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In continuation with my macro themes for 2017, today I look at Gold and what I consider to be the best way to get exposure to the sector. Gold had an explosive start to 2016, up 30% to $1,372 from $1,061 the start of the year in $ terms to its peak just after the BREXIT vote in the summer. Since then Gold has given up much of the gains, ending 2016 at $1,173 just 7% higher than where it started. The price action has been unpredictable of late, gold traditionally does well in times of uncertainty/adversity and hence many gold analysts thought the prospect of Donald Trump in the white house would rally the yellow stuff, but no such joy. So what are the prospects for gold in 2017, will it be a year for the gold bugs or the gold bears?
Gold, back to basics
Gold is pretty useless compared to most other commodities, it has very limited industrial application, with its key industrial use being as a conductor in precision electronic appliances. Gold’s industrial demand is very limited compared to for example copper, oil or iron. Theoretically therefore demand should be limited and the price pretty cheap, but it isn’t, Warren Buffett once famously summed up the paradox as follows:
“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
Gold though is a) pretty and b) relatively rare. Demand historically was driven by the very nature of these two factors. Gold also doesn’t corrode and has just one grade, adding practicalities to its repertoire, i.e. gold doesn’t lose its value and is very simplistic to value. These factors meant gold became the global standard store of value and thus used as Currency for thousands of years. For at least the first millennia this was as a physical currency, but latterly as a backing to paper currency, known as the ‘gold standard’.
The Gold Standard met its demise in the 70s though, this was largely to allow flexibility, i.e. so the growth of the money supply wasn’t restricted by how much gold could be physically dug out of the ground. This all meant that today’s modern currency is no longer backed by gold, but it is worth noting that most countries still hold some stores of gold, albeit the amounts in their vaults generally accounts for a small % of the total money supply in issue.
So whilst the role of gold in monetary policy is reduced, one thing that hasn’t changed though is gold’s cultural significance. Gold is still considered a luxury item and thus it remains a key input to expensive jewelry. So theoretically then this should be the only factor that really drives the gold price? Not so simple, even though gold is not official currency anymore, it still is a store of tangible value. Fundamentally paper is very common and thus worthless if the system is removed, this is exactly why gold does well in times of great uncertainty, as we will go on to see.
So what drives the gold price today?
One of the theoretical drivers and frequently cited reasons for gold price increases is a decline in the interest rates, since gold has no yield then theoretically an increase in base rates should decrease the appeal of gold and hence gold prices should decline. Figure 1 shows the link between US interest rates and the gold price is US$.
There is clearly some inverse correlation between US interest rates and gold prices, but the relationship does not always hold true. Interest rate decreases are also likely to weaken the US$ and hence make the price of gold relatively cheaper to non US buyers.
This leads me nicely on to the next driver; the strength of the US$ which is another key factor which influences the gold price, whether driven by interest rates or otherwise. The US has the largest gold reserves, over 8,000 metric tons, double the next largest holder Germany so a lot of gold buying may have been historically domestically led. However, China and Russia have been more recently been heavy buyers of gold and they would all benefit from any weakening in the US$. It is also worth noting though that a strengthening US$ provides some protection for existing overseas gold holders, in that a stronger US$ also increases the value of the holding when converted back to local currency.
Inflation is another factor than is often cited as a driver for the gold price. As inflation reduces the real value of currency then gold is seen as a way of protecting wealth. Be careful what you wish for though, periods of high inflation are usually correlated with periods of high interest rates, which as discussed above theoretically dampen the gold price. As expected therefore there is some but not a strong correlation between the gold price and inflation.
For example, inflation rocketed to 18% in the late 70s/early 80s, but interest rates also rocketed to 20% to attempt to control the inflation. Interest rates stayed above 10% into the early 80s with the gold price collapsing over the same period!
As you can see with all of the first three factors mentioned, i.e. interest rates, inflation and US$ strength, they are all very much linked in that they all drive each other. The final economic factor I look at it is semi ‘delinked’ from the others, I use the word delinked extremely loosely, as clearly the macro drives the micro, i.e. individual stocks. The performance of the stock market is though probably the most inversely correlated to the gold price, but hold your horses! In figure 3 below you can see the performance of the S&P over the past 5 years against the performance of a physical gold ETF. The S&P500 index has risen 100% whilst the return of physical gold has been 0%. This is far from perfect inverse correlation, which would be -1, i.e. gold declining 100% (impossible). Taking a shorter time frame looking at this year though, the S&P500 has risen 18% and our physical Gold ETF has risen 6%, i.e. a somewhat positive correlation, which isn’t what it is in the textbook!
It is clear there is no perfect relationship here, in fact the longer term correlation is just -0.14, so only slightly inverse. This might not seem a lot, but when you leverage this onto producing companies the share price performance of these can potentially vastly outperform, but more on this later.
As a final analysis let’s take a look in Figure 4 at how gold performed in the last financial crisis, overall gold rose 60% during 2008-2010 against a 20% decline in the S&P500. In this crash gold did provide some protection, but perhaps not just as a result of the general fear and uncertainty. Over the same period interest rates also declined, which as we discussed earlier make holding gold more attractive.
