For And Against Gold

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– Geopolitical risks linger
– Physical demand shifting
– US economy an uncertain factor
– M&A activity undisputed
 

By Greg Peel

Right now gold must be feeling like a celebrity who was top of the A-list for several years before very quickly being dropped into the “whatever happened to” basket as a precursor to the eventual “what are they doing now” ignominy.

For a decade gold reigned supreme, rising quietly from the ashes of the Long Term Capital Management Collapse in the late nineties and subsequent central bank gold dump intended to ward off what was then feared would be a GFC (on a risk of US$6bn, can you believe), accelerating through the US dollar downward spiral of the post 9/11 Greenspan era, and finally surging when the real GFC came along and there was not enough gold left to sell.

Gold rallied from under US$300/oz to a peak over US$1900/oz in 2011. It then traded nervously sideways before the first hint of Fed tapering in 2013 which sealed gold’s celebrity-fall-from-grace. Now gold is only enjoying the odd little burst of excitement, is feeling friendless and is wallowing in self-doubt. The GFC is fading as a memory yet disinflation is wracking the developed world, neither of which provide much support for the alternative store of wealth. Gold was once the go-to asset in times of geopolitical unrest but while a burst of activity followed the Ukraine crisis, even the threat of Cold War II could not excite the pundits into reaffirming gold’s fame.

So where to now? Different analysts have different views.

Joe Foster is Van Eck Global’s portfolio manager of gold strategies. It is perhaps thus no earth shattering shock that Foster sees a promising outlook for gold in the second half of 2014, but he offers up several supporting arguments.

Foster suggests geopolitical risks in emerging markets have likely been the main driver of a more positive gold price so far in 2014. Ukraine is not the only source of risk, given issues in Thailand, Venezuela and Turkey have also led to an outflow of capital from those countries, and thus those currencies, into safe havens. With no resolution in sight for most of these disputes, gold will at least be supported throughout the year, Foster asserts.

No analyst will disagree that China and India are the two most fundamental nations when it comes to gold demand, not through safe haven financial plays but through physical demand for jewellery. China nevertheless is offering up two separate positives for gold at present, Foster believes, relating to physical demand and to economic concerns.

Beijing has been attempting to reposition China’s economy toward domestic-driven consumption rather than foreign-driven export markets and in so doing has slowed GDP growth from three decades of double-digits to a March quarter 7.4%. Further signs of a slowdown in China could create financial risks that drive investors to gold, says Foster.

Yet China’s April trade data showed gold imports plunged in the month, to the point Macquarie’s implied measure of gold imports indicate they were only half their recent average and on a net basis the lowest since September 2012. Macquarie suggests China’s “call on the international gold market is set to be much weaker this year, even if gold demand remains robust”.

A recent report from the World Gold Council predicts Chinese gold demand will remain flat in 2014 from 2013. Foster dismisses negative responses to this prediction and suggests it is positive news. Gold demand was unprecedented in 2013 as the Chinese stepped in to take advantage of lower prices, so if that demand is maintained (flat growth on 2013) it is very supportive for gold. Indeed the WGC suggests Chinese demand will rise 25% over the next four years.

Up until last year, India still outranked China as the greatest importer of physical gold, almost entirely as a result of the two major annual Indian festivals which require gifts of gold to be given even by those of modest means. But in order to head off a collapse of the rupee, the previous Indian government introduced import restrictions which saw gold demand drop off significantly in the second half of 2013. The new government has now announced some tentative relaxations of those restrictions, and several Indian trading entities will now again be permitted to import gold.

This could be another catalyst to send gold prices higher, Foster suggests. Morgan Stanley is not so sure, and does not expect a sudden demand surge from India. “We think a significant share of the ‘lost’ demand was already being met by unofficial imports,” says MS.

Foster then throws up the argument of the world’s largest economy. Here the camps are divided into three: US economy is recovering sufficiently to warrant the Fed’s QE tapering program, US economy is not recovering sufficiently at all and the Fed will soon be forced to “taper the taper”, and OMG I’m so confused. Foster is aligned with the second camp.

“The current US recovery is now longer than the average for post-World War II recoveries, yet growth has been half the average and unemployment has never been higher at this stage in past recoveries,” notes Foster. “The withdrawal of US Fed stimulus may have unintended consequences, putting further pressure on a weak US economy. Gold could respond favourably if the Fed finds it needs to reverse its tapering initiative”.

“The UBS house view is that the gold price in 2014 is likely to remain capped by the US Fed’s plans to ‘taper’ the rate of quantitative easing,” says UBS.

Take your pick.

Foster’s last observation is not a view but an undeniable truth. Merger and acquisition activity is on the rise in the global gold sector as many a beaten-down gold miner suffering financial difficulty has bowed to the “strong hands” of those in a more comfortable position with an eye on the promising reserves of the “weak hand” players. Valuations on gold stocks are very attractive at present (that is a view), says Foster, including those in Australia. M&A potential will keep the share prices of gold mining stocks underpinned (that is a fact).

Macquarie is another to note rising M&A activity as well as the fact large short positions are being held in gold names at present, thus potentially providing for “green shoots of a revitalisation of the gold equities in the coming quarter”. At the very least, gold miners across the globe, from large to small, have been concentrating on cutting costs to the bone to increase their margins on free cash flow.

The gold price has recently been retesting the US$1300/oz mark, and the average “all-in sustaining cost” (AISC) level for Australian gold miners is in excess of US$1100/oz, Macquarie notes. Most cost-cutting programs started 12-15 months ago are now entering a second phase of operations optimisation. Macquarie is forecasting a fall in AISC to US$988/oz in 2015 and US$954/oz in 2016.

Australia’s lowest AISC producers are Alacer Gold ((AQG)), Independence Group ((IGO)) and Beadell Resources ((BDR)), notes UBS. UBS believes investors will continue to be drawn to low-cost producers and those with M&A appeal such as Papillon Resources ((PIR)), although subsequent to the UBS report Papillon has already announced merger plans.

If Joe Foster and Van Eck Global have a nemesis, it is Citi. Citi notes gold remains depressed since the 2013 decline and sees “limited upside catalysts” in 2014-15. In terms of gold miners and their evasive action cost-cutting programs, Citi notes 75% of the global industry is still burning cash at current prices.

Yet in historical terms, gold mining stocks continue to enjoy a price/earnings premium to other resource stocks. Citi believes such high PE ratings are temporary and only occur during “mega gold bull markets”. “When gold settles back into its routine of simply following mine supply and jewellery demand rather than being the ‘go-to’ insurance asset during huge global systemic risk periods,” says Citi, “the market re-focuses on this sector’s seeming inability to deliver sustainable production growth”.

Citi believes 2013 exposed the industry’s “intrinsically bad fundamentals” and believes a shift from “short-termness” to longer term value is needed. “We are yet to see this happen,” says Citi.

Citi’s list of global gold mining stocks “least likely to deliver shareholder value” includes Newcrest Mining ((NCM)).
 

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