LONDON (GFMS) -- At the beginning of the year analysts are busy trotting out their forecasts of how it's going to be this time round. Probably the most comprehensive listing of who thinks what in the precious metals' world is the annual forecasting exercise sponsored by the LBMA.
Last year's consensus turned out to be insufficiently bullish right across the precious metals complex. Although I'm still positive towards gold, silver, palladium and platinum - in that order and even from current levels - it worries me that this time around the consensus is likely to be an extremely bullish one. What might go wrong?
The biggest threat is that, far from continuing to grow, the investor inflows that have driven precious metals prices begin to reverse. That could happen for a number of reasons. A key one though is that U.S. short-term interest rates rise much further and for longer than expected. At present there is a widespread view that the Fed will stop at 4.75% or 5.00% and that Ben Bernanke is an "inflation dove."
But what if U.S. economic growth surprises to the upside this year and Mr. Bernanke and his colleagues therefore have the motive and opportunity to raise rates beyond expected maximum levels? In such case, we could see a gold contango of over 5%. That fact coupled with spot gold prices at a 24-year high could test the nerve of the longs and encourage some enthusiastic short selling; possibly even some producer selling at the margin.
A continued rise in U.S. short-term interest rates could kick away another expected prop for precious metals this year, namely the long-awaited slide in the U.S. dollar. Last year the focus on interest rate differentials, as opposed to the twin deficits story, did a lot to boost the U.S. currency, much to the surprise of many analysts, including myself.
My view remains that inevitably the dollar's poor fundamentals will reassert themselves but, regarding 2006, this is partly based on U.S. rates topping out and even starting to fall before year-end. If, instead, U.S. rates continue to rise and, especially, at a faster pace than in either the Eurozone or Japan, then it's not inconceivable that the dollar's slump is once again postponed. Notwithstanding some occasional de-coupling of gold and the dollar, that could spell trouble for the yellow metal and by extension, the rest of the precious metals complex.
The Devil's Advocate also has some evidence in favour when looking at precious metals' supply/demand fundamentals. Taking first the demand side and gold, here GFMS is forecasting a price-induced fall in fabrication demand in the first half. This is mainly due to an expected year-on-year slump in high carat jewellery sales in developing countries, in particular India. And, price-sensitive India could also prove problematic when it comes to silver jewellery demand.
Meanwhile, last year's star performer in the jewellery firmament, palladium, would be highly vulnerable to any setback in the Chinese market. As for platinum, at prices above $1,000/oz this metal is being forced back into a niche jewellery category.
On the industrial front too questions would be asked about the sustainability of demand for, especially, the white metals. With over 40% of its demand now in industrial uses, silver is more vulnerable than ever to slower global industrial production growth. And as for the PGMs, what if forecasts of increasing auto production turn out to be wide of the mark? That, plus the impact of continued thrifting, could see less PGMs than expected end up in autocatalysts this year.
On the supply side of the metals, gold mine production after a flattish trend in recent years now looks to be starting a period of fairly strong growth. As with the other precious metals, this will not be enough in 2006 alone to create a supply shock but if investors start to perceive that the outlook for mine production has changed, then that alone could be a big negative for prices. Supply from above-ground stocks may also be an issue this year, at least for gold, silver and palladium.
GFMS are expecting some reduction in official sector gold sales in the first half, mainly due to some moderate buying from outside the Central Bank Gold Agreement. Though, what if this does not materialise and, instead, other sellers emerge to take advantage of $500-plus gold? In silver too, we could see a higher than expected level of government sales if prices remain closer to $10 than $6/oz. And, finally, in palladium, there are large stockpiles in both Russia and Switzerland that could come into play at the right price.
In conclusion, the supply/demand risks cited above are material ones but on balance are likely to be tempered by, for example, demand gradually adjusting to higher prices or countervailing buying emerging on price dips. Sentiment, after all, remains very positive and setbacks to precious metals prices - this year at least - are more likely to attract bargain hunters (both investors and end-users) than to signal a general rush for the exits by existing longs. This is particularly likely to be the case if, as I expect, both U.S. short-term interest rates and the U.S. dollar decline before the year is out.
So, in spite of some clouds on the horizon, the bull market in precious metals looks set to continue in 2006.
Philip Klapwijik is Chairman of GFMS.