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Gold Miners Battle Great Expectations

July 12, 2022

Read Time 8 MIN

Gold finds support in the $1,800 per ounce range as it enters a transitional stage. A disciplined approach by the gold mining sector may lead to future outperformance.

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: trading like a champ

Gold prices averaged around $1,837.20 per ounce in June, trading as high as $1,871.60 on June 10 before closing at its monthly low of $1,807.27 on June 30 (a 1.64% loss for the period). Inflation, the U.S. Federal Reserve Bank (the “Fed”) and gold were, once again, central figures in June’s macroeconomic story, as the tug of war between all three remains contentious, yet balanced. Year-to-date, gold stands firmly, generating losses of only -1.2%, despite an approximately 20% loss in the S&P 500 Index,1 a 9.4% increase in the U.S. Dollar Index (DXY)2 and a doubling of 10-year U.S. treasury yields in the first half of 2022. As one of our colleagues likes to say: “gold is trading like a champ” (and we would have to agree!).

History’s lessons on rate hikes

While far from levels reached in August 2020, gold has found support in the $1,800 per ounce range. We believe this price reflects a fairly benign economic outlook, where inflation starts to decelerate as the Fed increases its target fund rate and the economy does not go into a recession. While present conditions are different from those during previous rate hiking cycles, it is always helpful to look back. One observation, as seen in the chart below, is that most rate hike cycles in the past have eventually driven the economy into a recession.

Rate hikes and recessions have typically gone hand-in-hand

Rate hikes and recessions have typically gone hand-in-hand

Source: St. Louis Federal Reserve. Data as of May 31, 2022.

Another observation is that inflation is slow to respond to gradual increases in the Fed funds rate. The chart below shows the U.S. Consumer Price Index (CPI)3 before and after the beginning of the rate hiking cycles. The current cycle resembles the August 1977 to March 1980 cycle (teal colored line), in terms of the levels of inflation at the start of the cycle. During that cycle, the Fed increased the funds rate from 6% to 20% in 31 months, hitting the brakes because of an economic recession, and all the while inflation just kept rising from about 6.5% to 14%. The one cycle that shows inflation coming down rapidly is the 1980 cycle (lime green line). In that cycle, rates went from 8.5% to 20% in eight months. Rates were at 0% at the beginning of the current tightening cycle. The Fed's dot plot shows a median projection for a 3.25-3.50% federal funds target range at the end of this year. Inflation has kept rising. It is hard to be optimistic when looking at the past for guidance.

Rate hikes haven’t always slowed inflation…

Rate hikes haven’t always slowed inflation

Source: NDR, St. Louis Federal Reserve. Data as of May 31, 2022.

Priced just right?

Gold may trade around the $1,800 level for the rest of the summer. There is risk that at these levels as gold is vulnerable to market action by speculators and short sellers that could drive it lower. We have seen such activity in the past, and it can be damaging. However at $1,800, most of the “gold negative” news (higher rates, strong dollar, stable economy, under control inflation) appear to be priced-in, allowing gold to form a new and stronger price base around this level. This positions gold favorably to respond to a number of potentially “gold positive” news in the longer term (recession, persistent inflation, continued weakness in financial markets, a pause in Fed tightening) which could drive gold and gold stocks much higher.

Higher costs still a drag on miners

While gold is hanging in there, the performance of gold stocks has been far more disappointing. Year to date, the NYSE Arca Gold Miners Index (GDMNTR)4 is down 14% and the MVIS Global Juniors Gold Miners Index (MVGDXJTR)5 has declined 23%. Gold stocks carry leverage to the gold price and that works in both directions, so any moves in the gold price are expected to be amplified for the stocks. However, with gold down just 1.2% in the first half, the stocks’ leverage to the metal can only partially explain the recent underperformance.

