Gold - May Not Be All That Glisters

by: Colin Lloyd

Uncertainty about US trade policy has truncated the rally in stocks.

Gold remains supported by central bank buying and fears of a US dollar collapse.

Gold miners look best placed to reap the benefits regardless of direction.

A collapse in the US dollar is needed for gold to rally substantially.

In Q4 2018, as stocks declined, gold rallied 8.1% and gold mining stocks 13.7%. It was a prescient reminder of the value of gold as a portfolio diversifier. There have, however, been some other developments, both for gold and gold mining stocks, which are worthy of closer investigation.

Central Banks

Central bank net purchases of gold reached 651.5 tons in 2018, up 74% from 2017, when 375 tons were bought. The Russian central bank, perhaps fearing US sanctions, sold almost all of its US Treasury bonds to buy 274.3 tons of gold last year. For probably similar reasons, the Turkish central bank bought 51.5 tons, down from the 88 tons purchased the previous year. Other big central bank buyers included Kazakhstan, India, Iraq, Poland and Hungary.

In the first quarter of 2019, central banks purchased a further 145.5 tons, up 68% on Q1 2018. The trend is not new - central bank purchases have been rising since 2009:

Source: BIS, IMF, GEMS, Reuters

Putting global reserve holdings in perspective, here is the central bank world ranking as of March 2019:

Source: IMF, Statistica

Despite the substantial buying from central banks, the price of gold has been broadly range-bound for the past five years:

Source: Trading Economics

The absence of a sustained rally suggests that many investors have forsaken the barbarous relic. However, concern that the gold price will collapse has to be tempered by the cost of mining an ounce of gold. Mining costs have increased substantially since the early 2000s due to increasingly expensive exploration costs and a general decline in ore quality. In the chart below, Money Metals Exchange shows the average cost of production for Barrick (GOLD) and Newmont (NEM) since 2000:

Source: SRSrocco Report, Kitco

A July 2018 post for Seeking Alpha, "Never Before Seen Charts: Gold Mining Industry's Costs Are Higher Than Market Realizes," shows that the amount of ore needed to produce an ounce of gold at Barrick’s Nevada Goldstrike and Cortez mines has increased four-fold since 1998:

Source: SRSrocco Report, Barrick Gold

The market capitalisation of the sector has halved since 2012, leading to understandable consolidation and deleveraging. Gold, however, is an unusual commodity in that its stock is far larger than its annual production. About 3000 tons of gold is mined annually, and this is dwarfed by the 190,000 tons that have been mined throughout history, according to World Gold Council estimates. Since it has little industrial use, almost all the gold ever mined remains in existence: central bank reserves are a key determinant of its price. Interesting research on the subject of what drives gold prices can be found in this article from the London Bullion Market Association: "Do Extraction Costs Drive Gold Prices?" It concludes that, due to the large stock relative to production, the price of gold is the principal influence on the mining industry.

The US dollar and inflation expectations

The rally in the gold price in 2011-2012 was linked to the eurozone crisis, and the moderation since then has coincided with a recovery in the US dollar Index. Other factors which traditionally drive gold higher include inflation expectations, these fears have continually failed to materialise, whilst the inexorable increase in debt has led some to speculate about a debt deflation spiral - an environment in which gold would not be expected to excel:

Source: Trading Economics

A different approach to gold valuation is the ratio of the gold price to the total return index for ten-year US government bonds. This ratio has been moving steadily higher, suggesting a shift to an era of structural inflation, according to Gavekal Research. Other evidence of inflation remains muted, however.

Is gold perfectly priced, or do the central banks know something we do not?

A look back at the decade after the end of gold reserve standard is a good starting point. The Bretton Woods agreement collapsed in 1971. In the years that followed, currency fluctuations were substantial and the US dollar lurched steadily lower:

Source: Trading Economics

The US dollar was so little revered that in 1978, the US Treasury had to issue foreign currency-denominated Carter Bonds in Swiss francs and German marks - such was the level of distrust in the mighty greenback.

Confidence was finally restored when Paul Volker took the helm of the Federal Reserve. Volker did what his predecessor but three, William McChesney Martin, had only talked about - taking away the punch bowl just as the party got started. He hiked interest rates and managed to subdue inflation: the fiat US$ was back in favour.

Today, the US dollar is undoubtedly the first reserve currency. In the era of digital money and cryptocurrencies, the barbarous relic has stiff competition. Added to which, it is an unexpected inflation hedge and traditionally affords scant protection in a deflationary environment. Given the global overhang of US dollar-denominated debt, many believe this is the next challenge to the international order.

Considering the conflagration of factors alluded to above, I believe gold is destined to remain a much-watched side line. Gold mining stocks may fare better, as S&P Global Market Intelligence's article, "Gold Mining Investment Outlook 2019: US$3.9B Increase In Earnings For Majors," explains:

... rising production in 2019, higher metals prices and lower costs could increase free cash flow by US$1.3 billion, or 19%, year over year. Companies will use this increased cash flow to lower net debt, which is expected to fall 19% year over year in 2019, placing the majors at their lowest level of leverage in five years. The majors have been focusing on returns to shareholders. Higher earnings have led to dividend payouts increasing 103% to US$2.0 billion in 2017 from US$1.0 billion in 2016 and remaining at about US$2.0 billion in 2018.

As for the price of gold itself? The attractive fundamentals underpinning mining stocks is likely to cap the upside, whilst continued central bank buying will ensure the downside is muzzled too. When I have little fundamental conviction, I am inclined to follow the trend. A break to the upside may be closer, but the long period of price consolidation favours a break to the downside in the event of a global crisis.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.