Facts and fiction about gold

If there had been an official Top 10 list of most disappointing trading and investment ideas these past number of years, no doubt gold would have been nominated by many.

Look no further than the share price performance of global industry stalwarts Newmont Corp and Barrick Gold over the past five years or so. Those are truly ugly-looking price charts, mostly heading in the wrong direction.

The situation for ASX-listed gold miners and explorers is more diverse, and a number of them have participated in the general equities rally from October lows, also carried by the recent rally in the price of gold bullion, but volatility overall has been exceptionally large.

Many an investor who's had the courage and the tenacity to stay on board these past number of years would be feeling bruised and brutalised, and not necessarily vindicated as of today.

As per usual, the devil hides in the details

Gold bullion, typically priced in USD, has actually performed quite well. Total return for Global X's ETF GOLD has been 11.93% per annum over the past five years, and 7.99% p.a. over the past decade. In comparison, the total return for the ASX200, including dividends but not franking, has been 8.75% over five years and 8.21% over ten.

And now for the Big Surprise: VanEck's Gold Miners ETF, which comprises 53 internationally listed gold miners, mostly in Canada, the USA, Australia and South Africa, has only generated 5.51% per annum these past five years. As indicated, the return from many individual companies has been far, far worse.

Conclusion number one: the outlook for gold does not by definition equal the outlook for producers of the metal. This is one lesson that needs to be learned and re-learned by investors time and time again.

For good measure: there are times when the return from gold miners exceeds the performance of gold bullion; this usually occurs when gold is in favour, experiencing a bull market. Hence, the indication from gold miners underperforming the metal is gold has not been in a bull market these past number of years.

That makes sense as the USD price first reached above US$2000/oz during the early covid panic in 2020 and only recently, upon the third attempt, has the price of gold managed to surge away from it.

Here the irony is, of course, once the panic subsided and the worst of the global pandemic had been relegated to the past, the world economy was confronted with an outbreak of consumer goods inflation, which did not result in gold outperforming.

This would have been another Big Surprise to many: the ruling narrative is gold acts as a safeguard against inflation. But when inflation did announce itself, gold ducked for cover!

Let's get this straight: does gold act as a trade-off against inflation?

The short answer is: yes. But the correct answer is: not in the way many think it does.

And herein lies the apparent enigma surrounding gold. To most investors who buy into the narrative of gold protects wealth versus inflation, this means when inflation goes up, so too should follow the price of gold.

A detailed analysis of gold's behaviour in the past reveals that's simply not how it works.

Admittedly, when looking at gold's performance in the 1970s, for example, it seems, at prima facie, that's how gold protects against inflation. But the true driver, even back then, is the so-called real yield on US Treasuries. To determine that real yield, we simply compare inflation with the US bond yield.

In today's context, consumer price inflation in the US is trending down from circa 8% in early 2022 to an estimated below-3% later this year. If the Fed's projections prove correct, the CPI should be back around 2% in 2025. In the same respect, the yield on the US ten-year Treasury rallied to 5% last year, and is currently around 4.20%.

We don't have to consult a mathematical genius to see the real yield is now in positive territory; the CPI is trending below the ten-year yield. History suggests this is not a beneficial environment for gold. Bullion benefits most when the real yield is negative, i.e. when CPI exceeds the yield available on the US bond market.

But simply drawing such conclusion is to deny financial markets' foresight. Equities have been rallying on the prospect of central banks lowering their cash rates. It requires no stretch at all to assume gold too is already looking forward to official cash rates falling later in the year.

With lower cash rates and lower inflation numbers come lower bond yields, and also lower real rates as bond yields eventually fall more than inflation. This is the core projection expressed by Fed economists and many of their peers elsewhere.

In a slower-growing world economy, and that pathway on longer-term trendlines hasn't changed, the long-term equilibrium is estimated at circa 2% annualised inflation and bond yields at circa 2.50%.

This only leaves a real rate of 50bps at the equilibrium; well below the averages from the past. It's also not difficult to see how quickly the real rate can possibly shrink to zero again, or return in the negative.

A valuable lesson for investors: it's not what the numbers look like in the here and now that determines the outlook for a financial asset such as gold. It's the destination on the horizon that outweighs the present. When real rates move from positive to negative, that's when gold thrives. When a reasonably firm positive real rate is shrinking in size, i.e. falling towards zero, that's equally a positive for gold.

It's when the real rate starts trending in the opposite direction that gold loses its support. And this is exactly what happens at the end of every bull market for gold; the real rate starts trending in the wrong direction.

This is also why gold remains an enigma to many. Inflation can still be high when the price starts trending lower, and vice versa. In the current context inflation is falling, but optimism regarding the outlook of gold is firming. Understand the underlying driver as being the real (inflation-adjusted) US bond yield, and a lot of what happens to the price of gold makes a lot more sense.

And yet again, this is not the full story, alas.

If gold has been in a bear market phase these past few years, how come the price hasn't genuinely tanked?

It's one observation to make that gold miners perform worse during a bear market, but the price of gold overall has remained relatively stable post covid, mostly fluctuation in between US$1800 and US$2000/oz.

This is even more impressive when one considers gold is also impacted by the US dollar, which has been strong, and often trades in the opposite direction of equities, which have been strong too (all-time record highs for all major US indices). Add the fact most related ETFs have seen funds outflows for the past 24 months, and something else seems to be happening; something unusual.

