Precious metals
Summary
Precious metals have enjoyed a period of strong performance in recent months. Gold has risen over +25% year-to-date while silver is up nearly +33%, outperforming most major global asset classes. From its lows in 2015, gold is up +85% in US dollar terms. Despite this strong performance, investment in paper and physical bullion amounted to less than 5% of the global equity and investment grade debt markets as of 2Q20, well off historical highs.
There are many positive forces which are likely to drive precious metals higher from current levels. From a macroeconomic standpoint, global monetary dynamics and further central bank purchases will likely support prices. From an equity perspective, valuations of gold mining companies remain attractive relative to history, balance sheets are more stable and capital expenditure plans are more rational. From a demand perspective, central banks, investors and consumers are increasing their purchases.
This demand is happening against a supply constrained industry where reduced capital expenditure over the last decade combined with lower exploration success is leading to a structural supply deficit. Overall, we think this combination of factors can support a sustainable gold price above $2,300, a substantial increase from current levels of $1,950 per oz.
How to think about precious metals?
Investors have long held opposing views on the role of gold in the modern financial system. John Maynard Keynes once famously called gold the ‘barbarous relic’, suggesting that its usefulness and its value was antiquated. In contrast, a young Alan Greenspan in 1966 declared that “gold is the only thing that fulfils all the requirements of money: It is scarce, it cannot be fabricated or produced in large quantities, it is durable, it is homogenous and divisible (so each unit is of comparable quality to the next) and it is widely acceptable as money. Obviously, printed money can’t meet these criteria. Only gold can.”
In our opinion, it makes sense to compare precious metals to fiat currencies rather than traditional asset classes such as equities and bonds. Throughout history, currency debasement has been a recurring theme. From ancient civilisations to today’s monetary conditions, the debasement of mediums of exchange has been a constant threat. In 2020, government debt to GDP of the G7 countries stands at around 120%, its highest level since World War II. This is accompanied by historically low global interest rates and an unprecedented expansion in the monetary base.
The result is an environment in which the opportunity cost of holding precious metals has fallen while expectations surrounding inflation have grown, especially considering the Federal Reserve’s recent comments on its inflation targeting mandate.
‘It makes sense to compare precious metals to fiat currencies rather than traditional asset classes such as equities and bonds. Throughout history, currency debasement has been a recurring theme’
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Figure 1: Gold and silver have recently performed well in USD terms
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Q3 2020
Precious
metals
Figure 2: Gold has performed well in major global currencies over the long term
Figure 3: Gold investment as a percentage
of global equities and investment grade
fixed income is increasing
We view precious metals, especially gold, as long duration assets with
no government backing and no liability attached. Historically, the correlation between gold and real yields has been high. Over long periods of real yield compression, such as 1960-1980, 1999-2012 and 2013 to today, gold has performed well. Based on the assumption that inflation expectations are permitted to rise above 2%, we do not think it would be difficult for real interest rates either to remain negative or even decline further from
current levels.
In a scenario of a 100-200 basis point reduction in real interest rates (10 year), gold is well supported at current levels and has significant upside. 30-year US Treasury bonds yielding a nominal 1.5% as of 9th September 2020, based in a currency that the Federal Reserve is explicitly devaluing, are not compelling.
Just as the monetary base expands into a country’s money supply (M1, M2 or M3) through the creation of credit in the banking system, gold is a hedge against the potential for the monetary base to expand into the money supply. Therefore, looking at the monetary base is a relevant metric for evaluating gold’s potential. The balance sheets of the ‘G4’ have grown 9x from 2002 reaching $24 trillion, $4 trillion of which came in 2020 alone.
How to value precious metals?
The recent strength of the investment market for gold has offset the weakness in physical demand, which primarily stems from the Covid-19 induced weakness in the emerging market consumer. ETF flows are at record highs for precious metals while gold now ranks third behind US equities and short-term treasury markets in value traded per day, reaching $145 billion per day, according to the World Gold Council.
This sharp increase in investment demand offsets the Covid-19 related slump in consumer demand. Chinese and Indian gold bar and jewellery consumers, which historically account for 60% of global jewellery demand, have dramatically reduced their purchases. Over the last 10 years, jewellery demand averaged 51% of total physical demand but, as of the end of the second quarter, this figure was only at 25%. Chinese demand has started to recover, and we expect Indian demand to follow as economic activity improves.
Following the Global Financial Crisis, central banks became net buyers of gold reserves for the first time in 50 years. This trend has continued in recent years and, despite the slowdown in 2020, results from the World Gold Council’s most recent annual survey indicate that 20% of central banks expect to add to their gold position over the next 12 months. This figure compares to only 8% in 2019. Additionally, in many countries, gold still represents a minor portion of total reserves. For instance, gold accounts for 3% of total reserves in China vs. 79% in the United States as shown below.
Growth in demand
Constrained supply
The outlook for the supply of precious metals is materially constrained in our opinion. If one were to gather all the gold mined over the last 2,000 years,
it would only amount to a 200,000-ton block of gold worth approximately
$12 trillion and approximately the volume of 20mx20m cube or three Olympic-sized swimming pools.
While most of this tonnage was discovered post-1950, recent exploration
has not delivered meaningful incremental reserves. The world’s total remaining gold reserves equate to only 54,000 tons which is roughly 15 years of current global production. Additionally, the chart below shows there has been a significant drop in exploration success to replenish reserves and more than 80% of gold production is derived from emerging and frontier countries, some of whom possess greater political and capital constraints than
developed markets.
