The silver market: Near-term scenarios and long-term prospects

By:
on Aug 23, 2022
  • Paper silver prices declined sharply last week pressured by a stronger dollar.
  • David Morgan believes that silver could perform well in the coming months even amid a recession.
  • The long term case for silver is still strong with shrinking supply expected to provide outsourced gains.

Perhaps nothing in the market should surprise us these days. Surging inflation has ravaged the economies of many a country, while supply chain bottlenecks continue to persist in a variety of sectors. Pent-up demand resulted in a meteoric rise in the price of essentials, with a high likelihood of this trend continuing.

An incendiary geopolitical climate, new viral variants and extreme droughts in several regions added to the malaise.

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Natural gas prices skyrocketed, particularly in Europe, while crude oil has receded to the 80s and 90s. The dollar is at multi-year highs with market confidence in global growth taking a turn for the worse.

Global central banks are attempting to force normalization after more than a decade of ultra-loose policies. In such a chaotic economic environment, several key commodities raced higher this year before snapping back violently amid a strengthening dollar.

Source: Business Insider, MarketWatch, Investing.com

David Morgan, a globally renowned metals expert expects that the “stuff we need, food and energy, is probably going to continue higher” for the foreseeable future.

Amrita Sen, a leading expert on oil and energy economics agrees that oil prices are likely to rebound sharply this year, and forecasts them to rise to approximately $120 by year-end.

Silver price

Silver traded at highs of $26.9 as recently as March, but has slid nearly 29.8% since then to $18.87 at the time of writing.

During the previous 5 sessions, the metal has fallen 6.8%, and despite the surge earlier in the year, is down 19.3% YTD.

The recent weakness in silver has been a function of the accelerating dollar, which continues to strengthen amid global headwinds. The Dollar Index or DXY now stands at 109, having risen 2.3% in the previous 5 sessions, and 13.6% YTD.  

From the above graph, we can see that this year silver prices have moved largely in opposition to dollar strength.

This is expected since international commodities including silver are priced in dollars which usually implies that a rising dollar will lead to falling prices.

Jim Wyckoff, a financial journalist with expertise in the stock, financial and commodity markets, notes that with the inverse relationship to the dollar, buying pressure for silver and other precious metals has fallen across the board.

Despite the continuing price weakness of silver in the summer, having fallen 13.3% in the previous 3 months, physical demand is extremely strong. At June’s end, inventories of silver in London vaults reached a six-year low, driven by relentless investor appetite.

Neil Vance, the General Manager of the Perth Mint also stated that production is unable to keep pace with physical demand.

Echoing Vance, Steve Penny, a full-time trader specializing in silver, gold, and uranium, also added, “What’s the price of silver today? What we’re seeing is the price from the supply and demand on paper contracts that are bought and sold and created at will on the commodities exchange…. The physical market and paper market are two different things.”

This suggests that the preference for physical silver in times of market uncertainty and high inflation is robust compared to paper silver. In fact, the strong dollar may be paving the way for buying opportunities in the physical space.

As discussed in an earlier piece on gold derivatives, there seems to be a deep dichotomy between the physical and paper markets for silver.

Where can silver go from here?

With discretionary spending and industrial activity struggling to gain momentum, commodity prices have generally come off the highs that they reached amid the onset of the Ukraine-Russia conflict. It could be argued that the slowdown in China would only further slow the demand for metals including silver, consequently pulling prices down, as seen during the previous week.

However, many experts including Morgan and Matt Watson, founder of Precious Metals Commodity Management hold an altogether different view.

Silver supply

Silver supplies are becoming tighter, which could prove beneficial for investment demand. According to Morgan, the metal could even perform well in recessionary conditions.

In fact, he believes that unlike the more common claims of the greening of the economy pushing up silver demand and influencing price, the contraction in supply could be a much more supportive factor in the long run.

Silver is sourced from two types of mines – primary and secondary. As per Gold-Eagle, Primary mines are those where silver extraction accounts for the bulk of revenue operations.

Secondary mines, on the other hand, are where silver is a by-product in the process of mining other substances such as copper and lead, and thus, makes up a smaller share of revenues.

