Systemic risks spark gold’s gains
Gold and gold stocks have a strong April
Gold and gold stocks retraced the previous month’s losses to end higher in April. As the pandemic market panic subsides, investors are trying to gauge the risks and opportunities amid a level of uncertainty that only those with memories of the Great Depression and WWII have experienced. Continued strong inflows to bullion exchange traded products, along with robust demand for retail coins, suggest that both institutions and individuals are turning to gold as a store of value and hedge against uncertainty. Gold jumped US$40 per ounce on April 9 when the US Federal Reserve (Fed) unveiled an unprecedented US$2.3 trillion program to aid local governments and small- and mid-sized businesses. It then jumped to a new seven-year high of US$1,747 per ounce mid-month, before consolidating its gains at around US$1,700. Gold ended the month at US$1,686 per ounce with a US$109 (6.9%) gain.
Many large gold miners buck the trend of disappearing dividends
A recent Wall Street Journal article stated that “more companies have suspended or cancelled their dividends so far this year than in the previous ten years combined” in the wake of the COVID-19 outbreak. Yamana Gold bucked the trend by increasing its dividend by 25%, Newmont by 79%, and Kirkland Lake by 100%.* All three companies have temporarily suspended production at some of their mines due to the lockdowns. These companies exemplify the financial strength and earnings power of the gold industry.
While most industries are struggling, the gold industry is thriving while dealing with COVID-19 protocols and suspended operations. On April 13, BofA Global Research estimated 11% of global gold output had been idled. Since then, Mexico has issued partial closure orders, while Quebec, Argentina, New Zealand, and South Africa have allowed gold miners to resume work. We expect most remaining gold mine lockdowns to be lifted in May.
Four drivers of the secular shift
Gold carries no counterparty risk; its supply is limited; it fits in small places; exists outside of the mainstream financial system; and is universally seen as a store of value. These attributes make it a unique safe-haven investment. Likewise, gold companies hold vast resources of gold locked in the ground that only they have the technology and skills to extract and bring to market. While gold and gold stocks are highly tradeable, volumes are dwarfed by stock, bond and currency markets. A relatively small shift in global asset allocations can drive the gold markets. We believe such a secular shift has begun, driven by four broad categories of systemic risk: deflation; debt; inflation; and loss of confidence.
The COVID-19 pandemic is a deflationary shock of the highest order, where demand for almost everything has collapsed virtually overnight. As global GDP has fallen sharply, it seems that in the best of outcomes, this will be an average recession. Gluskin Sheff calculates the average post WWll duration from the peak of the S&P 500 to the trough of the subsequent recession has averaged 13.6 months, while the S&P 500 fell 29.0% on average. Therefore, if this is to be an average recession, it would not trough until April 2021. However, myriad factors make it easy to imagine a recession with deflationary pressures that lasts longer than average. Here are just a few of our concerns:
- Most people in democracies have never experienced state-controlled lockdowns in which fellow citizens are looked upon with suspicion. Many are horrified by the 24/7 COVID-19 media coverage. As a result, once lock-downs are lifted, investment and consumptions patterns might become more cautious and conservative, at least until a vaccine is widely available and perhaps much longer. Meanwhile, a resurgent virus and more lockdowns are a possibility.
- Economists surveyed by The Wall Street Journal expect US unemployment to hit 10% in December, which suggests a lingering deep recession.
- The IMF forecast that global GDP will contract 3% this year, compared to a 0.1% contraction amid the global financial crisis. While growth may return in 2021, it warned that there is a higher risk of a worse outcome as many countries face a multi-layered crisis comprising a health shock, economic disruptions, falling external demand, capital flow reversals, and a collapse in commodity prices.
Debt is always a problem in a deflation, while excessive debt can become a crisis. The elephant in the room is corporate debt, while the whale in the room is sovereign debt. Goldman Sachs forecasts the US budget deficit will reach US$3.6 trillion this fiscal year and US$2.4 trillion in 2021. This is on top of US$17.9 trillion worth of existing debt, which now exceeds 100% of GDP. Based on these figures, it appears unlikely that the government will ever pay back the money it owes. At zero interest rates, money is free and sovereign debt keeps piling up. The Fed may never be able to raise rates for fear of a ruining rise in debt service costs. Anyone who owns a business, or runs a household, knows intuitively that this is unsustainable. Nonetheless, no one knows whether it can persist, end in failure, or whether government debt eventually gets pared down in a cycle of inflation.
According to Rosenberg Research, the volume of business debt has roughly doubled this cycle to over US$10 trillion in the US. Many businesses are now taking on more debt to deal with the collapse in revenues through bond offerings, revolving credit lines, and new government lending programs. All corners of the private debt markets are under acute pressure:
- As of April 24, S&P Global Ratings issued 125 corporate upgrades and 1,270 downgrades this year and figures the total for selective defaults could top the US$340 billion level of the financial crisis.
- Private pensions have nearly US$1 trillion of corporate bonds in their portfolio, while some state and local pensions are effectively insolvent at this point.
- According to the US Chamber of Commerce, over 40% of the US’s small businesses could close permanently in the next six months.
- Bloomberg News reports home lenders bracing for up to 15 million mortgage defaults in the biggest wave of delinquencies in history.
We believe the global economy will be mired in deflationary pressure for the foreseeable future. Central banks have been trying unsuccessfully to generate wage and price inflation for years. Instead, their policies have brought asset price inflation – bubbles in stocks, bonds, real estate, etc. However, if economic growth ever returns to historic norms, complacency towards inflation, coupled with the massive pandemic stimulus, could bring high levels of wage and price inflation, along with asset bubbles.
The world is on a war-footing to fight the pandemic. Past wars have brought double-digit inflation in the US. The end of WWI also coincided with the Spanish Flu pandemic:
|End of War
|24% / 1920
|20% / 1947
|15% / 1980
The COVID-19 war might end with another cycle of unwanted inflation.
4. Loss of Confidence
The government took on unconventional fiscal and monetary policies after the financial crisis with trillion-dollar deficits, quantitative easing (QE), and zero interest rates. It tried to scale these extraordinary measures back during the expansion but failed. Now with unlimited QE, rescue programs to all corners of the debt market, and multi-trillion-dollar deficits, fiscal and monetary policies have transformed from unconventional to dangerous. We acknowledge that a massive response to the lockdowns is necessary, but piling onto an edifice of record peace-time deficits and central bank balance sheets creates a very unstable financial system.
After WWll, the Bretton Woods Agreement created a global monetary order in which dollars were convertible to gold by foreign governments. The Bretton Woods system ended in 1971 as the US was spending heavily on social programs and the Vietnam War. Some countries lost confidence in the US dollar, demanding more gold than the US was willing to provide. Thus, the gold window was closed and the current system of fiat currencies and floating exchange rates was adopted. The fiat currency system is now being trashed by rampant QE and government borrowing. We believe the Fed could be on the verge of issuing money directly to the Treasury to fund spending and debt payment. Call it monetisation, helicopter money, or modern monetary theory; no financial system has survived such currency devaluation. If investors and foreigners lose confidence in the dollar-based system, it will be time for a new Bretton Woods, a new global monetary order. Gold would be the last currency standing.
*Source: Company Reports. As of April 30, 2020, these positions represented approximately 1.90%, 15.57% and 4.45% of GDX net assets, respectively. This is not a recommendation to buy or sell any security.