Don’t ditch the insurance policy

The crisis is over and the economic recovery seems to be picking up speed. Does that mean the case for holding gold is finished? We wouldn't be so hasty.

If you've read MoneyWeek for any length of time, you'll know that we think most investors should have a chunk of their long-term savings between 5% and 10% in physical gold. As an asset class, gold works well to diversify your risk.

In other words, it tends to move in the opposite direction to most other things you own in your portfolio, such as stocks and property. That makes it good insurance against bad things happening, such as financial crises or other unexpected shocks to the system.

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However, up until the end of 2011, gold seemed like much more than mere insurance. It had enjoyed a lengthy bull market, rising from less than $300 an ounce near the start of the millennium to nearly $2,000 an ounce. But the last three years have been hard on the precious metal.

Gold has left many of its fans feeling bewildered, even disappointed in recent years (as our regular gold writer Dominic Frisby's world-weary attitude demonstrates below).

With both the eurozone crisis and the global financial crisis apparently over, and central banks in both the UK and US looking at raising interest rates rather than printing even more money, fewer and fewer investors can see good reason to hold gold.

But we think it would be a mistake to dump your insurance policy just yet. Although markets are not yet inclined to fret about it, public finances the world over are in a mess the UK's finances remain particularly dire, as we note below.

The least painful way for governments to pay off their debts is by encouraging inflation, while keeping interest rates low this leaves you with negative real' rates. It's known as financial repression' a process of confiscating money from savers to ease the burden of debtors.

This has been going on for some time, and it's likely to continue.As Julian Jessop at Capital Economics points out, even when rates rise, the "level of real interest rates in the US and elsewhere" is likely to be lower than in the past as rate hikes lag inflation.

That's good for gold it's seen as an inflation hedge and historically does well when real rates are low or below zero. To us, that's ample reason to hang on.

But beyond the monetary reasons to hold gold and silver, its fellow monetary metal there are other, more fundamental reasons to expect higher prices in future. Dominic and Bengt Saelensminde explain below, and look at ways to play these precious metals.

Why I'm still backing gold

I'm much more ambivalent about gold than I used to be, writes Dominic Frisby. Sometimes, I stare at my pot of the stuff and grow irritable. The investment is just sitting there doing nothing. It's not part of a growing firm that's contributing something. It's not paying interest.

And while it's sat there so indolent, the stock market has broken to new highs, the property market has broken to new highs, high-yielding bonds have broken to new highs.What a frustrating investment gold is!

I rather sympathise with Warren Buffett's appraisal: it "gets dug out of the ground in Africa, or someplace, then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility.Anyone watching from Mars would be scratching their head."

Yet, when it was rising at 15%-20% a year, it was protection from inflation, falling markets and governments. The point was that gold is inert. It is immutable. Gold is money.

I'm writing this on a plane headed out to Kuala Lumpur, where I'm about to give a talk on gold in a strengthening economy'. I may be the one giving the talk, but I think I'm the one who's going to gain the greater insights. As I see it, gold has become almost an irrelevance for those in the West.

Yes, people wear it as jewellery. Yes, a few nutters on the internet, yours truly among them, are shaking their heads at the systematic manipulation of money that has taken place, marvelling at how long it has gone on and concluding that gold, somehow, has to reclaim at least some of its historical role as money.

But the reality is that to the vast majority of people in the West gold is meaningless. It has hardly any role to play in their daily lives and it hasn't had for a generation or more.

However, head East and the story is different. China has become the world's largest producer and the world's largest importer. Russia is about to be become the world's second-largest producer. Indian buying is at all-time highs.

Last year, Indian gold demand (1,100 tonnes) and Chinese imports through Hong Kong (1,200 tonnes) accounted for 2,300 of the 2,600 tonnes of gold that were produced outside of China.

Now, I don't buy the theory that Russia and China are planning a new global reserve currency to be, in part, backed by gold. Gold-backed currencies have traditionally been associated with high levels of individual freedom and small government. Neither is consistent with either China or Russia's history.

But this doesn't change the fact that individuals and governments are buying. The insight I am hoping to gain is an answer to the question: why?

If the West is more advanced than the East, and the East is following the same path to middle-class-ness' that we have travelled, then gold, surely, is going to become an irrelevance to them as well. They might be buying now, but that is because their appreciation of gold is antiquated.

On the other hand, perhaps they have greater levels of monetary sophistication than we do, can see the modern monetary system for the sham that it is, and want to store wealth outside of it. I have to say, in my present frame of mind, I'm leaning towards the former.

