Go with the cash flow

The price of gold, after peaking earlier in the year along with the prices of gold mining stocks, has faced the headwind of a strong US dollar. The US dollar is benefiting from rising rates, the US Fed’s tough talk about inflation and the US’s economic outlook relative to Europe and China.

Earlier this year, gold was boosted by the quick pick-up in inflation and geopolitical instability. Looking ahead, markets and economic data releases point to an imminent recession, but this recession will be different from the recent past as the US Federal Reserve grapples with choosing between the fight against high inflation or stimulating growth. It cannot do both and either way gold could possibly win.

We expect the gold price to increase by the end of the year and its key driver could be a combination of factors, or a single catalyst, including continuing high inflation, ongoing geopolitical tensions, any weakness in the US dollar, or if the Fed does a policy u–turn.

Gold miners stand to benefit too, as their balance sheets remain strong and they offer something the market will be looking for in an economic slowdown: cash flow. Gold miners have become more profitable as the price of the yellow metal has appreciated and since the GFC, gold companies have been implementing changes to address mistakes of the past, which in our opinion, should lead to outperformance by gold equities relative to bullion in a gold bull market. The additional advantage of gold miners is that many pay dividends.

If inflation remains elevated for several years, the financial system will not be able to return to normal for an extended period. This could create a favourable environment for gold and for gold miners to shine.

It’s all pointing to a recession, but so far gold has been on hold

Markets and the economy are beginning to show the signs of an imminent recession. Many retailers have cut their 2022 forecasts. Sales of new homes in the US plummeted by the most in nearly nine years and pending US home sales have been falling all year.

First quarter US GDP growth was negative and New York State manufacturing activity contracted in May for the second time in three months.

In markets, crypto assets, special purpose acquisition companies (SPACs) and technology stocks have intermittently been in crash mode all year. The S&P 500 has entered official bear market territory.

Earlier in the year, driven higher by the Russian invasion of Ukraine, the gold price touched its all-time high price of US$2,075/oz. Since then, however, it has fallen. The strength of the US dollar has been a headwind affecting the price of gold, rising to a 20-year high in May.

The US dollar has benefited from rising interest rates, the Fed’s tough talk on inflation and a favourable economic outlook compared with Europe and China. The chart below shows gold falling below its bull market trend-line that has been in place for three years now and an imminent recession could see the gold price get back on trend.

Chart 1: Where does the gold price go from here?

During the last four recessions since 1990, the Fed aggressively stimulated the economy. However, those downturns occurred in a secular disinflation environment, where each recession began with an inflation rate that was lower than the last. Today, unless inflation miraculously comes under control, the Fed will have to choose between lower inflation and higher growth. It can’t have both, and it might get neither if stagflation (i.e., high inflation and no growth) sets in. Stratospheric debt levels compound the challenge.

Either way, high inflation may endure and that supports gold

Inflation is likely to persist into the end of the year. Traditionally, to hedge against inflation investors have used gold. In the face of the recent inflation spike, the gold price did not respond as it has in the past.

Chart 2: Gold versus inflation

The gold price may appreciate if the Fed cannot curb inflation, or if it does a policy U-turn to protect markets.

The added appeal of gold companies

The advantage of holding gold miners in such an environment is that their price typically rises more than the gold price itself, as gold miners will add their own margins to gold production. Many miners pay dividends too, adding to the potential return.

Gold companies have been becoming more profitable as the yellow metal has risen in value since the GFC. Since that time gold companies have been implementing changes to address mistakes of the past that, in our opinion, should lead to outperformance by gold equities relative to bullion in a gold bull market. Gold miners’ balance sheets are strong.

Chart 3: Debt to equity of NYSE Arca Gold Miners Index

In addition to debt reduction, a focus on cash flow has transformed the valuation of gold miners. More miners have positive free cash flow than ever before and this is leading to more businesses that are profitable with the ability to reward shareholders.

Many gold mining companies are holding their costs below US$1,000 an ounce and are returning the cash to shareholders via increased dividends and share buybacks.

Investors can gain exposure to global gold miners via the VanEck Gold Miners ETF (GDX).

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