Edison Investment Research, the investment research and advisory company, has published its latest mining report – A Golden Future: The Outlook for Gold and Gold Equities.
The report examines the relationship between gold prices and monetary conditions historically and analyses the recent price performance of gold relative to mining and general equity indices alongside other metals.
In summary, with markets spooked, uncertainty locked in, interest rates effectively zero and the Fed keeping the US economy afloat by whatever means necessary, there is much to support a buoyant gold price for the foreseeable future.
Based on the current US monetary base, Edison analysis suggests the gold price should be near US$1,900/oz, and with the potential for this to rise to more than S$3,000/oz.
Capital markets have not caught up with this outlook and taking the full range of scenarios into account many gold equities appear to be decidedly undervalued.
Real and nominal interest rates echo 1979
Although interest rates are currently negative, the Fed’s volte face on its 2017 plans to reduce its balance sheet from US$4.5tn to US$3.0tn by 2020 may introduce interest rate and inflation volatility similar to that which was witnessed between September 1979 and October 1980 – gold’s first great bull run in the period of fiat money.
Observing that gold prices have been extremely strongly correlated (0.909) with the total US monetary base since 1967, the report suggests that gold prices could very reasonably be expected to rise to US$1,892/oz and potentially as high as US$3,000/oz, now that the Fed’s bond buying program has increased the monetary base by 58%, to US$5.1trn, over the course of the last three months.
If the economic conditions of 1979 do indeed set a relevant precedent for the potential trajectory of current gold prices, Edison suggests that gold prices are likely to continue to rise until real interest rates move out of negative territory.
Gold did not top out until real interest rates reached over 4% in the latter half of 1980, and with the Fed funds rate unlikely to rise anytime soon, it seems that only a persistently negative CPI might thwart gold’s continued uptick in price.
The report stresses that a crucial determinant of gold’s price will be the evolution of the coronavirus crisis, however.
The rapid development of a vaccine and equivalent economic bounce back could allow the Fed to contract its asset base – this is what the gold price appears to be discounting now.
Yet, the longer the crisis continues, the more entrenched its asset base will become, and the more gold should tend towards its predicted level.
Divergence in performance between equity indices
Since the start of the coronavirus pandemic, the performance of gold equities has proved to be widely divergent. Comparing the performance of seven mining, near mining and general indices relative to the gold price over the last twelve months, Edison finds the rising gold price in both Q319 and Q120 resulted in a rapid (and geared) response from large-cap producing gold equities, represented by the HUI and FTSE Gold Mines indices.
There was an equally rapid (and geared) downward reaction in mid-March when gold fell approximately US$181/oz, or 11%; and, as the gold price recovered afterwards, the HUI and the FTSE Gold Mines index also recovered.
This performance is in sharp contrast to the performance of both smaller-cap exploration juniors, general and general mining indices.
Indicating that the share price performances of junior exploration companies are probably more dependent on perceived global financing conditions than the projects they are trying to finance, the report reveals that there was little reaction from smaller-cap junior exploration equities when the gold price rose in H219 and Q120.
The performances of general and general mining indices were similarly impacted by concerns of economic slowdown in H219 and H120.
Except for uranium, the value of industrial metals has declined relative to those of precious metals amid the coronavirus-induced slowdown.
Overall, gold and mining equities of all types have almost never been cheaper relative to the price of gold in the period 2002 to the present.
Since the average performance of a gold equity was 46.4% and 14.5% for gold over the first four and a half months of 2020, Edison concludes that, as expected, gold equities are generally showing a geared relationship to the price of gold.
The one bright spot on the horizon
If the coronavirus crisis persists, and the Fed’s balance sheet stabilises or continues to increase, existing producers will capitalise on the increasing gold price.
Edison deduces that while larger companies with higher levels of gearing should benefit the most in percentage terms, the share prices of junior exploration companies will also slowly outperform equity markets over 2.5–5.5 years.
In this scenario, the report highlights that the dearth of financing in the wider economy will give existing producers the opportunity to fund the junior sector, potentially ushering in an era of wider wholesale consolidation within the industry.
Charles Gibson, report author and Director at Edison Investment Research, comments:
“Our latest mining report, A Golden Future: The Outlook for Gold and Gold Equities, is an opportunity for investors and mining companies alike to understand the evolving issues driving global equity valuations for gold, and how different coronavirus crisis scenarios will likely affect macroeconomic conditions and consequently the gold market.
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“Gold, with its safe haven and monetary status, has been an obvious beneficiary of the current uncertain environment and that seems unlikely to change for as long as the coronavirus remains a largely unknown quantity.”