But despite all this, I still think the gold price is going to go higher in the years to come. Here's why. Officially, China has just over 1,000 tonnes of gold. That's about 1% of its foreign-exchange reserves. But here's the thing it last announced its official holdings in 2009.

It's thought that it holds closer to 3,000 tonnes now. And even though 3,000 tonnes would make China the world's third-largest gold owner (behind Germany on 3,300 tonnes and the US on 8,100 tonnes), this still amounts to just 3% of China's foreign-exchange holdings.

By comparison, the US, Germany, Italy and France all have more than65% of their foreign-exchange reserves in gold. China badly needs to diversify as does Russia, by the way, whichhas about 9% of its reserves in gold.

So, this gold accumulation you are seeing by both the Russian and Chinese governments is not some great plan to start gold-backed money it is just sensible portfolio re-allocation. Yet it's still hugely significant.

Given the sheer scale of the numbers that apply whenever you discuss almost any topic in the context of China, if the country was to increase its gold holdings to a mere 5% of its reserves, China's government alone would have to buy more than two-thirds of last year's global production (3,000 tonnes a record).

If it were to go to 10%, not only would China need to find another 7,000 tonnes from somewhere, it would usurp the US as the world's largest owner. So the psychological impact on the gold price of China's next announcement on its gold holdings will, I believe, be substantial.

Meanwhile, gold supply could be set to fall. As I noted, global production hit a record last year. But due to the current cost pressures in mining, miners have been high-grading' (only mining the best- quality rock). As a result, the cheap-to-mine stuff is running out and deposits are being depleted.

At the same time, there have been very few new discoveries over the last five years. Exploration budgets that were there a few years back have now gone. And even when new deposits are found, environmental, geographical, economic and political hurdles mean it is taking many more years to get that metal to market than it once did.

So, there are plenty of pressures that can send the gold price a lot higher in the years ahead, whether you think the metal is irrelevant or not. And if you add to the mix the not-insignificant threat that all this monetary manipulation that has gone on for decades will actually in fact have consequences some day, suddenly you have a perfect storm for gold.

Dominic writes for our daily email, Money Morning. Sign up for free.

The compelling case for silver

The last decade has proved to be a bit of a roller-coaster ride for precious-metals investors. And none has been more volatile than silver, writes Bengt Saelensminde.

Having climbed from less than $5 an ounce in the early 2000s, the metal's bull run reached an exhilarating climax in 2011, peaking just below $50 (which is roughly where it also peaked in early 1980).

From that peak, the down leg has been hard and fast. However, as of today the metal seems to have found a solid base around the $20 mark. And I suspect that the bottom is now firmly in.

That's not because of any technical analysis or even my concerns about the indebtedness of our governments. It's down to simple fundamentals. Supply of silver is falling, while demand is rising strongly.

Historically, the main industrial use for silver was in photography. All those reels of camera film relied on silver compounds to capture images as they changed with exposure to light. But the digitisation of photography has seen these reels replaced with memory cards.

As a result of this, industrial silver demand fell off a cliff. So it's ironic that today it's the electronics industry that is giving a massive boost to silver demand and not just for cameras.

Nearly half of industrial demand for silver now stems from the electrical and electronics industries. Households the world over are accumulating ever more electronic devices, many with a very short life cycle. Landfills, drawers and lofts are filling up with defunct gadgets, each absorbing a tiny share of this precious element.

And silver isn't used only for circuitry. It's also increasingly required by battery manufacturers seeking to improve the performance of the lithium-ion batteries that power all this mobile gadgetry.

And just think about all the new demand generated by photovoltaic cells for the ever-expanding solar industry. Solar-energy demand alone is expected to consume more than 100 million ounces of silver next year.

Silver's electrical properties are not unique. For the really important stuff, the electronics industry uses gold. But with silver coming in at well under a hundredth of the cost, silver's industrial future looks secure. There's plenty of scope for prices to rise without giving itsusers an incentive to go hunting for substitute materials.

A silver bullet for bacteria

Interesting as silver's electrical properties are, it's not the area that excites me most. Instead, it's silver's unique anti-bacterial properties. The metal is perfectly safe for humans to handle, yet it has a devastating effect on all manner of bacteria, algae and diseases.

You may have noticed a growing range of consumer products such as liquid soap that incorporate silver. Socks, towels, and even bed sheets are now touted as having the capacity to self-clean'.

