Gold could shine once liquidity fades

Strong US dollar continues to weigh on gold, emerging markets currencies

The robust US dollar has weighed on gold since May, and in August the US Dollar Index (DXY Index) again reached new yearly highs. US dollar strength was mainly due to emerging markets (EM) currencies that weakened in response to a currency crisis in Turkey. President Trump tweeted that he would increase steel and aluminum tariffs and impose sanctions against two officials in an effort to gain the release of a US pastor detained in Turkey. The fragile nature of Turkey’s financial system was exposed when these tweets precipitated a crisis. According to The Wall Street Journal, Turkey has one of the largest trade deficits among EM countries, high inflation, and heavy borrowing in both US dollars and euros. The 74% decline in the Turkish lira this year makes repaying US$330 billion in foreign currency debt held by banks and businesses very problematic. The Turkish government also has issued foreign currency debt equal to 11% of GDP.

Turkish holders of gold were able to preserve their wealth, as the gold price rose 31% in lira terms in August. The Turkish people responded to their financial crisis as others have responded throughout the millennia. Metals Focus reported a lack of selling despite the high lira gold prices as people kept their gold as a hedge against further turmoil.

Gold stocks decline while sentiment and changing mandate add pressure

The gold price in US dollar terms has not responded to the Turkish crisis because, at this time, it poses virtually no immediate threat to either the US economy or global financial system. Gold fell US$22.69 (1.9%) to end the month at US$1,201.40 per ounce in response to the August US dollar strength. The gold price made what appeared to be a capitulation low of US$1,160 per ounce on 16 August. Thin summer trading activity enabled sellers to dominate as net speculative positioning on Comex (the primary futures and options market for trading metals) turned short for the first time since 2001 when gold was under US$300 per ounce.

The gold price weakness caused gold stocks to fall in August as the NYSE Arca Gold Miners Index (GDMNTR) declined 12.5%. The underperformance was reminiscent of February when GDMNTR lagged gold by 8%. By July, the miners had clawed back the performance they had lost in February. While we know of no fundamental company news that explains the weakness of gold stocks, we do know of potential selling pressure that could account for it. The Vanguard Group announced that its US$2.3 billion Precious Metals and Mining Fund will change focus in late September to a more diversified mandate that features telecommunications, utilities, materials, and natural resources. The last time Vanguard changed the fund’s mandate was also at a low in the gold market. In 2001, “gold” was dropped from the fund’s name, enabling a broader portfolio that included other metals. The fund subsequently endured the secular gold bull market with as much as 50% of its portfolio in non-gold stocks. As of 30 June, the Vanguard fund was approximately 77% invested in gold, silver, and other precious metals stocks. We are afraid that Vanguard is missing the gold boat once again. The Wall Street Journal reports that Vanguard forecasters have increased the odds of a recession, while warning of poor prospects for the US stock market. Vanguard puts the chances of a recession in the next two years at 30-40%, its highest-ever estimate for that time frame. Vanguard has a noteworthy track record in this respect, having placed a greater than 40% probability of recession six months before the December 2007 recession. If these forecasts are right, perhaps Vanguard’s shareholders will wish they had kept their precious metals fund.

Less liquidity, more Turkeys could benefit gold

While it was disappointing to see gold fall below US$1,200 per ounce, current extreme positioning (also characteristic of the lows in 2001) suggests the price will not remain at these levels. Gold has established a long-term base in the US$1,100 to US$1,365 range. We now expect some consolidation around the US$1,200 level, followed by short covering and seasonal strength that potentially moves the price higher over the remainder of the year. We believe the Turkish crisis is symptomatic of a larger trend that eventually benefits gold. According to a report by Gluskin Sheff + Associate, since 2009, the world’s central banks have injected US$13 trillion of stimulus into the financial systems. They are now beginning to withdraw that stimulus. The US Federal Reserve has so far raised interest rates eight times and will likely increase its securities selling from US$30 billion to US$50 billion per month in October. The Bank of England has stopped easing. The European Central Bank plans to stop adding to its balance sheet next year and may begin to raise rates. As the liquidity that fueled the expansion is slowly drained away, those areas of the financial system that are most vulnerable will be the first to fail. We believe Turkey was the first domino to fall, with its years of monetary mismanagement and over-borrowing made possible by low rates and ample liquidity. Bank for International Settlements (BIS) data shows US$3.7 trillion of US dollar-based loans have gone into EM countries. As central banks continue to tighten, we expect more Turkeys to come out of the woods. The US may find it hard to remain an island of prosperity.

The fundamentals of Gold companies remain strong and able to weather current prices

Most gold companies have ample flexibility to weather a slump in gold prices. Debt has been reduced to levels that are manageable at lower gold prices and many companies have no net debt. The average all-in mining cost for the majors and mid-tiers is around US$835 per ounce. Mining costs exclude exploration, capital projects, and other administrative costs. When accounting for all the money companies are spending, using a gold price of US$1,200, BofA Merrill Lynch Research estimates aggregate industry free cash flow of US$2 billion in 2018, rising to US$7.3 billion in 2020. While we expect to see higher prices in the fall, we always consider industry fundamentals should prices decline further than expected. At US$1,100 per ounce, free cash flow goes to $0 in 2018 and trends to US$2.7 billion in 2020. At the US$1,100 level we would expect companies to trim discretionary expenses and postpone new mine development. Approximately 10% of global production has all-in mining costs above US$1,100 per ounce; therefore, there could be a few high-cost mines that consider curtailed production or closure.