Another factor affecting performance is the broader equity markets sharp selloff, which has also dragged down gold stocks. In addition, the first quarter earnings reports for the gold miners were generally below expectations, with cost inflation and COVID-related interruptions negatively affecting results. Higher operating costs are impacting margins. We now estimate average all-in sustaining costs for the sector of about $1,200 per ounce in 2022, which is more than a 10% increase over 2021.

Nonetheless, at $1,800 per ounce, free cash flow generation for the gold producers remains very strong and should be supportive of gold stocks. Gold producers are to a certain extent naturally hedged against cost inflation in that higher inflation has historically supported higher gold prices. We should see gold stocks outperform if this historical correlation plays out in this cycle. For the junior/developer companies, there are other factors at play affecting performance, which we discussed in our May commentary.

Only part of a bigger challenge, though…

At present, the gold mining sector faces a particularly daunting challenge: establishing itself as an investable sector through all market cycles in order to attract a broader investor base. We view this as a work in progress. A lot of the hard work has already been done. The transformation of the sector began in the second half of 2012 with widespread management team changes across the industry. This was followed by a decisive shift in strategy. The message was clear and consistent across the sector: growth was no longer the single priority; instead, the new focus was on controlling costs, meeting expectations and generating attractive returns to shareholders. The result is companies with little debt, a lot of free cash flow, attractive dividends and share buyback programs and a disciplined approach to growth.

In order to keep generating cash that can be returned to shareholders (the market’s main focus), companies must grow – and while the focus has been, and rightfully so, on growing margins and increasing returns instead of growing production – companies also have to replace their reserves and resources. On average, we estimate the life of the sector’s existing mines at approximately 15 years. To be able to sustain production beyond the next 15 years, companies have to find more gold; they have to grow their resources. They can do this organically through exploration around existing operations (brownfields) or in new properties (greenfields), or they can acquire the gold already discovered by others. Organic growth is cheaper than acquired growth, but all growth comes at a cost: The cost to find the gold and the cost to develop that gold deposit into a producing mine.

“Do everything but do nothing”

Which brings us to the next phase of the larger challenge faced by the industry. Gold producing companies are financially strong and able to fund their growth plans. However, the markets do not seem to like companies spending to find, develop and build mines. Whether it is through an acquisition of an asset or another company or through the development of one of the company’s assets, the market seems to generally punish gold stocks on announcements of significant spending towards growth.

We understand there is reason for skepticism. It may be tough to forget the value destructive acquisitions, over spending and excessive indebtedness of the last gold bull market. However, companies, over the past 10 years, have demonstrated their continued discipline, focus on profitability, defending margins and increasing shareholder returns. Since mid-December 2015, the gold price has increased by 60%, and positively this has not resulted in the excesses of the past.

For companies to continue to create value, they must invest in growth. Growth-at-any-cost is a thing of the past, but growth-at-zero-cost is fantasy. The current inflationary environment is complicating things further for the gold sector. Building a mine requires a lot of materials, energy, labor and capital. Capex estimates for new projects are being revised up 20-30% due to cost inflation. The market naturally is spooked by such news, so stocks generally drop when the revisions are announced. But in reality, in their quest to demonstrate that they can run a profitable and sustainable business with good returns through the economic cycles, gold companies have no choice but to explore, build and expand/upgrade mines even during periods of high inflation. It takes a long time (typically 10 or more years) to discover, permit, develop and put a gold deposit in production. Those companies that can manage to do so while maintaining attractive returns should outperform.

A work in progress

Gold stocks appear to be in a transitional stage. The market may recognize the health of the industry, but it could take more time to demonstrate that the sector can continue to deliver good, sustainable results over the longer term, and despite the movements in the gold price. During this transition, it is imperative that companies meet their targets in order to continue to build credibility. Eventually, this disciplined approach should lead to gold companies earning their place as attractive investments within the broader equity universe.

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Important Disclosures

All company, sector, and sub-industry weightings as of June 30, 2022 unless otherwise noted.

Nothing in this content should be considered a solicitation to buy or an offer to sell shares of any investment in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction, nor is it intended as investment, tax, financial, or legal advice. Investors should seek such professional advice for their particular situation and jurisdiction.

