Hope for the best, hedge with gold for the rest

Market review

Gold has outperformed most asset classes so far in the latest market sell-off. It ended March with a slight loss of US$8.51 (0.5%) at US$1,577.18 per ounce. Gold rose early in the month to a fresh seven-year high of $1,703 on March 9. However, similarly to the crash in 2008, funds had difficulty selling their losers and became desperate for cash. As the market panic gained momentum, gold was sold as a source of liquidity for margin calls, redemptions and risk-off positioning. Gold fell to monthly low of US$1,451 on March 16,  before rebounding  on the back of the US Federal Reserve’s (Fed) second emergency rate cut. The Fed subsequently announced unprecedented stimulus aimed at injecting massive amounts of liquidity into credit markets that had seized up, but stock markets continued to slump. Incredibly, cracks even emerged in the market for US Treasuries, as they sold off with the stock market on some days. Gold has performed as a hedge against both the turbulence and the inflation that might eventually come from all these interventions. Gold maintained its gains in the lead up to the  US government’s US$2.2 trillion stimulus package, which makes the existing trillion-dollar annual deficit seems trite.

Gold stocks have roughly tracked the broader stock market through the crash to date, as the NYSE Arca Gold Miners Index  fell by 10.4% in March. The MVIS Global Junior Gold Miners Index declined by 21.3%, underperforming the gold miners index due to its smaller, less liquid constituents. This is normal gold equity performance in a crash and the drawdowns so far are less than those seen in 2008. We expect gold stocks to rise to reflect the underlying strength in the gold price, once the panic has subsided and companies are able to return to full production. 

The pandemic has had a marginal impact on gold mining so far.  The miners are adhering to the health and safety protocols we have all become familiar with.  Several countries that declared lockdowns have included mining as a non-essential business. Bank of America’s Global Research estimated in a March 30 report that 9% of global mine output had been temporarily idled. However, most gold mines have maintained production and we don’t know of any so far that have been shut down due to the coronavirus outbreak. Gold miners are better positioned than many industries to handle this crisis. Mines are typically in remote areas, away from coronavirus hotspots. Many have African experience navigating AIDS and Ebola epidemics, while safeguarding employees and sustaining production. The sector is financially strong with low debt and strong cash flow. A BMO Capital Markets universe of 27 major and mid-tier producer have an average net debt/EBITDAof 0.34 times, compared to an average of 1.78 times for S&P 500 companies. All-in sustaining costs average roughly US$950 per ounce and low fuel prices will work to mitigate other cost pressures this year. 

Outlook

Dot-com stocks, mortgage-backed securities, FAANG stocks – remember those iconic symbols of investor complacency and market excess in past cycles? The expansions that preceded each of these bubbles ended as a result of Fed tightening and were usually accompanied by an unexpected catalyst. The recent expansion was struggling under a cycle of Fed rate hikes, falling profit growth, exorbitant debt levels, a global manufacturing recession and dysfunction in the repo market. Now comes the mother of all catalysts.

Everyone is now focused on COVID-19 and thinking about what the world will look like once it is gone. We can’t help but reflect on our July 2019 commentary in which we highlighted The Fourth Turning, written in 1997 by historians Neil Howe and William Strauss. The book lays out generational cycles that have recurred throughout history. Since 2008 America has been in the fourth and final “turning” of the current cycle. The fourth turning is “marked by an era of crisis that shakes a society to its roots and fundamentally alters the course of civilisation”. The fourth turning ends with a climax that lasts several years, “a spark that triggers a chain reaction of unyielding responses and further emergencies”. We speculated in July that, according to Howe and Strauss’ theory, the climax would begin in the 2020-23 time frame. Past American fourth turnings culminated in wars – World War ll and the civil war before that. We now have a global war against an invisible enemy. Gold mining has encountered a marginal impact so far from the pandemic. The miners are adhering to the health and safety protocols we have all become familiar with. A handful of countries that have declared lock-downs have included mining as “non-essential” business. Bank of America Global Research estimates in a March 30 report that 9% of global mine output had been temporarily idled. However, most gold mines have maintained production and we don’t know of any so far that have been shut down due to the coronavirus outbreak. Gold miners are better positioned than many industries to handle this crisis. Mines are typically in remote areas, away from coronavirus hot-spots. Many have African experience navigating AIDS and Ebola epidemics while safeguarding employees and sustaining production. The sector is financially strong with low debt and strong cash flow. A BMO Capital Markets universe of 27 major and mid-tier producer have an average net debt/EBITDA of 0.34, compared to an average of 1.78 for S&P 500 companies. All-in sustaining costs average roughly $950 per ounce and low fuel prices will work to offset other cost pressures this year.

• The best-case scenario, in our view, is a short, sharp recession, followed by a slow recovery that takes the economy back to normal in late 2021. We believe there are plenty of risks that would be supportive of gold that could possibly push the yellow metal to new long-term highs. The government will not be able to save all the businesses and households that need to be saved; it will probably save many poorly managed businesses that shouldn’t be saved. Failures and bankruptcies appear inevitable. There could be a resurgence of the virus in the fall. Investor and consumer behaviour may become even more conservative, at least in the recovery phase, and possibly in the long term. States and municipalities have been financially devastated by massive cost overruns and reduced tax revenue. Most worrying is the sovereign and corporate debts that are expanding from record levels to cope with the economic shut down. Other parts of the world could see worse outcomes than the US.

• The worst-case scenario is one in which the economy remains shut for longer than expected. A hard recession lingers through 2020. Social unrest becomes a problem. Business failures and household bankruptcies prompt additional trillion-dollar rescues. The Fed continues to expand its balance sheet because investors are unwilling, or unable, to support the market for Treasuries. A crisis of confidence forces the government to take even more extreme measures. The Fed moves to directly fund the US Treasury and currency markets go into disarray. A return of the geopolitical risks that made headlines before the virus – a hostile government launches a cyber-attack or military manoeuvre designed to take advantage of the crisis.

• Hoping for the best but preparing for the worst is an appropriate strategy that seems to be prevalent with all the hoarding going on. Financially, we believe gold and gold shares should be part of that strategy as a hedge against turmoil. In addition, from the best case to the worst case, the market’s complacency towards inflation may turn to worry as the economy absorbs the tidal waves of liquidity.