Does Gold Get Back To Work With “Transitory” Retired?

Monthly gold market and economic insights from Joe Foster, Portfolio Manager and Strategist, and Imaru Casanova, Deputy Portfolio Manager, featuring their unique views on mining and gold’s portfolio benefits. An expanded PDF version of this commentary, including fund specific information can be downloaded here.

Gold Reacting To Inflation, Moderated Growth Outlook

Despite posting a small loss on the month (down -0.50% to $1,774.52 per ounce by month-end), gold’s historical status as an inflation hedge and safe haven investment were on full display during November.

Early in the month, Bank of England’s surprise decision to forgo interest rate hikes pushed down U.S. treasury yields and nudged gold higher, with the metal moving above $1,800 per ounce on November 5. Gold furthered its rally on the back of November 10 U.S. inflation data reads which showed the headline consumer price index (CPI)¹ climbing from 5.4% to 6.2% from September to October—the fastest pace since 1990. The news renewed concerns around inflation and added support to the “persistent rather than transitory” argument for inflation. Intraday, gold traded as high as $1,877.15 on November 16.

While stronger-than-expected U.S. retail sales weighed on gold mid-month, it was the November 22 nomination of Jerome Powell (for a second four-year term) as U.S. Federal Reserve (Fed) chair, and current governor Lael Brainard for vice chair, which eventually led to another failed breakout opportunity for the metal this year. The Powell-Brainard combination was perceived as good for markets, providing continuity during a crucial time, reducing uncertainty, lowering risk, and, subsequently, driving the U.S. dollar to fresh yearly highs. Gold fell over $40 following the announcement, dropping back below $1,800 and erasing most of its previous November gains.

Gold did manage to trade back above $1,800 at least once more, though, as news of the Covid variant – Omicron – sparked a global market sell off over the Thanksgiving holiday in the U.S. On Black Friday, November 26, almost every asset class was down with the exception of gold.

Mixed Bag for Miners

Performance of gold mining equities was mixed with NYSE Arca Gold Miners Index (GDMNTR)² recording a small gain (+0.32%) and the MVIS Global Junior Gold Miners Index (MVGDXJTR)³ falling -1.46%. The sector reported earnings during November. Although most companies met or exceeded expectations, many companies continued to be impacted by Covid-related interruptions that affected their productivity. This, combined with increasing inflationary cost pressures, labor shortages and, in some cases, operational challenges, led to more companies lagging against guidance and consensus estimates compared to last quarter and previous years. However, in aggregate, we believe the sector remains in great shape—enjoying healthy margins at current gold prices and trading at historically low valuations.

Uncertainty Can Be Tough…

Last month, we talked about how gold markets have been struggling with uncertainty as investors seek to interpret the potential outcomes of Fed policy over the longer-term while also contending with higher inflation in the near-term. The good news for gold is that, in November, markets clearly signaled that owning gold in a rising inflation environment is a smart idea. There seems to be little confusion there, too, with gold trading up almost $100 from its month’s low on higher-than-anticipated inflation reads in the U.S.

However, the bad news for gold is that the market continues to struggle with how effectively the Fed will be able to combat inflation and to what extent expected tightening plans may slow down or kill economic growth and increase risks in the financial system. While Powell’s second-term nomination seems to have provided some confidence that the Fed will be able to successfully navigate through a potential storm, it also appears that the markets are now much more worried about the potential for a storm in general.

According to the U.S. Conference Board, consumer confidence dropped to a nine-month low in November, further exacerbated by the challenges the Omicron variant poses. During a Senate testimony on November 30, Fed Chair Powell said that it might be appropriate to accelerate the central bank’s tapering of asset purchases by a few months, given increasing inflationary pressures (and also pending more data and information on the new variant ahead of their next meeting on December 14-15). The stock market sell-off has intensified on Powell’s guidance for potentially faster tapering and gold has dropped on his statements too, despite an unquestionably much worse outlook for inflation.