And with an ever-growing demand for advanced food safety and extended shelf lives, silver is even used in food packaging to keep products fresh.This goes beyond consumer goods.

With fresh water becoming an increasingly rare and valuable commodity, and populations increasing, water purification is in growing demand. Securing supplies of safe, potable water is an urgent issue in many parts of the world.

And what do most of these water purifiers need? Silver, of course! In a similar way, hospitals, pools and spas all over the globe are increasingly shifting to silver-based chemistry in lieu of unpalatable chlorine-based products.

All of these growing uses for silver require the metal on a micro, or even nano, scale. This means that the actual material cost in most applications is tiny. So don't worry, you won't be paying precious-metals prices for a bar of soap any time soon!

But it is the sheer scale of applications, along with the vast numbers of units that are touched by the silver hand, that's set to stoke incredible demand. And yet, when we look to the supply side of the equation, a severe pinch could be just around the corner, as we'll discuss in a moment.

Why is the price of silver in a lull?

With so many rapidly emerging and exciting uses for silver, you might have expected the silver price to have exploded. But, as I mentioned at the outset, the silver price is in a lull. Why?Well, as with all things of a financial bent these days, we need to look to the dark and esoteric quarters of the central banks to find out.

Because of silver's historic use as a monetary metal (in coins and the like), central banks across the world held vast hoards of the stuff. Industry insiders have been aware of significant sales out of these coffers for decades.

The recent World Silver Survey from Thomson Reuters suggests that the central banks' great silver sell-off began to peter out just before the top of the market in 2011 in typical form, governments sold vast holdings of silver during all the years that the metal traded near its lows.

Yet, just as the central-bank vaults went dry, so a new form of supply hit the markets. That came courtesy of speculators who had built massive positions in exchange-traded funds (ETF) in the bull run. These short-term punters then dumped physical silver into the market around the 2011 rout.

But right now, both of these forms of supply central-bank sales and ETF sales have stabilised. What's more, silver mine supply has also declined in the wake of a fierce silver bear market. So there you have it: falling supply and rising demand the simplest and most compelling investment case of all.

Bengt Saelensminde writes for the Fleet Street Letter, with David Stevenson. To learn more about their views on silver, and the newsletter, view their report here.

How to invest in precious metals

If you want to buy physical gold or silver, you can use a bullion dealer, such as ATS Bullion or GoldCore.com, to buy coins and bars in person, online, or by post (we have a list of providers here).

You can either take possession of the metal and store it yourself (bearing in mind the potential impact on your home insurance), or in a safety deposit box, or you can pay the dealer to store it for you.

It's worth noting that if you buy physical silver, you'll be charged VAT in the UK, whereas VAT does not apply to physical gold. Also, if you buy gold in the form of British sovereigns or Britannia coins, you will not be liable for capital gains tax.

Alternatively, you could buy gold or silver online and have it stored for you using a service such as BullionVault or GoldMoney as you don't take delivery of the metal, there will be no VAT charged on silver using these services.

There are also exchange-traded funds that are backed by physical gold and silver that you can buy via your stockbroker the ETFS Physical Gold ETF (LSE: PHAU) and ETFS Physical Silver (LSE: PHAG). Both are denominated in US dollars (you can buy sterling versions, but there's no real benefit to it the currency risk remains as the underlying metals are priced in dollars).

If you feel more adventurous, then you could consider investing in precious-metals miners. To be clear, this is very different to investing in the physical metal miners will, of course, be influenced by the price of gold and silver, but you're also taking many other company-specific risks on top.

So, for portfolio purposes, you should view investments in miners as part of your equity' allocation, not your gold as insurance' allocation.

Dominic notes that "for the miners, the worst seems to be over but it's a stock picker's market. For now, quality companies with decent operations are starting to move up.

Others companies with uneconomic mines, overpaid management, diluted share structures and so on will continue to atrophy. There's no reason to expect this to change unless either the gold price moves up or companies get their houses in order."

If you're looking to track the stocks of the larger miners, the US-listed Market Vectors Gold Miners ETF (NYSE: GDX) does the job. Or on the active fund side, you could invest in the ever-popular, London-based BlackRock Gold & General Fund.

As for individual tips, Dominic suggests Minera IRL (Aim: MIRL) as a "small cap with a decent chance of a re-rating, if it can get its financing deal in place".

Meanwhile, Bengt likes Mexican silver miner Fresnillo (LSE: FRES). It's the world's largest silver producer and also offers exposure to gold.