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The precious-metals markets were bolstered on Monday by the first of several critical economic developments taking place this week in the U.S. and abroad. The early-week rise has been largely attributed to early indications from Italy suggesting that the electorate is leaning toward the candidate not likely to support the continued discipline of austerity. This has the potential to reawaken the European debt crisis, and that means the safety of silver and gold upticked significantly. Where all the major indices were off by the most since November, silver, as represented by the iShares Silver Trust (NYSEMKT: SLV ) , was up 0.86%.
Looking to the rest of the week, Federal Reserve Chairman Ben Bernanke will spend two days testifying before Congress, the minutes from the Federal Open Market Committee were released, more home data is coming, and it will all culminate on Friday, when the sequestration cuts are due to go into effect. As things currently stand, no deal has been reached and negotiations are not looking promising -- it's the fiscal cliff all over again, but Wall Street seems to be taking the fool me once, been there, done that attitude. Not surprisingly, the White House is demanding an extension to prevent the very real economic consequences that the cuts could have, while congressional Republicans have indicated that without tax reform and spending cuts, no extension will be given.
Ultimately, another extension on the sequestration cuts is likely to come, as neither party wants to run the political risk of being blamed for the very real impacts that will result if no accord is reached. What little credibility Congress had with investors before the fiscal cliff fiasco -- and it was not much -- is assuredly gone. Still, sequestration has the potential to drive the economy into the ground and with it send silver soaring.
What is sequestration?
Given that recent polling suggests that most Americans don't really understand what sequestration means or how it will affect the economy, it might be worthwhile to spend a little time covering the basics. The plan started nobly enough as a threat to both parties of what cuts would be put into place if comprehensive reform could not be agreed upon. The theory was that if each party had some of its most cherished spending targets threatened, it would foster more cooperation and compromise.
Almost as if to prove that it would not be bullied by itself, Congress failed to reach any kind of a compromise and is now facing the automatic cuts that, according to the Congressional Budget Office, have the potential to cost 1.4 million Americans their jobs. To put an even finer point on the nature of these cuts, not only will they result in a decrease in Department of Defense spending by $500 billion over the next 10 years, but they could also result in the loss of jobs for 31,000 teachers, the elimination of positions for 1,000 agents in federal law enforcement, and the reduction of FEMA's budget by $1 billion. These are real cuts that will have a real impact.
Taking the seriousness of the situation one final step is that the Fed has made clear its intention to keep rates artificially low as long as the unemployment rate remains above 6.5% and inflation stays in check. Quantitative easing will also continue, meaning that huge amounts of cash will keep flooding into the economy, silently driving inflation. While indications from the U.S. Bureau of Labor Statistics suggest that inflation is under control, anecdotal evidence like grocery shopping or buying gasoline suggests that inflation is present.
And this matters for silver because ...
There are two primary effects that sequestration can have on the price of silver and, thus, silver-based assets. First, the loss of that many jobs coupled with all of the ancillary impacts will probably cause a recession. This is bullish for precious metals as a flight to safety occurs. The inflation effect favors investment in the commodity or the ETF, SLV in this case, over purchasing mining stocks like Pan American Silver (NASDAQ: PAAS ) or First Majestic (NYSE: AG ) . Miners are, first and foremost, corporations that are adversely affected by recessionary pressures. This is part of why SLV has outperformed on a year-to-date basis.
The other impact is on inflation. As I mentioned, higher unemployment will lead to increased Fed action, which will almost certainly create inflation. Inflationary pressures are beneficial to all silver assets, and to the extent that they can override the recessionary ones, the miners may catch up on a performance basis. Both First Majestic and Pan American look attractive on a longer-term basis and are attractively priced at current levels.
Ultimately, I believe that another compromise will be reached on Capitol Hill and the sequestration cuts will be postponed yet again. There will, however, be enough of an impact that the mere concern has the potential to be bullish for silver. If the cuts are not avoided, silver should quickly move higher, but in either case, the medium-term outlook remains strong.
If you're looking for a company whose success is determined by the metals market, but without involving itself in the risks of physically mining the metals, then Silver Wheaton provides a unique play on the future of silver. SLW chooses to finance the mining of silver; it has grown sales and net income every year since 2008 and also has increased competitive advantages over its limited peer group. More details about our outlook for Silver Wheaton can be found here in our Motley Fool analyst report.