Silver - fundamental outlook for next year

Summary:

• Silver and gold are perceived as safe haven assets

• Both commodities tend to move in the same direction in the long-term

• Silver may benefit from calmness across markets on the back of a different demand profile

• Speculative positioning suggests that silver remains oversold

Weak 2018

This year has not proved to be successful for investors in the silver market. Solid gains were seen only at the turn of 2007 and 2008 due to a massive retreat in the equity market. Subsequently, range trading began and the price was trading between $16.2 and $17 during the first half of the year. This consolidation moved toward a profound sell-off during the second half of this year. What was the prime cause behind this change? The answer is the strong US dollar and a rally seen in equity markets across the globe. The greenback was supported by higher bond yields as well as the anticipated quicker pace of monetary tightening (4 instead of 3 hikes this year). The last move (the 4th rate increase) could take place this Wednesday. In recent weeks we have seen some signs of a bounce in silver prices but momentum has been weakish so far. The similar scenario has been seen in gold prices. Will silver prices follow gold prices if the latter go up?

Gold prices have moved higher compared to silver prices in recent weeks as evidenced in the chart above. Note that gold has reached the bottom sooner than silver. Source: xStation5

Production and costs

Silver output shrank last year compared to the level seen in 2015 and it is expected to shrink this and the following year. As a result, the deficit has occurred. Mining costs are hard to determine due to the fact that silver is mined as if ‘inadvertently’ when other industrial metals are mined - copper in particular. However, cash costs are estimated to be around $11 per ounce (the average global cost), whereas total costs are estimated to be between $13 and $16 per ounce (not that this is again the average range and costs differ markedly as we move from one mine to another one). As a consequence, one may arrive at a conclusion that silver production should not fall substantially in the years to come. Nevertheless, in case of gold one may expect further production declines which to some extent could lower silver production as well.

Gold production is forecast to fall in the next year, therefore the silver market could experience lower output alike. What’s more, the lower gold production could translate into higher gold prices and thereby silver prices. Source: Bloomberg

Where does the demand come from?

Industrial demand should account for a lion’s share of the total demand in the silver market next year. It could be tied to a marked increase of demand in sectors such as automotive and photovoltaics. Furthermore, nowadays there is increasing interest of alternative sources of energy with a move toward cars being powered by these energy sources.

Industry could constitute the largest portion of demand in the silver market. Source: Bloomberg

Higher expected household income in India may boost the jewelry demand. Source: Bloomberg

The investment demand does not look so optimistically. ETF funds shed some of their silver holdings in the past quarter. What’s more, negative correlation between these holdings and silver prices arose. However, higher gold prices seen in recent weeks could bring an end to this. Source: Bloomberg

Are bond yields a good leading indicator?

The gold/silver ratio is high but there could be some delay in case of silver prices which needs to be taken into account. For example, in 2011 the peak in silver prices occurred six months after the peak in gold prices. The same was seen in 2016. Nevertheless, some relationship could be seen also between the gold/silver ratio and the US 10Y yield. After the latter has seen a massive decrease in recent weeks one may suspect that the ratio could move south soon. What’s more, if the Federal Reserve delivers a dovish hike, yields may continue moving down and weighing on the mentioned ratio. In addition to this, a possible extension of falls in the equity markets could support higher gold and silver prices as well.

US yields point to overvaluation of the gold/silver ratio. However, it needs to be said that it does not mean that silver prices have to rise - gold prices may simply rise slower than silver prices in order to see the lower ratio. Source: xStation5

Speculative positioning still points to silver undervaluation

The net speculative positioning remains negative but it has rebounded of late. However, a number of longs has not increased suggesting the weak bullish momentum. Source: Bloomberg

Silver - a chance for higher levels

Based on historical movements of silver prices one may suspect that silver prices may have already bottomed out. The pace of rate hikes in the US is expected to slow in quarters to come and economic growth should lose some momentum next year. Seasonally, gold and silver prices tend to rise when a year kicks off and we think that this scenario could repeat at the beginning of 2019.

Silver prices tend to increase when a year starts. Source: Bloomberg

Based on some technical patterns one may expect a rise in silver prices at least by $1.4 per ounce. Nonetheless, if the Fed turns out to be more dovish, it could push silver prices yet higher. Therefore, we recommend to go long at a market price with a stop order at $13.75 and a target at $15.65 and $17. Source: xStation5