Financial risks to support gold

Gold stocks, along with gold bullion have underperformed other asset classes so far in 2021, weighed down by elevated US Treasury yields and a stronger US dollar. The rollout of coronavirus vaccines and optimism of a global economic rebound have also dulled its lustre.

However, there are several catalysts that could propel a recovery in the yellow metal’s price into 2022 and in turn, its miners’ stock prices. One of these is inflationary pressures. Wednesday the 13^th October looms as a big day as US CPI data will be released and the market is anticipating a result well above the 2% Fed target. At the time of writing the Bloomberg median estimate was 5.3%. Should the result be so high, or even higher, we do not think the market can continue its ‘inflacency’.

Inflacency is inflation complacency, built on a belief that this year’s surge in global inflation was a short-term phenomenon caused by post-COVID reopening. Inflacency cannot continue in the long term and the Fed has already started to open the door on tapering, not that you could tell from markets.

Importantly for investors, gold equities appear cheap compared to the gold price and other equities. They stand to benefit, as their balance sheets remain strong and they typically rise more than the gold price in an upswing.

Gold in 2021

Gold prices have now been consolidating for over a year, since hitting an all-time high of US$2,075 in August 2020. The price has barely moved from the beginning of the year, underperforming most markets.

Figure 1: Performance of major indices so far in 2021

A spike in interest rates following the September FOMC meeting in which the Fed suggested it could begin tapering its US$120 billion per month purchases of Treasuries and mortgage-backed securities in November was the most recent event weighing on the gold price. The Fed also indicated it might begin raising rates as soon as late 2022.

We believe there are a myriad of risks that will come with a Fed tightening cycle, including:

• Stimulus-fuelled economic growth could grind to a halt;
• Debt service costs become a problem with higher rates; and
• Bubbles in certain sectors, bonds, crypto assets, and housing could come crashing down.

None of this is slowing the market down. According to the Wall Street Journal, IPO activity has already surpassed that of every full year on record. Sales of junk-rated bonds and loans have also topped previous annual highs. In 2021, the average daily notional value of stock options traded is set to surpass the value of underlying stock trades for the first time. NFT’s (non-fungible tokens) of digital art are selling for millions in a bubble reminiscent of the seventeenth century tulip mania, when a single tulip sold for more than some houses.

Frothy markets don’t worry about risks and don’t see a need for safe havens. As a result, so far in 2021, gold has not shone for investors.

However, that could change on Wednesday following the release of the US inflation numbers. As we noted in our past two quarterly ViewPoints, ‘inflacency’ has reigned. Inflacency is where inflation meets complacency, and it sums up the attitude of many market participants and policy makers.

Risks ahead provide supportive backdrop for gold

During the June quarter for example, the US inflation data overshot expectations by a long way, core CPI overshot market expectations by an annualised 4% over the quarter. The way bond markets shunned the result was unprecedented, but bond markets were not the only ones in denial. So were central bankers. While the Fed did revise up its CPI projection for 2021, its 2022 forecast did not change, with no policy action expected until the following year. The word transitory became a part of the lexicon.

The ‘transitorians’ pointed to the downside surprise of the June CPI, which eased, and while we are not disputing there were transitory upward pressures on prices at the start of the year, downward transitory pressures may have been understated. One example is rents. Rents froze during COVID, but rent rises are back in a big way. Owners’ Equivalent Rent (OER), which represents a quarter of the entire CPI has picked up, but it could go further.

Figure 2: Transitorians may have overlooked Owners’ Equivalent Rent that will affect CPI

Labour markets too are putting upward pressure on prices. For example, increased overtime, higher wages to attract new workers, and extra spending on transportation added US$450 million to costs in FedEx’s quarter ended 31 August.

Energy prices have skyrocketed in Europe and China. The UBS Bloomberg CMCI commodities index made new seven-year highs in early October, driven by fossil fuels, metals and agricultural commodities. Supply chains are being realigned and businesses are relocating sources of production, creating bottlenecks that limit supply. Record numbers of container ships are parked off the coasts of California and Georgia, waiting for warehouse space and trucks to ship the goods inland.

While some inflation drivers are related to the reopening of the economy, it seems the majority are long-term post-pandemic structural changes in consumer behaviour, the workforce, raw materials dynamics, and production and transport of goods that all point to a sustained period of rising prices. Perhaps the most compelling argument is the fact that for years easy monetary policies, and more recently fiscal policies, have been stoking inflation. We would expect the gold price to react into 2022 if inflation metrics remain elevated.

Gold stocks provide leverage to bullion

Gold equities tend to outperform gold bullion when the price rises, and underperform if the gold price falls. Although this expected relative performance may not hold during certain periods, gold equities have consistently demonstrated their effectiveness as leverage plays over the years. As investors become more confident that the current low multiples are not merely ‘value traps’, given their improved earnings and fundamentals, gold miners could benefit from an upward re-rating as capital flows towards value shares such as commodity-related stocks.

Compelling valuations

We also noted in the most recent ViewPoints that the revenues and earnings generated by gold mining companies at the end of August were essentially the same as they were in the previous corresponding period, yet the stocks are trading at lower prices, creating a value opportunity. You can this see in Figure 1 above, when the gold price staged a comeback in August its miners continued to retreat.

Gold miner stocks are trading at well below historical averages and they have not been this cheap since April 2020. You can see this in figure 3 below, which shows the value of gold mining equity, measured using the NYSE Arca Gold Miners Index relative to the gold price.

Figure 3: Gold companies relatively cheap at current levels

Most companies are holding their costs below US$1,000 an ounce, and are returning the cash to shareholders via increased dividends and share buybacks. We believe that an unhedged exposure is the best way for Australian investors to access this asset class. Investors can access the opportunity to invest in gold miners on ASX with an ETF, which can give investors instant access to the largest and most liquid global gold mining companies.