1S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States. 2The U.S. Dollar Index measures the value of the U.S. dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. 3U.S. Consumer Price Index (CPI) is a measure of the average change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers. 4NYSE Arca Gold Miners Index (GDMNTR) is a modified market capitalization-weighted index comprised of publicly traded companies involved primarily in the mining for gold. 5MVIS Global Junior Gold Miners Index (MVGDXJTR) is a rules-based, modified market capitalization-weighted, float-adjusted index comprised of a global universe of publicly traded small- and medium-capitalization companies that generate at least 50% of their revenues from gold and/or silver mining, hold real property that has the potential to produce at least 50% of the company’s revenue from gold or silver mining when developed, or primarily invest in gold or silver.

Any indices listed are unmanaged indices and include the reinvestment of all dividends, but do not reflect the payment of transaction costs, advisory fees or expenses that are associated with an investment in a Fund. Certain indices may take into account withholding taxes. An index’s performance is not illustrative of a Fund’s performance. Indices are not securities in which investments can be made.

NYSE Arca Gold Miners Index is a service mark of ICE Data Indices, LLC or its affiliates (“ICE Data”) and has been licensed for use by VanEck ETF Trust (the “Trust”) in connection with VanEck Gold Miners ETF (the “Fund”). Neither the Trust nor the Fund is sponsored, endorsed, sold or promoted by ICE Data. ICE Data makes no representations or warranties regarding the Trust or the Fund or the ability of the NYSE Arca Gold Miners Index to track general stock market performance.

ICE DATA MAKES NO EXPRESS OR IMPLIED WARRANTIES, AND HEREBY EXPRESSLY DISCLAIMS ALL WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE WITH RESPECT TO THE NYSE ARCA GOLD MINERS INDEX OR ANY DATA INCLUDED THEREIN. IN NO EVENT SHALL ICE DATA HAVE ANY LIABILITY FOR ANY SPECIAL, PUNITIVE, INDIRECT, OR CONSEQUENTIAL DAMAGES (INCLUDING LOST PROFITS), EVEN IF NOTIFIED OF THE POSSIBILITY OF SUCH DAMAGES.

MVIS Global Junior Gold Miners Index (the “Index”) is the exclusive property of MarketVector Indexes GmbH (a wholly owned subsidiary of Van Eck Associates Corporation), which has contracted with Solactive AG to maintain and calculate the Index. Solactive AG uses its best efforts to ensure that the Index is calculated correctly. Irrespective of its obligations towards MarketVector Indexes GmbH, Solactive AG has no obligation to point out errors in the Index to third parties. The VanEck Junior Gold Miners ETF (the “Fund”) is not sponsored, endorsed, sold or promoted by MarketVector Indexes GmbH and MarketVector Indexes GmbH makes no representation regarding the advisability of investing in the Fund.

Please note that the information herein represents the opinion of the author, but not necessarily those of VanEck, and this opinion may change at any time and from time to time. Non-VanEck proprietary information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Historical performance is not indicative of future results. Current data may differ from data quoted. Any graphs shown herein are for illustrative purposes only. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of VanEck.

The Strategy is subject to the risks associated with concentrating its assets in the gold industry, which can be significantly affected by international economic, monetary and political developments. The strategy’s overall portfolio may decline in value due to developments specific to the gold industry. The strategy investments in foreign securities involve risks related to adverse political and economic developments unique to a country or a region, currency fluctuations or controls, and the possibility of arbitrary action by foreign governments, or political, economic or social instability. The strategy is subject to risks associated with investments in Canadian issuers, commodities and commodity-linked derivatives, commodities and commodity-linked derivatives tax, gold-mining industry, derivatives, emerging market securities, foreign currency transactions, foreign securities, other investment companies, management, market, non-diversification, operational, regulatory, small- and medium-capitalization companies and subsidiary risks.

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