Arguably the description of Gold as a “Barbarous Relic” might be even more appropriate in the post modern financial era of crypto and NFTs. However, gold has around 4000 years of financial history as store of real value against the devaluation of fiat currencies. More recently, a key point to note is that the spot price of gold still largely reflects underlying fundamentals; 1) the real yield or the value of the competing asset; 2) the inverse of the US dollar; and 3) the price of financial risk. Gold remains an important potential portfolio diversifier, particularly when there is a negative real yield on most fixed income. Similarly, gold mining equity appears undervalued and a potential diversifier in risk asset portfolios.
Tactically, the key drivers of gold have been moving in opposite directions. The dollar index has appreciated over the past three months and the credit spread on financial assets has continued to compress as a reflection of the recent strength in aggregate risk perceptions. In contrast, the real yield on the US 10 year Treasury (nominal – breakeven inflation) has eased to -100 basis points and is probably consistent with spot Gold above $1900 US dollars (chart 1). Recall that because gold has no yield and a cost of storage, the real interest rate is the competing asset for gold. The other tactical positive is ongoing reduction in net speculative long positions and under-allocation of reserve managers to the precious metal.
On the negative side for gold, positive sentiment and risk perceptions have increased the preference for pro-cyclical assets over the past 12 months. In a global cyclical expansion, investors will tend to have a preference for assets and commodities leveraged to growth (chart 2). For example, copper (a cyclical commodity) tends to out-perform gold (a defensive commodity) as growth accelerates and Treasury yields rise, similar to the performance of cyclicals versus defensives within the equity market. In this context, the sustained strength of copper relative to gold despite the recent correction in Treasury yields is probably encouraging for investors bullish on growth and pro-cyclical assets. Alternatively, gold and gold miners are a diversifier for pro-cyclical assets if the signal from the nominal Treasury yield is correct on the potential for another growth scare or tightening in the fiscal impulse.
Specifically on the gold miners, recent underperformance has brought the sector back to a 45% valuation discount to global equities. Of course, historically the sector has traded at an average discount of around 40% on a price to book value basis. On the positive side, the bullish case for gold producers is the ongoing strength of free cash flow. A key observation we made in 2015 was the pivot in the sector to managing the business for cash and the trend improvement in free cash flow, rather than the prior behaviour of over-investing during a bull market in the underlying metal. Clearly, the improvement was also supported by the rise in spot, but there was a genuine improvement in free cash flow over that period. The valuation discount was a lot more episodic in December 2015.
More importantly, the ongoing strength in free cash flow and the warranted spot price above $1900 suggests that gold miners are around 25% undervalued as a sector. Gold miners are also an inexpensive portfolio diversifier with positive carry – in terms of cash-on-cash returns to shareholders. Looking forward, while the sector is undervalued, the key risk to further under-performance would be a renewed phase of pro-cyclical/reflation asset out-performance and a rise in real yields or the competing asset for gold. We are still “standing aside” on the miners for the time being.
About the Author:
Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.