In 2019, physical gold production fell for the first time in over a decade. In 2020, we expect a steeper decline due to Covid-19 related lockdowns while green-field capital expenditure remains low. Despite the constrained supply situation, we do not see large producers expanding exploration budgets. Conversely, we expect further industry consolidation, which generally results
in a reduction and optimisation of green-field budgets.
Despite record gold exploration budgets in 2011/2012, new discoveries and gold in reserves have gradually fallen to historical lows in 2019. Additionally, gold exploration budgets remain less than half of peak levels. The largest gold miners are producing at or below levels achieved in 2011 while head-grades have fallen. The time and capital required to bring on large, low-cost mines is well above the potential firepower of producers, providing a significant moat around the industry.
Our price target scenarios
Given the demand and supply factors described above, we expect a narrowing of the ratio between central bank assets and precious metal prices, specifically gold. As has happened in previous cycles, precious metals can be more closely correlated with the monetary base which would likely result in prices being supported above $2,000. A return to long-term averages may lead to a gold price above $3,000 per ounce. If we consider relative value versus other assets such as global fixed income and equities, precious metals could return to previous peaks seen in 1980 and 2011. This suggests that the gold price could find support at lows of $2,300 to highs of $6,000 over the coming years.
Figure 4: Long term correlation between gold and interest rates
Figure 5: Negative yielding debt
encourages shift into gold
Figure 6: The gold price has a positive correlation with developed central bank assets
Figure 7: ETF inflows are at record highs in 2020
Figure 8: Physical demand declined materially during Covid-19
Figure 9: Global central bank
gold holdings
Figure 10: Gold supply by country
Figure 11: Gold discoveries have fallen amid declining exploration
Figure 12: Covid-19 will likely affect world gold production
The team
John Malloy and James Johnstone co-manage the RWC Emerging and Frontier Markets team. The team is composed of a further 18 analysts, economists and strategists based in Miami, London and Singapore, many of whom have worked together for over twenty years. The team joined RWC Partners in 2015 and now manages c.$8.8bn for its clients.
Figure 1: Gold and silver have recently performed well in USD terms
Figure 2: Gold has performed well in major global currencies over the long term
Figure 3: Gold investment as a percentage
of global equities and investment grade
fixed income is increasing
Figure 4: Long term correlation between gold and interest rates
Figure 5: Negative yielding debt
encourages shift into gold
Figure 6: The gold price has a positive correlation with developed central bank assets
Figure 7: ETF inflows are at record highs in 2020
Figure 8: Physical demand declined materially during Covid-19
Figure 9: Global central bank
gold holdings
Figure 10: Gold supply by country
Figure 11: Gold discoveries have fallen amid declining exploration
Figure 12: Covid-19 will likely affect world gold production
Why gold miners?
The outlook is particularly encouraging for gold miners. The average all-in cost of extraction for these companies is around $1,000 per ounce. If prices stay at current levels, operating margins will likely average 50%. Furthermore, cost deflation from lower energy prices and weaker export currencies can act as further tailwinds for margins. Valuations also remain attractive. While earnings estimates for next year remain strong, implied multiples remain 50% below peak earnings during the previous cycle in 2011. As illustrated by the HUI Index relative to the gold price below, miners remain discounted relative to the underlying commodity.
Figure 13: HUI index (gold ratio) is at cyclical lows
Investment opportunities
Within emerging markets, our exposure to gold includes Anglogold Ashanti and Goldfields, two South African based miners focused on portfolio optimisation and free cash flow generation. In terms of production, we expect Anglogold to average 3 million ounces of production per annum following the completion of low-cost project in Ghana early 2021. For Goldfields, we expect production to grow above 2.5 million ounces over the medium term following the completion of its low cost mine in Chile.
Both producers operate at similar all-in-sustaining cost levels of c. $1,000 per ounce. Both growth assets remain at the low end of the cost curve, providing additional support for margin expansion at current spot prices. Valuations
for both companies remain attractive at less than 5x forward EV/EBITDA and less than 10x price to forward earnings at spot prices of $2,000 per oz. The fund also has exposure to Sibanye Stillwater, a precious and platinum group
metals producer with operations in South Africa. Importantly, forward free cash flow yields for the fund’s holdings are above peers indicating attractive valuations and low levels of ownership in emerging and frontier precious
metal companies.
In our frontier and smaller emerging markets strategy, we currently own AngloGold, Hochschild Mining, SolGold, Managem and Endeavour. Hochschild Mining is a family-owned Peruvian miner focused on silver and gold production for over 100 years. We believe profitability may increase dramatically if current spot prices are maintained. The company trades at a significant discount to peers. SolGold is an Ecuadorian mining company whose base and precious metal project, Alpala, will likely reach definitive feasibility in 2021. Managem is a Moroccan miner of which silver and gold make up 66% of revenue. The company is expected to more than double its gold production to over 200k ounces due to projects in Sudan and Guinea. Endeavour’s production is expected to increase to 1 million ounces through its project in Hounde, Burkina Faso.
Portfolio holdings are subject to change at any time without notice. This information and the names above should not be construed as a recommendation to purchase or sell any security.
Figure 14: Free cash flow yields are very attractive for precious metal miners
Conclusion
Gold’s value is derived from its status as a hedge against expansive fiscal and monetary policy. The more egregious government policy becomes, the more valuable gold becomes. The risk and, therefore, the sell signal will be when the world appears ready to give up on debt and easy money. This policy reversal does not seem to be imminent.
Based on this positive view on precious metal prices, an allocation to precious metals provides both diversification opportunities as well as the possibility of significant upside. Precious metal miners are even more compelling due to their current discounted valuations, their strong earnings and cashflow momentum and the margin uplift expected at current and future prices.
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