Silver Weekly: Industrial Demand And Its Implications For Prices

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About: iShares Silver Trust ETF (SLV)
by: Orchid Research
Summary

SLV has stabilized thanks to its safe-haven characteristics.

ETF investor sentiment toward silver has improved markedly in recent weeks; speculative sentiment remains negative.

As silver is significantly impacted by industrial production growth, rising US-China trade tensions could deteriorate silver’s fundamental picture.

Although SLV looks relatively cheap compared to GLD, we expect SLV underperformance to continue in the coming months.

Introduction

Welcome to Orchid’s Silver weekly report, in which we wish to deliver my regular thoughts on the silver market through the iShares® Silver Trust (SLV).

SLV seeks to track the performance of silver spot prices by physically holding silver bars in England or New York.

The physically-backed methodology used by SLV prevents investors from getting hurt by the current contango structure of the Comex silver forward curve (forward>spot), contrary to a futures contract-based methodology.

Source: Trading View

SLV appears to have stabilized since the start of May, in part benefiting from friendly macro forces following the escalation of the US-China trade war.

Although ETF investor sentiment has improved recently, we believe that rising US-China trade tensions could undermine the industrial demand for silver, which accounts for nearly 60% of physical silver demand.

As silver is more cyclical than gold, we believe that SLV could continue to underperform relative to GLD in the coming months.

Speculative positioning

Source: CFTC

Based on the latest Commitment of Traders report (COTR) provided by the CFTC, non-commercials turned net short Comex silver in the week to May 7, for a second time this year.

Non-commercials cut their net spec length by 481 tonnes from +332 tonnes (1% of OI) on April 30 to -149 tonnes (0% of OI) on May 7. This was exclusively the result of fresh shorting (516 tonnes), while longs lifted slightly their exposure by 35 tonnes.

Speculative sentiment toward silver remains negative whereas that toward gold seems to have improved as a result of the escalation in the US-China trade dispute (producing stronger safe-haven demand).

Although the current silver’s spec positioning is already bearish (current net spec length: -149 tonnes vs historical average: +4,131 tonnes), the speculative community could become even more bearish and hold a net short position as large as in September 2018 (-4,506 tonnes, as shown in the table above).

Implications for SLV: In such a bearish case, silver spot prices would fall markedly (~10%, in our view), which would in turn push lower the value of SLV.

Investment positioning

Source: Orchid Research

ETF investors lifted their silver holdings by 26 tonnes last week, pushing the month-on-month pace of net inflows to 166 tonnes from 152 tonnes a week ago. ETF silver holdings rose for a fifth straight week

In the year to date, ETF investors remain net sellers of 311 tonnes.

Source: Orchid Research

ETF investors have boosted their silver buying since the start of May. This is due, in our view, to the increasingly interesting value proposition that offers silver compared to gold.

The gold/silver price ratio is at ~87, at its highest level since 2009 and far above its historical average (2001 to present) of 64.

Source: Bloomberg

As investors become aware of this mispricing, they switch their interest from gold (whose ETF holdings have moved sequentially lower amid a fragile sentiment) to silver.

Implications for SLV: Silver ETF inflows are pushing the monetary demand for silver higher, thereby lifting silver spot prices and SLV.

Industrial demand and correlation with silver prices

Although silver is a safe-haven asset and therefore tends to perform well when financial conditions become turbulent, it also is a cyclical asset due to its industrial demand.

According to the Silver Institute, industrial demand represented nearly 60% of physical silver demand.

Source: Silver Institute

We received an interesting comment by a Seeking Alpha member last week after the publication of our previous Silver Weekly (see: Silver Weekly: Underperformance Likely To Continue On Weak Fundamental Demand, May 7, 2019).

As a reminder, it is statistically correct to refer to “correlation” when we deal with two stationary series. But because the silver price and fundamental silver demand are not stationary, “co-movement” is more appropriate when describing their relationship.

Interestingly, if we look at the year-on-year changes in the silver spot price and the year-on-year changes in the global manufacturing PMI, these two series become stationary and therefore, a correlation analysis can be made.

Source: Bloomberg

We estimate that the correlation between the year-on-year change in the silver spot price and the global manufacturing PMI is +0.29, a clear evidence that industrial production dynamics (and therefore industrial fabrication for silver) have a fundamental impact on silver spot prices.

Worryingly, the escalation of the US-China trade dispute could push industrial production growth below trend, which in turn would be negative for industrial demand for silver, silver spot prices, and thus SLV.

Conclusion

Although we recognize that SLV has become increasingly cheap judging by the gold/silver price ratio metric, we would not be surprised to see silver continuing to underperform considering that 1) silver is more a cyclical asset than gold (and thus more negatively impacted by the US-China trade dispute) and 2) industrial demand for silver could be negatively impacted by US-China trade tensions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Our research has not been prepared in accordance with the legal requirements designed to promote the independence of investment research. Therefore, this material cannot be considered as investment research, a research recommendation, nor a personal recommendation or advice, for regulatory purposes.