Of Gold And Gold Stocks

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Gold stocks have been hot property in 2016 as the Fed's enthusiasm for rate rises has waned. But where does that leave us now?

– Gold price has jumped in 2016 thanks to a dovish Fed
– Gold miner share prices have risen further
– Fed rate rise speculation is a swing factor
– Not all Australian gold stocks are overvalued

By Greg Peel

Gold and Central Banks

Gold could be worth US$1700/oz, argues Deutsche Bank.

The reason why gold could be at this level is based on the correlation between the gold price and the balance sheets of the Big Four central banks – the US Federal Reserve, the European Central Bank, the Bank of Japan and the People’s Bank of China. Since the beginning of 2005, the combined balance sheets of the Big Four have steadily increased by 300%, Deutsche notes, albeit the total has levelled off since 2015.

The Fed started the process when it introduced the first of its quantitative easing programs in 2009, post-GFC. The Fed then began tapering off its bond buying in 2014 and by 2015 was talking rate rises, delivering the first at year-end.

In the meantime, the BoJ has picked up the ball and run with it since 2013, while the ECB finally settled on a way to begin its own QE program in 2015.

Since 2005, the quantity of actual gold in the world – above-ground gold stocks – grew by 19%. If it is assumed the value of central bank balance sheets should be equivalent to that of total above-ground gold, then gold should be trading at US$1700/oz, Deutsche calculates.

Deutsche notes there is a strong correlation between central bank balance sheets and the gold price, and every time the gold price runs above/below the correlation value it soon reverts. The only recent times the correlation broke down were in 2008 at the height of the GFC, when desperate investors were liquidating gold positions to cover margin calls on plummeting stocks, and in 2013, when the Fed first began to talk about winding down QE, at a time it was thought Cyprus would have to sell all of its gold on market to avoid bankruptcy.

So, gold should be trading at US$1700/oz. But Deutsche is not expecting it to anytime soon. Indeed, gold could yet trade lower if the probability of a second Fed rate hike increases, the analysts concede.

Gold and Physical Demand

Macquarie asks, why is gold not at US$2000/oz?

2016 has seen a huge surge in physical gold buying via exchange traded funds (ETF), pushing the gold price up 24%. In the past decade, only 2011 saw a sharper gain. Yet at current prices gold is around 30% below 2011’s all-time high price of US$1895/oz, Macquarie notes. That peak would equate to greater than US$2000/oz in today’s dollars.

One reason that peak hasn’t been reached is because the 2016 rally began at the lower level of US$1050/oz, so US$2000/oz would represent a more significant gain. The second is that the US economy is not in the same dire straits it was in 2011 (when its AAA rating was lost), and hence the US dollar is stronger.

A third is that jewellery demand has waned, particularly as the economies of emerging markets such as China have slowed. It is oft overlooked that the bulk of the world’s actual gold ends up as jewellery. Hence jewellery demand is as important as investor demand.

The US dollar will likely continue to be strong on the assumption the Fed will eventually raise rates. But Macquarie still sees upside for the gold price – not as any sharp spike upward, but as measured appreciation.

Outside of gold buying for investment and as jewellery (although there is overlap between these two), gold is bought by central banks to support currency valuations. From the late 1990s to 2011, global central banks were net sellers of hundreds of tonnes of gold, Macquarie notes. Net selling has now swung to net buying, but almost entirely by China and Russia.

Unless there is some shock change in policy, Macquarie expects ongoing buying from China and Russia but at a slower pace as gold prices rise.

The Swing Factor

One of the primary drivers of the 2016 gold price rally has been dovish shift in Fed sentiment. When the Fed delivered its first rate rise in December 2015 it was assumed, by the Fed and the market, a gradual but consistent tightening phase had kicked off. At the beginning of 2016 the Fed was talking four rate rises in the year.

At the beginning of September, we’re still waiting for the first one. A week ago speculation began to build we might see a hike this month but then out came a soft US jobs number, followed by surprisingly weak readings for US manufacturing and service sector data. September is now considered unlikely. There’s no meeting in October and November is off the table given the presidential election. That just leaves December, again, if indeed there is to be a 2016 rate rise.

A Fed rate rise is the biggest threat to the US-dollar denominated gold price. Yet as recent moves in the US dollar index have underscored, a lot still depends on what other major central banks are up to. China continues to ease quietly, Japan has moved to negative rates, the ECB has stepped up its QE program and the UK recently saw a rate cut on Brexit fears.

Such widespread central bank easing poses an inflation threat, and in theory gold is a hedge against inflation. Mind you, we’ve been hearing about this “inflation threat” since 2008, and like subsequent Fed rate rises, it never seems to arrive.

The bottom line is such central bank activity ex-Fed likely puts a floor on the gold price, Morgan Stanley suggests. Upside would be constrained were the Fed to finally move. Further support is provided by aforementioned significant purchases of ETFs. The bulk of these purchases emanate from China, Morgan Stanley notes, and given this represents the fear of the growing national debt in China, there’s no reason to believe Chinese buying will evaporate in the short term.

Gold Stocks

Outside of physical or paper gold buying, the other (and arguably simplest) way to invest in gold is to buy gold mining stocks. And that’s certainly been the case in 2016.

Total shareholder returns for global precious metal equities had by mid-August exceeded 169%, Morgan Stanley notes. While the surge has been aligned with a rising gold price, more than 50% of increased valuations can be ascribed to multiple re-rating.

This means less than half of the increase in gold stock price/earnings ratios can be attributed to actual increased earnings thanks to the higher gold price. More than half is attributable to share prices rising beyond that suggested by earnings increases. Such expansion of PE “multiples” is a simple reflection of investor sentiment.

PEs have risen to the point that the market is paying a premium of some 32% over historical averages for the global gold stocks covered by Morgan Stanley. Looking at it another way, gold stock share prices imply a gold price 24% higher than it is now into perpetuity.

In short, Morgan Stanley is warning that global gold stocks are overvalued.

But there’s never been a better time to build a gold mine in Australia, Macquarie suggests.

The US dollar gold price is at post-GFC highs and the Australian dollar gold price is at all-time highs. It appears global central bank monetary policy will be supportive of gold, Fed notwithstanding, for some time yet.

Given the mining investment boom is over, there is a surfeit of skilled workers looking for employment and service company rates have fallen back to earth. The currency tailwind enjoyed as the Aussie dropped back down through parity has now abated somewhat, Macquarie notes, but mining cost depreciation has been significant.

Which is all well and good, but you won’t get much of an argument out of Macquarie regarding Morgan Stanley’s assertion gold stocks are overvalued. Yet, not all gold stocks are overvalued, Macquarie argues.

Macquarie highlights two local gold stocks developing projects which offer competitive costs and better or comparable mine lives than more recognisable names along with considerable exploration upside potential. On a risk-adjusted basis (which means applying a valuation discount to a development that is yet to be completed), the broker sees considerable share price upside for Gold Road Resources ((GOR)) and Dacian Gold ((DCN)).

Despite calls of overvaluation, Bell Potter suggests there are a handful of local gold stocks that are well positioned even if gold prices were to remain subdued on Fed hike speculation. The bottom line is a miner with a strong balance sheet and/or solid cash flow is less leveraged to short-term shifts in the gold price and better able to pursue growth opportunities.

Offering the greatest high-margin, free cash flow are Northern Star Resources ((NST)) and Evolution Mining ((EVN)), Bell Potter believes.

On the other side of the coin are miners offering strong leverage to gold prices, thus providing solid upside potential were gold to rally (and vice versa). Here Bell Potter favours Perseus Mining ((PRU)) and Metals X ((MLX)).
 

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