Gold has been on an impressive run. The price has risen 33% this year (as of August 18, 2020) on the back of unprecedented global fiscal and monetary expansion, an economic crisis and a declining real rate of interest. In fact, gold breached its highest nominal price ever recorded of US$2,050/oz on August 6, 2020.
The question now has become whether current and forecast market conditions can keep gold on an upward trajectory? Just as important, can the gold equity sector allocate capital more prudently than observed in prior gold cycles?
The RBC GAM Precious Metals Team recently discussed risks and opportunities in the sector. Their consensus: in the near term, gold is likely to pause. But longer term, as we highlight below, gold is likely to challenge its January 21st, 1980 nominal high of US$850/oz or US$2,737/oz in inflation-adjusted dollars.
What forces could drive gold higher?
In the global financial crisis, the gold price rose 175% from the trough in 2008 to the peak in 2011. Gold equities increased more than 300% in those three years. Arguably, today there is more stimulus and more debt in the economy. RBC GAM forecasts that a USD bear market may be unfolding after the 9-year USD bull market. Yet the NYSE Arca Gold Miners Index is still ~30% below its 2011 peak. Therefore, a case could be made that we are still in the early days of a multi-year gold rally.
In our view, gold prices may rise in response to these three main forces:
- A weakening U.S. dollar is historically positive for gold. When the dollar falls, gold looks relatively more attractive to those purchasing with other currencies. We believe the U.S. dollar may be overvalued, and in the COVID crisis it is losing its reputation as a safe haven. Also, central banks were very quick to provide liquidity, short-circuiting any hoarding activity.
- Lower nominal and real interest rates can also drive gold higher. Even before the pandemic, the U.S. interest rate differential advantage was vanishing. Even if interest rates rally in the U.S., we don’t expect the differential with other nations to change significantly. This in turn will cap U.S. dollar strength – propelling gold upward.
Also, with interest rates low, we could see a flow from fixed income assets into gold, as the opportunity cost of lost yield has decreased.
- Lastly, inflation could be a catalyst for gold prices. Admittedly, in the global financial crisis of 2008-09, we didn’t see much inflation. This time, however, could be different, based on the sheer level of stimulus, coupled with populist regimes – particularly with governments not wanting to see massive declines in asset values. However, it’s admittedly tough to envision the classic inflation definition of “too much money chasing too few goods,” so the prospects for inflation remain unclear.
The price of gold (USD/oz)
Source: Bloomberg. Jan 1, 1970 - Aug 18, 2020
What are some of the risks to the bullish case?
We spend a lot of time looking at what could end the gold strength. Rates rising would certainly be a headwind, albeit an unlikely one given the current economic crisis. As strange as it may sound, a vaccine would also be negative, as investors would move back from safe haven assets to risky assets. Again, that appears to be less of a risk in the near term, but one we’re following.
As far as signals that the market has gone too far, we’re not seeing that yet. We’re watching for the single-asset small-cap names to go on a strong rally. Historically that’s been a sign of excessive optimism, yet we have only witnessed four months of select small cap outperformance so far.
We also know there is an element of seasonality to the gold price. Generally we see July/August strength that fades around the Denver Gold Forum in September. The rally could continue this year, however, given the U.S. election in November -- particularly since you could make a bullish case for gold with either candidate. With Trump comes an expectation of four more years of turmoil, trade war and general uncertainty. With Biden comes expectations of tax hikes, a weaker broader market and, perhaps even more ominously, the unknown outlook for Biden's economic policies. This outlook is guided by Stephanie Kelton, author of “Modern Monetary Theory.” Kelton defends a heterodox school of economic thought known as Modern Monetary Theory, which claims that governments can spend freely without regard for deficits.
What’s your view on current valuations of gold stocks?
We think gold equity valuations are still reasonable. They are 30 to 50% lower than prior peak valuation levels, with much lower levels of debt. In fact, most companies are net debt free.
The best valuations are observed in the mid-cap and small-cap space, as many investors (particularly index investors) have yet to work their way down from the largest names. Kirkland Lake, for instance, produces more than a third of the free cash flow of Barrick Gold, but at a much more reasonable valuation.
The royalty space is where valuations are a concern, even after accounting for their exceptional business model advantage. Not only are they expensive, but future prospects for these companies are murky, as not many producers need to seek funding help right now. Furthermore, streaming is becoming much more competitive, at a time where producers are becoming more disciplined in their growth.
Perhaps what is most attractive and unusual about the gold equity space today is the refreshing discipline learned from the prior down cycle, a cycle that destroyed a lot of capital and investor faith in the sector. We are now witnessing a renaissance in capital allocation. Gold companies appear to be wisely allocating capital to increased dividends, share buybacks and judicious use of organic capital.
Evidence of this is the 20.9 million shares of Barrick Gold acquired by Berkshire Hathaway. Warren Buffet’s choice to invest in Barrick rather than physical bullion represents an important vote of confidence for the industry.
Perhaps most importantly, we are seeing nil or no premium mergers of equals, as pioneered and championed by Mark Bristow, CEO of Barrick, over the last two years. M&A has been exceedingly rational and at low valuations thus far. Expansion and new projects seem reasonable. There doesn’t seem to be extreme excess at this point.
Contrast that with 2011, when companies were trading at much higher premium levels to net asset value (NAV) and double-digit enterprise value (EV)/EBITDA multiples. In many cases they had gone on M&A binges (e.g., Barrick utilizing $8 billion of debt for acquiring copper companies).
With the Q2 reporting period essentially now over, most gold companies are generating strong free cash flow. They navigated a number of setbacks exceptionally well, including COVID-19 temporary mine shut-ins and disruptions. They even earned the reputation for being essential services in certain provinces, states and countries by incumbent politicians.
In summary, the outlook for the gold sector is strong, even at 15 to 20% lower gold prices. The gold sector went through an eight-year (2010 to 2018) capital destruction phase and learned to build profitable businesses at much lower gold prices.
With an estimated 1.5% dividend yield, we are seeing surprising restraint on capital expenditures. The industry has built a profitable business at below US$1,500 gold and remains committed to disciplined capital allocation. As this discipline is further appreciated and delivered upon, investors may continue to reward the sector.