Estimates suggest that two-thirds to 70% of global silver is obtained from secondary mining operations. This implies that the supply of silver depends directly on the health of the base metals demand.

The ongoing slowdown in GDP and further economic contraction signalled by inversion in the US yield curve will ultimately lead to a reduction in silver extraction. 

Secondly, in the current environment, with oil prices expected to rebound, silver mining costs will increase substantially. The biggest outlay in operations is usually oil costs, which can account for 25% of input.

This could push many marginal mines into the red, making them economically unviable and forcing closures or prolonged maintenance. Morgan anticipates that this would take ”a great deal of silver supply off the market,” resulting in a “measurable” decline in output.

Mike Maloney, the founder of GoldSilver.com estimates that in the case of a severe downturn, this decline in output could equate to more than half of silver production.

Such a “double whammy” to both primary and secondary mining operations, could lead to demand outstripping supply, ultimately pushing up prices.

Silver demand

Precious metals are qualitatively distinct from base metals. Base metals are utilized only in industrial applications, and thus, are tightly correlated with the macroeconomic cycle. Precious metals on the other hand, such as silver, are “a unique set because they represent money or financial stability.”

Although a deep economic slowdown is imminent and base metals are likely to continue their decline, the demand for silver may see an uptrend in line with falling confidence in local currencies, lack of political trust and soaring national debt burdens.  

This echoes Professor Harold James’ comments on the “millennia-long link between money and precious metals”.

Vance notes that the Perth Mint has seen “an incredible surge in demand…in times of uncertainty, people to move to a safe haven.” He notes that in the last 12 months leading up to July 2022, physical sales of silver by the Mint have dwarfed those of gold by nearly 18 to 1.

Much of this demand may have been a result of silver’s comparative affordability vis-à-vis gold, as well as the Gold-Silver Ratio (GSR) which we will discuss a little later.

Silver is a unique element because not only does it act as a store of monetary value like gold, but akin to base metals has industrial demand.

Due to its extraordinary properties of light, heat and electric conductivity, industrial demand accounts for approximately 50% of silver demand. It is used in cell phones, semi-conductors, batteries, refrigerators, washing machines and plenty of other electronics.

According to the Silver Institute, one of the key growth areas for silver demand is solar-PV manufacturing which is expected to see rapid growth amid the global energy transition.

It should be noted that most silver once used is not re-cyclable and ultimately reaches landfills the world over. This implies that the total volume of silver available has the potential to keep declining. Further, substitutions are very difficult.

In the longer term, Morgan believes that there is a clear trend toward silver demand outstripping silver supply. He refers to this as a “natural corner”, where the silver market is fully bought up due to industrial demand.

Although this may represent an extreme scenario, Morgan does believe that such a situation may be “on the cards.”

What does the future hold – near and far?

Silver is arguably the most undervalued asset right now, given that it is trading at half of what it was in 1980. With demand set to increase and supply being squeezed, there appears to be great potential to the upside.

In the near term, Morgan notes that there is a strong seasonality between silver and mid-term elections in the US, suggesting that on a historical basis, the metal would be expected to strengthen till the end of the year.

However, as discussed, the strength of the dollar and Fed actions will likely have a high degree of impact on the silver price.

Silver’s near-term direction will depend on what markets expect the dollar to do, and that depends heavily on what the Fed is likely to do in its September meeting.

Source: CME

If the Fed hikes rates, non-interest-bearing assets such as precious metals become less attractive vis-à-vis financial products.

Given its global reserve status, portfolio flows into dollar assets would strengthen the DXY further, pushing down the price of paper silver.

At this time, market expectations suggest that there is a 60-40 chance that the Fed will hike by another 75 bps.

If the Fed were to stay on its hawkish path and hike by three-quarters of a per cent, the market will have greater confidence in the Fed’s credibility to continue to fight inflation. As a result, silver will likely decline in favour of interest-bearing assets.

At the same time, given the brief reprieve the US has seen from slowing inflation, monetary authorities may only choose to hike by 50 bps. This will most likely be viewed as a weakening of the Fed’s resolve, a possible course reversal and would likely be beneficial for silver prices.  

