Why precious metals will shine again

Precious metal prices may have taken a breather recently, but there's no reason to suggest the upswing of the past few years is over. Demand is strong and prices are likely to carry on rising.

Precious metals have taken a breather over the past few weeks. Gold and platinum have slid by around 14% from their March records; silver and palladium are a fifth and a quarter below their March highs respectively. But the upswing of the past few years in this sector of the raw material market looks far from over.

For starters, there is "further upside potential" in platinum prices, as Barclays Capital notes, given the prospect of further disruptions to electricity supplies, and hence mine output, in South Africa, which accounts for 77% of global production. Power problems are expected to persist for years.

The main driver of demand is the automotive sector, where platinum is used in catalytic converters. Growth in this area has been largely resilient to high prices owing to increasingly stringent emissions standards worldwide. Note that auto demand in North America surged by 32% last year amid tighter emissions rules for diesel SUVs.

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Investec expects demand for cars and autocatalysts in Asia to offset a slowdown in vehicle demand in America and Europe this year. South Africa's largest producer, Johnson Matthey, foresees another "substantial deficit" in the market in 2008 and reckons that major further supply disruptions could propel platinum to $2,500 an ounce, compared to around $2,000 now.

A strong performance by platinum tends to bolster palladium too, as investors then expect higher demand for palladium rather than platinum jewellery and increased use of palladium in autocatalysts. There is a limit to the substitution effect, however, as palladium is far more efficient in petrol-based engines than in diesel-based ones. The palladium market, furthermore, is expected to be in surplus again this year; in 2007, sales from large stockpiles in Russia, the biggest producer, helped increase the country's overall output by 16%. According to Johnson Matthey, prices currently at $433 an ounce are likely to trade between $400 and $575 in the next six months.

As for gold, the ultimate safe haven and store of value, "inflation and stagflation are now stalking" Western and developing markets alike, says Mark O'Byrne of Gold & Silver Investments. The impact on economies of tighter credit is only just beginning to be felt, raising the prospect of a nasty slowdown in America and the rest of the Western world. With further dollar weakness in the offing, supply tight and both investment and jewellery demand likely to increase (the latter thanks to the growing middle classes in emerging markets), the outlook is positive. Citigroup's John Hill sees gold averaging $950 in 2009 and $1,000 in 2010.

That's good news for silver, which, says Martin Spring in his On Target newsletter, "tends to rise more strongly than the yellow metal in a boom market". As far as industrial demand (up 7.2% to a new record last year) is concerned, metals consultancy GFMS notes that new uses for silver have more than offset the decline in demand from the photography industry, although mined supply is set to rise this year.

The key for silver will be investment demand, and here, thanks to generally increasing interest in commodities, inflation worries and gold looking likely to do well, the outlook is positive, says GFMS. Silver should average $17 an ounce this year, up from $13 last year, with another gold run towards $1,000 taking silver to $20 an ounce.

A London-listed ETF (PHPP) provides access to a basket of all four precious metals.