It doesn't happen often that a financial asset can rally to a new record high when investment funds are abandoning exposure in search of better returns elsewhere.

One group of buyers that has been noticeably active are central banks, in particular those from emerging countries, including Russia and China. In a world full of conspiracy theories, we could draw the conclusion those countries are preparing for trading relationships without having to involve the US dollar.

Adding more exposure to gold by implication means those central banks are diversifying away from US dollars. The Russians in particular have an extra motivation or two to do so. And so does Iran.

There could be a link to the notable increase in geographical risks with central banks purchasing noticeably higher quantities of gold since the outbreak of the Ukraine war.

Gold equally responds to central banks printing more fiat money and supplying markets with plenty of liquidity.

Officially, the Federal Reserve is now running down its expanded balance sheet -called Quantitative Tightening- but in practice the Fed and the US Treasury under former Fed-chair Janet Yellen have been working closely together in order to prevent liquidity falling too much, so that markets don't suffer from adverse affects.

One indicator for global liquidity is Bitcoin, and that price has been on a tear, probably indicating liquidity is not shrinking. The enormous expansion in US money supply means, when measuring against this particular benchmark, gold has only become relatively cheaper in the post-covid years.

Talking about relative valuation; compared to US equities, gold has seldom been as cheaply priced as it is today.

Quite a few experts believe it looks like central banks can never wean themselves off the liquidity tap ever again. In the foreseeable future, a re-election of Donald Trump as president of the USA would most likely bring about easier monetary and fiscal policies. This would likely lead to a weakening US dollar.

A recent research update from Oxford Economics was titled: QE makes a difference - and it's here to stay.

Standard modeling of bonds versus inflation versus gold and the US dollar suggests the price of gold bullion should be some -US$600/oz lower than where it is today. And gold managed to rally to a new all-time high without the added support of financial investors.

Might the answer be found in the additional drivers mentioned above?

Reasons to be positive on the outlook for the price of gold include the prospects of Fed rate cuts, weighing down the real rate, which is also expected to weaken the US dollar, while equities look expensive, and the risk for an economic recession remains. Also, the technical picture has improved, favouring an outbreak to the upside, which could start a renewed uptrend and with it the return of investor interest.

Where does this leave the Aussie gold miners?

On a simplistic comparison relative to the price of gold, gold miners might never have been as 'cheap' as they are priced today. But it's good to realise this is not simply the result of negative investor sentiment towards the sector.

Post covid, many businesses in general have found it hard to keep operational costs down, and many a mining company is still struggling with this challenge today. Gold miners have been among the worst performers inside the mining industry, also because the price of gold has not followed other commodities in rallying higher until recently.

Apart from rising costs, and thus downward pressure on margins, there have been plenty of other ways for gold miners to disappoint. Analysts at UBS in a recent frank report also added the need to replace depletion and grow production, as well as a dismal industry track record to generate accretive returns from buying growth (M&A), plus management teams' predilection to provide too optimistic a guidance which later on is not met.

One added observation is that a higher gold price in AUD seldom puts a rocket under the local sector. The real and decisive driver tends to be an up-trend in gold priced in USD, possibly indicating the sector needs foreign money inflows to genuinely move into bull market mode.

In recent weeks, significant rainfall in Western Australia is shaping up as the next operational challenge for miners in the state.

Recent sector updates by UBS might as well come with the warning of Buyers Beware!

However, after having underperformed by some -30% against bullion over the past three years, it is noticeable investors are starting to look at renewed exposure to gold miners again. In particular since momentum seems to be building for a renewed up-trend for gold.

Were we to witness another gold bull market, share prices in gold miners should make up for the relative valuation discount, plus some, potentially promising outsized returns a la lithium in 2022 and uranium more recently. That's an attraction few will be able to ignore.

So which companies offer the best risk-reward?

If we were to ask those sceptical sector analysts at UBS, their response would likely be to point in the direction of Evolution Mining ((EVN)), as your typical turnaround from past misfortunes story.

At the smaller end of the market, UBS holds a positive view on De Grey Mining ((DEG)) and Gold Road Resources ((GOR)).

Sector analysts at Canaccord Genuity, while having an overall supportive view on the local industry, considered too cheaply priced generally, recently highlighted Northern Star Resources ((NST)), Ramelius Resources ((RMS)), and Gold Road Resources as three favourable highlights.

Analysts at Goldman Sachs tend to favour Evolution Mining among the larger caps and Gold Road Resources and De Grey Mining among smaller caps.

The team of sector analysts at Morgan Stanley is probably the most cautious, only carrying one Overweight rating for the sector, with Regis Resources ((RRL)) the lucky stand-out.

Macquarie, on the other hand, has plenty of Outperform ratings spread across the sector, starting with each of Northern Star, Newmont Corp, and Evolution Mining among the larger players.

In the mid-cap segment, Outperform ratings have been given to Perseus Mining ((PRU)), De Grey Mining, Bellevue Gold ((BGL)), Gold Road Resources, Regis Resources, West African Resources ((WAF)), Resolute Mining ((RSG)), and Westgold Resources ((WGX)).

A popular prediction is to see the price of gold appreciating to US$2300/oz in the months ahead.

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