing supply could act out a bit like the fall in commodity prices: new supply comes online, property developers have overestimated demand and prices plunge, which puts increasing pressure on new developments in the pipeline.”

Callam’s piece can be read in full here.

As regards the potential implications for gold – they are clear. Deterioration in our housing market will almost certainly lead to further (and potentially significant) reductions in domestic interest rates, further punishing savers and forcing them to look for alternatives, as well as exert downward pressure on the Aussie dollar.

These aren’t positive economic developments, but we can only play the hand we’re dealt. Physical precious metals are definitely the ace up your sleeve.

Until next week

Jordan Eliseo

Disclaimer

This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.