Good tidings for gold
In early November, an eclectic cocktail of news including the Federal Open Market Committee (FOMC) rate hike decision, the jobs report and the US midterm elections led to US dollar weakness, which pushed gold higher. On November 10, the US Consumer Price Index (CPI) for October came in at 7.7% year-on-year, slightly below expectations and lower than the previous month of 8.2%. This gave markets renewed hopes that the US Federal Reserve (Fed) may soon slow down the pace of rate hikes, causing the dollar to slide and helping gold trade as high as US$1,786 per ounce on November 15. On the last day of the month, during his speech at the Brookings Institution, Fed Chairman Jerome Powell signaled that the Fed may slow down the pace of rate increases as soon as December. Gold responded closing at US$1,768.52 per ounce on November 30.1
Gold equities got a jolly ride in Santa’s November sleigh. NYSE Arca Gold Miners Index was up 13.62% . This strong outperformance by gold equities during the month demonstrates both their leverage to the gold price and how oversold they have been over the past couple of years—both historically and relative to the gold price. Despite recent cost inflation, which has hit the miners hard this year, the sector remains profitable. At today’s gold prices, gold producers enjoy healthy margins, generating substantial free cash flow to allow them to continue to pay dividends and fund future growth.
Growth challenges for miners
Growth is hard to come by in the gold space. It is not a matter of access to capital, as the major gold miners have plenty of liquidity. It is a matter of access to large and economic gold deposits. Those do not come easy, as recent sector mergers and acquisitions activity would tell us. This month we saw two gold producers, Agnico-Eagle and Pan American Silver teaming up to launch a competing bid against Gold Fields to acquire Yamana Gold. The Agnico/Pan American offer had an element that was hard to compete against: the transaction would see Agnico-Eagle consolidate ownership of the Tier 1 Canadian Malartic mine, which is presently owned 50% by Yamana and 50% by Agnico.
The gold sector is fragmented, with small assets held in many hands. Agnico controlling 100% of Canadian Malartic makes sense. Pan American would acquire Yamana’s Latin American assets, a natural fit within its portfolio of eight producing mines in the region. Yamana’s South American assets would have been a stretch for Agnico, which doesn’t have operations there at present, so the acquiring partnership is logical. Gold Fields’ offer, in contrast, while creating a bigger gold major, which we recognised as advantageous, was weighed down by other risks that made it difficult for investors to digest. This illustrates the challenges faced by gold producers as they pursue growth. In an industry with so many different sources of risk, investors expect acquisitions to deliver not just production growth and value creation, but a reduction in risk. Gold Fields is a well-run company with good assets which now has a fresh start (and a nice break fee) at fulfilling its growth aspirations.
This month we attended Barrick Gold’s investor day at the New York Stock Exchange. Barrick’s presentations placed the spotlight on the other side of growth, organic growth, much preferred by most investors, as it usually comes at a lower cost. Even factoring in all the recent capital costs escalations, adding ounces through the drill bit is the preferred option, not least because those ounces often come with much lower risk. Expanding the capacity or increasing the life of an existing mine or adding a new mine to an existing district or operational region reduces the associated risks. We were encouraged to see the extensive pipeline of projects and prospective grounds that, in our view, will continue to drive Barrick’s growth for decades to come.
Market risks keeping gold in the fold
In the crypto world, the Grinch stole Christmas early! The sudden collapse of FTX raises many questions about the entire crypto ecosystem and creates much uncertainty in what is still a fairly new asset class. Perhaps it should not surprise us that as this sector grows, invents and defines itself, there are going to be some casualties. We are often asked about the impact bitcoin has had on gold demand, as they are both seen as alternative investments. No doubt, gold has lost some investors to bitcoin. However, we believe the core gold investors are different from bitcoin investors. Those investing in gold are looking for the safe haven, inflation protection and portfolio diversification—benefits that gold has historically offered. It is too early to tell what role bitcoin and crypto assets will play in a portfolio, and this month’s developments are a setback in that discovery process. Until this is better understood and corroborated over time, crypto will have a tough time stealing gold’s investors.
The real contender for gold this year has been the US dollar. Investors are tasked with deciding whether to hold gold to protect their portfolios from high inflation and geopolitical tensions or to reduce their holdings as global interest rates rise. In an environment of rising rates and an outlook for lower inflation as a result of the monetary tightening programs by Fed and other central banks, investors have chosen the safety of the US dollar, propelling it to 20-year highs, which has been the biggest headwind for gold this year. The US dollar index (DXY) was down 5% during November.
