Gold is many things to many people. A perennial battleground subject, gold remains arguably one of the most debated asset classes across global financial markets, but as Goldman's precious metals equity analyst notes, from a fundamental perspective, the risk/reward looks more balanced than that of its bulk and base metal peers, especially in terms of the supply/demand dynamics.
Bulls believe gold is the ultimate store of wealth, and should be compulsory in a welldiversified portfolio given its perceived safe-haven appeal.
In contrast, bears are quick to highlight the lack of industrial use for this non-yielding asset and focus on the fact there is an abundance of above-ground inventory.
Love it or hate it, gold will always be relevant and mentioned in the same sentence as oil when market participants refer to the all-important commodities complex.
Gold is probably the pick of a bad bunch from a future investment standpoint.
Macro trumps micro
Gold is the chameleon of commodities, but ultimately it is primarily used as a financial asset by investors as a store of wealth, a hedge against the threat of inflation, and in some instances, as portfolio insurance. Historically, one of the strongest relationships is the inverse relationship between the gold price and US real interest rates; higher TIPS, lower gold prices, mainly owing to the fact that gold is a non-yielding asset and as such the opportunity cost will increase for investors holding gold as rates increase.
As can be seen from the chart below, the relationship between US 5-year TIPS and gold has been very strong, returning an R-squared of 0.85. In 2016, our economists expect above-trend US economic growth and a corresponding recovery in US inflation expectations.
As we gingerly move through 2016, and the market recalibrates its expectations for the imminent Fed rate hiking cycle, the gold price could be an interesting sideshow and alternative store of value for investors, if the currently anticipated timetable is pushed out.
One of the reasons for the drawn out correction in gold prices in 2013 was the partial liquidation of ETFs.
Above, we show that the number of ounces of gold in ETFs has stabilised in the past 12 months, and in fact, has ticked upwards in 2016.
Saving lustre
While a US market correction is not our base case, below we identify the major risk-off periods over the past 45 years, and investigate whether gold acted as effective short-term portfolio insurance. We observe that for nine of the last 10 major downturns in US equity markets, gold outperformed the S&P with 1980-82 the only exception (the gold bubble burst in 1980). Moreover, gold generated positive returns in eight of those instances.
Chindia
In 2014, the world’s two most populous nations accounted for over 50% of total gold demand. Citizens and the governments of these two countries play pivotal roles in the global gold market from both a supply and demand perspective. China is now the largest gold producing nation, more than doubling its output over the past decade to 450t. To put this in perspective, China was listed as #4 in 2005. In India, gold has always been a symbol of wealth, status, and a fundamental part of many rituals. In 2013, the government tried to introduce policies to reduce its current account deficit that included curbing gold imports, but these policies ultimately increased smuggling. While the 80:20 gold import rule was scrapped in November 2014, the 10% import duty on all gold imports is still in place.
Miner miner 49er
The fundamental difference between gold and other commodities is that once extracted, it is generally not consumed. It remains in existence in a form (jewelry, art, coins, bars) that is easily recoverable and is periodically returned to the market through recycling. Owing to this, gold’s above-ground stock is always rising. Mine output accounts for about c.75% of total annual supply. A labour-intensive and costly activity with long lead times, mine production is relatively inelastic to prices in the short run. In 1Q15, mine supply increased by 1% yoy to 734t while in 2014, global gold production increased by 5% yoy.
Mine supply rose significantly during gold’s bull run in 2003-11, when prices rose 450% and new mines ramped up to full capacity following significant investments in new projects. However, with gold prices falling dramatically (by 42% since September, 2011), miners have been forced to delay/suspend new projects as they seek to increase operational efficiencies and cut growth capex. Consequently, reducing operating costs to optimise free cash flow has been a major focus for the gold companies.
While closures and suspensions have been limited to small and ageing operations, there have been deferrals of major development-stage projects as part of the drive to reduce unnecessary capital expenditure. Most activities are centered on the divestment of non-core operations. Miners have taken steps to enable their survival through the current squeeze of their margins, and it seems that the consequences of these actions will be detrimental to mine supply levels in future years.
The pain that the broader mining industry experienced in 2015 was endured by the gold sector in 2013/14. After the gold price fell 25% in the first six months of 2013, the gold companies were forced in to action to conserve cash. Dividends were cut, capex was significantly pared back, non-core assets were sold and balance sheets slowly improved. The aggressive action from gold companies resulted in a sector that is able to survive and generate cash at a US$1,000/oz gold price.
The need to conserve cash in the face of sustained lower commodity prices is a situation we believe that the broader mining complex is slowly coming to terms with. As the chart below indicates, the gold sector has been more decisive in addressing the issues.
Global miners are all facing their problems (BHP: dividend and Samarco; Glencore: debt; Anglo: debt & restructuring; Chinese producers: high debt) and these are likely to drag on performance in 2016. Buy-rated Barrick Gold (US$12.25) and AngloGold Ashanti (R172) have ‘cleared the decks’ on the cash conservation front and are well positioned to perform in 2016. They are cash flow positive at respective gold prices of US$890/850 per oz. FCF yields are strong and we believe the gold miners provide more stable mining opportunities relative to their large cap non-gold peers.
The need to conserve cash in the face of sustained lower commodity prices is a situation we believe that the broader mining complex is slowly coming to terms with. As the chart above indicates, the gold sector has been more decisive in addressing the issues.
via Zero Hedge http://ift.tt/1Rd0xbW Tyler Durden