Another observation to note is that a popular ETF which tracks the major gold miners only rose 30% against the gold price rise of 60%. This goes against the common advice of ‘buy the miners not the commodity’. At the peak of the crisis, late 2008 the gold miner sell off was actually even more intense than the broader S&P500. One of the key reasons for this was indiscriminate selling in an environment of extreme fear. However, if you had bought the ETF gold miner index in late 2008 you would have returned around 80% to the close of 2010. Timing was key in this period!
In summary, there are many drivers to the gold price and it is not as simple as looking at one variable and buying gold on that basis. It is not even sound advice to blindly load up on gold to protect against stock market declines. I am still of the view that gold does have a place in a balanced portfolio, but one should broadly consider the environment and carefully consider the weighting.
So what are the prospects for gold in 2017?
The following chart shows real gold prices over the last 100 years, we are some way off the two most recent peaks but even further from the recent trough.
I’m not going to perform any detailed analysis here, a) I’m not qualified to do so and b) you can find predictions from so called experts from around $200 to $10,000. The truth is that given the number of variables it is very complicated. However, looking at the drivers, some very quick thoughts.
- Inflation – picking up in many core economies.
- Interest Rates – picking up in USA and we may see this trend continue among other major economies later in 2017.
- US$ – Likely to continue strength.
- Stock Market – Markets are fairly fully valued but global growth prospects looks reasonable. But where is the next black swan?
All in all, I believe the strong US$, Interest Rates and Inflation are already priced in to gold and thus the key drivers may be driven more by geopolitics. There is also the European Union and how Trump settles into the White house to consider. My personal view is that gold can offer some downside protection against these events. There is also a potential major new demand source for gold. I won’t go into that here but take a look here at the Sharia Gold Standard over at ZeroHedge.com
How can I get exposure to gold?
There are many funds and ETFs which allow exposure to gold, these include through physical holdings, derivatives and the underlying producers. As a general rule I never invest in physical commodities or the derivative methods, the former is expensive and the later you need to deal with Contango (I’ll cover this in a separate piece). I prefer holding the underlying miners, i.e. investing in real businesses. In times of high gold prices, much of any price increase goes to the bottom line and producers can theoretically also work to minimise costs thus increasing the margins. You can see in figure 5 below that during the peak bull run of 2016 the gold price had increased 30% since the start of the year and hence the ETFS physical Gold ETF delivered a similar increase, however one ETF tracking the gold miners increased 160% during the same period. However, as mentioned above this didn’t hold true in 2008/2009 stock market crash, initially at least.
Should I go Active or Passive?
There are limited fund/trust options for active management. The most obvious active fund is the BlackRock Gold and General (BRGG) Unit trust, this performs well but the broker management fees are not included in the above chart (0.45% per annum for Hargreaves Lansdown) and the performance differential is not enough for me to give up the instant liquidity that come with exchange traded products. That said BRGG remains an excellent choice for those investing in smaller tranches.
The two ETFs I like in the sector are the Vaneck Junior Gold ETF (GDXJ) which fully replicates the Market Vectors Global Junior Gold Miners Index and the Vaneck Gold Miners ETF (GDX) which replicates the NYSE Arca Gold Miners Index, an index representing the larger gold miners. The performance has been interesting this year, with the junior miner index, represented by the green line in figure 5 outperforming in 2015 during a period of weakness in gold price but also in 2016 during a period of better prices. The other lines on the chart are the performance of Physical Gold ETF (yellow) and the popular BlackRock Gold and General Unit Trust (brown).
Let’s take a look at the fundamentals, the Price Earnings (PE) ratio of GDX is 44, which is expensive. After a good year for many miners the forward PE drops though, for Randgold the 2017 PE is expected to be 23. Further it is important to note the effect of even modest increaes on the gold price, ‘GDX’s top 17 component gold miners had average All in Sustainable Cost [AISCs] of $936, while the next 17 looked even better averaging $857.’ According to Analyst Adam Hamilton. This gives a margin of around 17% against a current gold price of $1,100. If the gold price hits a sustainable level of $1,300 then the margin is 38%. Major miners would be on P/E ratios at current share price of less than 10. A very attractive prospect. Moving on to the junior index ETF, the P/E of GDXJ is -24, this is mainly as the companies tracked are at an earlier stage of their life and may be explorers as well as smaller producers. The Price/Book ratio is just 1.24 though which is reasonable and suggests plenty of room for growth.
The key risk is a lower gold price throughout 17, a fall of the gold price towards $900 would wipe out earnings and some miners would be loss making. The pain in the junior miners may be more significant with some exploration/appraisal prospects likely to be canned.
Authors opinion – Buy Gold, on balance I see more bullish indicators than bearish.
Overall I like to have between 5%-20% of my portfolio in Gold depending on my view of the world. I’m currently planning on going into 2017 around about 7% and may look to increase this on weakness and/or geopolitical concerns and a bearish stock market.
GDX/GDXJ are both good ways to get exposure to the sector and you could consider a holding in each.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.