…But At Least Some Things Are Certain

During a congressional hearing at the end of November, Powell stated that inflation has proven more persistent than anticipated, running well above the 2% target for longer than originally expected, and suggesting that “transitory” is likely not the best word to describe inflation right now. The Fed comments did not indicate that rate hikes may come earlier than anticipated, and any acceleration of tapering would still depend on economic conditions. Only one message seemed to lack ambiguity, though: inflation is worse than they thought!

Improving Gold Demand

Gold’s consolidation around the $1,750-1,800 range is attracting improved physical demand this year from China and India, with net purchases from central banks now approaching pre-pandemic levels. Bullion-backed ETF demand has yet to pick up, but we are seeing inflows since mid-November after two months of persistent outflows. As price action in November demonstrated, gold should respond to increasing or persistent inflation. We believe the Fed’s tools to fight inflation could become a substantial risk to the economy and to the stability of the financial system. In a worst-case scenario, exposure to gold should help weather the storm. Even in the best case, exposure to gold, especially through the gold mining equities, could prove beneficial.

Why You Still Want to Own the Miners

The point is always made that gold mining equities work in a rising gold price environment. This is a valid point, as the cash flow generated by gold companies is highly leveraged to the gold price. For example, we estimate that a 10% or so increase in the gold price translates into about 30% more cash flow for gold producers, which is why equities’ price moves can be a multiple of the gold price move in any given period. This works both ways, of course, when gold is up or down. The gold price is certainly the most important parameter to watch when investing in gold equities.

Gold has averaged around $1,800 per ounce so far this year. At these gold prices, companies are generating a significant amount of free cash flow. This is because costs, the second most important variable to watch when it comes to gold miners, are under control. Margins are very healthy and companies have excess cash to invest in their operations and give back to shareholders, even if the gold price stays right where it is today. This brings us to another valid point: Gold equities also work during periods of high and sustainable margins. The gold price and margins are historically high at present, yet stocks are trading at historically low valuations.

Perhaps no surprise…gold miners are still trading at attractive valuations

Source: RBC, VanEck, FactSet. Data as of December 2021. Past performance is not indicative of future results

The chart above shows the price-to-cash-flow (P/CF) multiple commanded by gold stocks (as measured by GDMNTR) from 2006 to present. The average P/CF multiple during the 2006 to 2011 gold bull market period, when the gold price averaged $991, was near 15x. In stark contrast, today, with a gold price of $1,800, that multiple stands at around 8x. Other valuation metrics paint a similar picture.

Cost improvements are adding with higher margins for miners today

Source: Scotiabank. Data as of October 2021. Note: All-In Sustaining Costs generally reflect the full cost of gold production from current operations and typically include adjusted operating costs, sustaining capital expenditures, corporate, general and administrative expenses, and exploration expenses. Past performance is not indicative of future results.

Gold miners: lower debt and higher free cash flow

Source: VanEck, FactSet. Data as of September 2021. Note: EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization; FCF = Free Cash Flow. Past performance is not indicative of future results.

Re-Rating Seems Possible Still

The argument could be made that, to earn back their old multiples, gold miners need to demonstrate that they can sustain this level of profitability over the longer-term by continuing to post good results and delivering consistent value creation. We believe that even in a scenario of sustained (rather than increasing) gold prices, miners’ performance so far justifies a re-rating that brings valuations more in line with historical averages and reflects the significantly improved position of the gold mining sector. However, it may take the resumption of the gold bull market to achieve substantially higher valuation multiples for the gold mining equities.

Gold miners are also demonstrating increased sustainability efforts and commitments, further improving their re-rating potential. Newmont (6.12% of Strategy net assets) announced this month that the company has entered into a strategic alliance with Caterpillar (not held by Strategy) intended on transform mining by delivering a fully connected, automated, zero carbon emitting, end-to-end mining system. A fleet of 26 electric vehicles is expected to be deployed in underground and open pit operations by 2027, would should support Newmont’s net zero carbon goal by 2050.

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