Gold broke out of its recent downward trend trading well above US$1,700 per ounce and it now looks like it may be back on the longer-term bull trend that has been in place since 2016. This is a significant development for gold.
Gold: back on track with its long-term bull trend?
Source: Bloomberg. Data as of December 1, 2022. Past performance is no guarantee of future results. Not intended as a recommendation to buy or sell any securities mentioned herein.
We expect gold to continue to trade around the US$1,700 to US$1,800 per ounce range in the near term. If inflation remains at or near current levels, real rates are likely to stay in negative territory and we would expect this to support gold. A pause of the Fed’s tightening program would likely be a strong catalyst for gold. However, gold may rally even ahead of a Fed pause or pivot. The recent gold price action following the CPI report for October is a perfect example of this. Gold broke out as the market anticipated that Fed rate increases might soon start to slow down. Gold also rallied well ahead of a Fed pause during the last tightening cycle.
Similar to past cycles rate hiking cycles, gold is likely getting a boost from a potential pause
Source: FactSet, St. Louis Federal Reserve Bank. Data as of December 1, 2022. Past performance is no guarantee of future results. Not intended as a recommendation to buy or sell any securities mentioned herein.
November’s gold price move is unique as there was not a corresponding increase in gold bullion exchange traded fund (ETF) holdings, the best proxy of investment demand. In fact, gold bullion ETF holdings were down 0.9% during the month, although outflows did slow down. This is a welcomed change in the trend of persistent heavy redemptions since April of this year. Continued strength from other demand centers (central banks, jewelry, bars and coins) is supporting the gold price. We see opportunity for gold’s breakout to intensify, propelling it to its all-time highs around the US$2,000 per ounce level, but this will require investment demand to increase. So, the question is, what will drive gold investment demand in the medium and longer-term?
We have reviewed the risks that we believe are supportive of higher gold prices in the longer term. These include (in the US and globally) persistent and elevated inflation, a weakening economy, debt service strains, elevated geopolitical risks and black swan events, such as the Liability-Driven Investment crisis in the UK. However, the gold market is ignoring these risks for now. It is likely that the market will continue to ignore these risks until:
- Unemployment rates increase significantly: the jobs market is still showing resilience that the financial markets interpret as contributing to the possibility of a soft landing. Higher rates of unemployment due to Fed induced demand suppression will send a strong signal that the economy is feeling the strain of the tighter policies. Recently, former Treasury Secretary Larry Summers was quoted saying that a US recession and unemployment hitting 6%, are reasons that will take for surging inflation to be brought under control in America.2
- A recession is confirmed: it is not enough that most economists are calling for a recession next year, it seems markets want confirmation that we are smack in the middle of it. Even Fed Chairman Powell admitted that the path to a soft landing seems to have narrowed.3Markets are also ignoring the yield curve inversion, which has consistently been a good recession indicator. Corporates are also sending warning signals. FactSet reported that 179 S&P 500 companies cited the term “recession” during their earnings calls for the third quarter, which is well above the 5-year average of 63 and the 10-year average of 54.4
- Corporate earnings fall: FactSet also reported that for Q3 2022, the blended earnings growth rate for the S&P 500 was a tepid 2.2%.5 In addition, for Q4 2022, analysts are projecting an earnings decline of -2.1%. Companies are guiding to falling earnings, yet valuations still look rich. The forward 12-month price-to-earnings (P/E) ratio for the S&P 500 is 17.2. This P/E ratio is below the 5-year average (18.5) but above the 10-year average (17.1).
- Equity markets correct further: share prices need to fall further for market participants to appreciate the impact of tighter financial conditions on corporate profits.
- Inflation and inflation expectations stay above the Fed’s target rate: everyone wants to believe that inflation is under control and coming down. It is reassuring to see the downtick in October. Nevertheless, history tells us it can take many years to bring inflation down after it hits the present levels.
Market participants may not abandon the safety of the dollar and run to the safety of gold until several of these conditions are present. How long it may take for these risks to become reality is up for debate, but the increasing likelihood, we believe, will support higher gold prices in 2023 and beyond.