With the Jackson Hole Economic Policy Symposium later this week, financial markets will be searching for any indication as to what the Fed will likely do in its FOMC meeting next month.

Phil Carr of The Gold and Silver Club believes that there is a possibility that the Fed may look to surprise the markets altogether with a super-sized 1% hike, which would certainly create a frenzy for dollar investments and drag down silver.

Well-known analyst Peter Schiff of Euro-Pacific Capital does not expect the Fed to be able to continue to meaningfully tighten and believes that the Fed’s response thus far is “wholly insufficient” to curtail inflation.

In the longer run, Watson believes industrial demand for silver may be too much to furnish demand. He expects that in 20 years industrial demand will outstrip the inevitable contraction in supply.

Unlike other commodities, such as crude oil, the rising price of silver may not act as an effective counterweight to more demand. This is because it is used in very small quantities in any product, rendering its price inelastic.

For instance, researchers identified that in a cell phone there may be approximately 35 mg of silver. Today, 1 gram of silver is trading for $0.6, implying that the current market value of silver in the average cell phone is probably in the ballpark of $0.21.

Even a 5-10x surge in the cost of silver input would be easily absorbed by the cost of a cell phone which may sell at over $1,000. Thus, there is next to no economic incentive to reduce silver demand or develop a substitute (which has its own challenges) given higher prices.  

Without a quantum leap in the efficiency of using silver for technological applications, there may come a time in the not-so-distant future where a silver budgetary constraint may force the market to prioritize some products over others, such as semiconductors over jewellery and silverware.

How to invest in silver?

Morgan recommends everyone to “commit some (capital) to the silver market,” especially if investors are on the younger side and have a long-term horizon of over a decade. He adds that he is not suggesting that investors put the bulk of their savings here.

Penny notes that “we’re clearly in a buy zone.” He adds that “anything under $20 in silver is just an absolute gift” although he cautions that investors shouldn’t necessarily expect a turnaround “tomorrow.”

It is important to remember that silver has a deeply speculative element given the very small size of the global market. Financial flows of any significance in or out can cause severe volatility.

The Gold to Silver Ratio (GSR) is an important indicator to follow when making investment decisions around these metals. It represents the number of ounces of silver that are needed to purchase an ounce of gold.

In 2011, silver outperformed gold, and the GSR reached 31, has steadily increased and is trading between 91 and 92 at the time of writing.

At these elevated levels, one could argue that silver is undervalued compared to gold.

Morgan suggests that even long-term gold investors could look to purchase silver and hold for “a couple of years till the ratio falls to 40 to 1.” Then investors will be in a position to purchase twice as much gold for financial protection as today.

In this earlier piece, would-be investors can understand the strengths and weaknesses of both gold and silver in building a savings strategy.

Maloney echoes this sentiment and states that he tends to only buy silver at ratios greater than 75:1.

The expectation is that in time, the ratio will revert towards the mean (depending on the time frame chosen), meaning that silver prices will tend to rise faster than gold.

Penny notes that “nothing goes straight up”, and “what we don’t want to see are lower lows.” He expects that silver will continue to shift higher as long as it stays above $18, a recent technically-defined and psychological low. If silver stays above $18, financial algorithms will continue to purchase the metal.

According to Penny, “in the months ahead we are likely to see a fantastic rally in silver.” Crossing $21.5-$22.0 will confirm that the metal has broken through its resistance band, and will signal a “technical reversal in silver” in the coming months. This is a price band that investors and traders could keep an eye on.

Taking a decadal view of the metal, Peter Schiff expects that there “will be an explosive rally I think that will rival the percentage gains of the 1970s.” In 1970, silver was approximately $1 an ounce and by 1980, this was trading in the vicinity of $50, so “there is a long way for these metals to go yet.”

As a new investor looking to dip your toe in investment waters, physical silver can be a good option to diversify your portfolio as an inexpensive but highly liquid savings mechanism.

In the near term, all eyes will be on Jerome Powell at Jackson Hole come Friday.

Do keep in mind that none of this is investment advice and your reading of supply, demand, oil prices, dollar strength, recession risks and future price movement may differ from the above.

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