Gold Finds Synergies as Macro Views Diverge
Gold market sees several course reversals in March
After six months of gains in which the gold price rose by US$175 per ounce to US$1,345, March saw some profit-taking. The price of the yellow metal fell to its monthly low of US$1,280 at one point, before recovering on the back of a lacklustre February US jobs report and the European Central Bank’s (ECB) plan to hold interest rates at their current low levels until the end of the year at least, months longer than previously signalled. This caused recessionary fears to re-emerge, with long-term US Treasury yields falling to 15-month lows, and the yield curve inverted slightly for the first time since 2007. Gold rose up to US$1,324 on March 25. Towards the month-end, however, a slump in palladium prices led to broad weakness in precious metals . There were also reports of heavy official selling from Turkey to prop up the lira ahead of local elections on March 31. Gold lost about US$21 per ounce, or 1.6%, to end at US$1,292.30 over the month.
Gold stocks more or less matched gold’s performance in March, with the NYSE Arca Gold Miners Index gaining 0.74% and the MVIS Global Junior Gold Miners Index retreating 2.3%.
China expanded its gold reserves for the third consecutive month, raising expectations that central bank demand will remain elevated this year.
Merger mania subsides
First-quarter merger and acquisition (M&A) activity among the supermajors is near a conclusion. Barrick Gold withdrew its hostile offer for Newmont Mining on March 11, when the companies agreed to form a joint venture (JV) to unitise their Nevada operations. The combined unit is expected to produce four million ounces per year and Barrick, as JV operator, estimates it will generate about US$5 billion worth in synergies.
Investor attention was also on the friendly Newmont/Goldcorp merger announced in January. Initially, Goldcorp shareholders were not entitled to the savings from the Nevada JV, as the deal with Newmont did not exist at the time of the merger announcement. Despite that, Newmont decided to award a 2.5% special dividend to its shareholders as a partial upfront payment for future Nevada synergies. The dividend will be distributed if shareholders approve the Newmont/Goldcorp deal in April.
The recent burst of supermajor M&A activity is aimed at creating value for shareholders, improving mine efficiency and generating higher returns on capital. We hope the smaller players would be able to replicate what the supermajors have done. According to Pollitt & Co. Inc., a Toronto-based investment banking and brokerage services firm, just four companies account for 50% of iron ore production, and 10 companies to generate 50% of copper production. Contrast this with gold, where 25 companies account for 45% of production. Mining is a risky business and not all of these companies have an A-team. Management risk can be mitigated by joining strong managements with good properties, thereby enabling companies to optimise operations. M&A also allows smaller companies to gain the critical mass needed to efficiently access capital markets and strike better deals for materials, equipment, and services.
Diverging macro signals hint at risks ahead
Successful investing involves making the right call at the right time. A great investment idea can fail if the timing is off. We have been warning of the risks of recession for several years. As such, the portfolio is positioned aggressively for a stronger gold market. While gold and gold stocks have exhibited positive returns in two of the last three calendar years – perhaps driven by global systemic risks – we were certainly much too early on the recession call. Two years ago we shared this chart as a compelling indicator of a looming recession. Following a recent update, the chart is even more compelling.
Divergence Between Sentiment and Consumption Precedes Recessions
Source: St. Louis Federal Reserve Bank, Bloomberg. Data as of March 2019.
Notice the divergence between the “hard” consumption data and the “soft” consumer confidence data ahead of each recession. Sentiment remains strong before a recession, while actual economic indicators are weakening, and this time the divergence has become more pronounced. We believe this chart, combined with other late-cycle indicators, stock market volatility, bond market action, and central bank behavior all suggest a recession remains in the forecast and probably may occur sooner than many expect. If the economy tumbles into recession, we expect financial risks to escalate that drive gold higher.
US federal debt is growing fast
Federal debt stands at about 75% of US gross domestic product (GDP) and is growing rapidly. Trillion-dollar annual deficits were first seen in the Obama administration, and now President Donald Trump’s policies will again drive deficits through the trillion-dollar mark (4.5% of GDP) beginning in 2022, according to the Congressional Budget Office (CBO). Unlike in the Obama years, politicians rarely complained about the debt level. Spending more is easy, while cutting budgets seems politically impossible in Washington. Because of this, we believe a debt crisis is imminent, although the breaking point is difficult to forecast. It may come in the next recession, or at a time when rates spike as foreign holders of US Treasuries lose confidence in Washington. Failure to cut spending or increase taxes to boost revenues as growth weakens could lead to two ways of handling US debt: default or monetisation.
Modern monetary theory is not the answer
Some politicians appear prepared for debt monetisation. So far, no adverse consequences of the sovereign debt build-up have shown up in the financial system. Meanwhile, easy monetary and fiscal policies have not sparked inflationary pressures in consumer prices. As a result, a radical form of financial thinking has emerged called Modern Monetary Theory (MMT). Key characteristics of MMT include:
- Any country that prints its own currency can do so to pay national debts or finance deficits.
- Deficits don’t matter as long as interest rates remain below GDP growth.
- The natural rate of interest in a fiat currency world is 0%.
- Inflation can be controlled through taxation, rate increases, and regulation of big business.
- Economies should be guided by fiscal policy, i.e., government spending and taxation.
- The Central Bank would essentially be controlled by the Treasury.
Prominent economists and financial leaders have characterised MMT as “fallacious”, “garbage”, and “just wrong”. We agree with these characterisations. If adopted, MMT would likely lead to currency debasement and hyper-inflation on a scale seen in Weimar Germany almost 100 years ago or in modern-day Venezuela. Bond prices might collapse with the US dollar, and a financial crisis would probably ensue long before MMT is implemented in its full form.
An alternative would be to invest in a reasonably valued asset class with a proven track record, has an alternative store of value and negative correlation to the US dollar. For that, one need not look any further than gold and gold shares.