Gold’s value in a not-so-golden age

Policy and prices will be key for gold

Two key drivers of the gold price – central-bank policy and inflation – are on the move. As the chart below shows, these two influences have combined in various ways to shape the gold market since the early part of this century.

Now, following a coordinated and significant monetary and fiscal response to the pandemic globally, we have passed the point of maximum easing. Central-bank policy is beginning to tighten relative to its pace of easing last year.

At the same time, inflation is proving more persistent than many expected. It continues to surprise to the upside in many regions, with supply bottlenecks and temporary COVID impacts making price rises stickier than previously expected. This has led central banks to further ponder whether stimulus should be withdrawn.  Much of the debate in the market centres on how much of the inflation is transitory. Will base effects wash out or will the momentum continue? For investors, it’s worth thinking through the scenarios that might play out from here, and how they could impact gold.

Figure 1: Gold is driven by policy, but this is amplified by inflation

Note: ‘Policy – ‘ = tightening policy, ‘inflation – ‘ = low inflation; and vice versa.
Source: Ninety One, Bloomberg, 30 September 2021

Assessing gold’s prospects under inflation scenarios

Scenario 1:  inflation proves transitory

• Inflation surpasses its peak in early 2022 as it becomes increasingly challenging for aggregate prices to maintain their rate of change – particularly as short-term pressures (such as from used-car and energy prices) fade towards the end of 2021, which should ultimately cause inflation to moderate.
• Growth momentum continues to slow, although the absolute level remains above-trend.
• In this scenario, stagflation (low growth + inflation) is avoided, and central banks are able to remain on their tightening paths.
• Gold outlook: The combination of real rates rising from record lows and inflation no longer rising as base effects wash out proves to be a challenging backdrop for gold.

Scenario 2:  a structurally higher level of inflation

• Contrary to investor expectations, inflation maintains its momentum due to supply shocks, higher commodity prices and labour shortages.
• Having been behind the curve, major central banks – most notably the US Federal Reserve – continue to tighten policy, resulting in stagflation.
• Gold outlook: Even if real rates push higher, rising inflation and an environment of elevated risks act as tailwinds for gold, as investors seek to preserve capital. 

It’s not all about policy and inflation

Of course, central-bank policy and inflation are not the only issues that may influence how gold performs in 2022. 

There is also the fact that the path from here for the global economy is extremely uncertain – and gold’s reputation as a safe-haven asset means that, as economic uncertainty increases (typically associated with falling equities), investors tend to allocate to gold. With governments trying to normalise financial conditions and growth prospects diverging internationally, it remains challenging to forecast precisely what issues may arise in 2022. But it seems easier to forecast that there are likely to be issues. In such an environment, gold’s appeal should increase after a dull year for the precious metal, given its usefulness for investors looking to diversify their portfolios.

For investors getting gold exposure through the equities of companies that mine and produce gold, there are other reasons to look forward with a degree of optimism. We think gold-mining stocks are attractive on both valuation and fundamental grounds. In fact, gold companies are in their best shape for nearly 40 years. A number of them are reporting record cashflows and, increasingly, these cashflows are less reliant on a high gold price. The following case studies illustrate some of the opportunities in the gold sector across the market-cap spectrum. For an overview of gold equities, please see the boxed text.

SSR Mining: a mid-cap growing from a solid foundation

We believe that a number of mid-cap gold companies are emerging with solid foundations and good growth prospects – among which SSR Mining is a great example, in our view.

SSR Mining combines a strong balance-sheet (it has net cash of US$411 million) with various brownfield growth opportunities and exciting exploration ground around all of its operating assets.

Presents shareholders with an opportunity to own a defensively positioned company which is generating cash, and returning it via a dividend and buybacks (with a shareholder return of just under 5% in total currently for 2021). In addition, the company should be able to grow production by around 20-25% in the medium term and has a good chance of replacing – even growing – its reserves over that period.

If gold prices remain where they are, we would expect reasonable returns for SSR Mining’s shareholders, given the company’s free-cashflow yield of around 10% and growth prospects. In the event of a major equity market correction, history suggests that gold and gold equities tend to outperform. Thus, in a very uncertain macro environment, we think investors in SSR Mining are being paid for holding a diversifying asset in their portfolios.

Newcrest Mining: revitalising a major through acquisition

Newcrest Mining is a large-cap Australian gold company producing over 2 million ounces (Moz) per year. Newcrest has had a difficult few years, partly due to operational problems at its two large mines, Cadia in Australia and Lihir in Papua New Guinea.

With its Telfer mine in Western Australia near the end of its life and continued delays at the Wafi Golpu project it is aiming to develop in Papua New Guinea, the company looked unbalanced and undiversified. However, in 2018 and 2019, Newcrest built up a stake in Lundin Gold in Ecuador as Lundin brought on its flagship Fruta Del Norte mine, and acquired 70% of the Red Chris mine operation in Canada. It also took a majority stake in the Havieron deposit discovered by Greatland Gold near its Telfer mine.

By Q3 2021, the company could point to a recovering outlook for Lihir and a more stable plan for Cadia, helped not least by its high copper by-product credits. With pre-feasibility studies released for Havieron, Lihir expansion and Red Chris, it also could showcase a pathway for margin growth over the next eight years, with costs expected to halve due to mine developments.

Newcrest recently announced a planned acquisition of Pretium Resources, which will add around 350,000 ounces per year of gold production in the same region of Canada as Red Chris. One of the most experienced underground mining companies, Newcrest now has a world-class portfolio of assets with among the longest reserve lives in the industry.

Developing these assets will take time, and the market is reluctant to give full value for them as it worries about the short-term issues facing Newcrest. However, we believe that Newcrest’s recent acquisitions, combined with a focus on basic operating procedures, are beginning to revitalise a company with increasing belief in its skills and expertise. As recent acquisitions have appeared well-timed and operational results have improved, the company which had a major strategic problem only three years ago, now looks well-balanced and confident of delivering on its plan.

Why gold equities

Addition to offering many of the same investment characteristics as gold – inflation protection and cyclical resilience – gold equities provide complementary qualities to a portfolio.

• While physical gold offers no income, gold equities increasingly do, in the form of dividends. Gold miners are focused on producing value for shareholders rather than growth for the sake of growth. Gold companies’ ability to return cash to shareholders is bolstered by the fact that, as noted earlier, they are enjoying high margins and producing, in most cases, very high levels of free cashflow.
• Gold – the physical asset – does not offer growth potential over and above the changes in its value, since an ounce of gold will always just be an ounce of gold. A miner, however, is a business that can expand over time, and produce more gold by investing in its mining operations. As the case studies above highlight, the growth potential of gold companies varies widely and depends on the quality of their assets.

Investors should also be aware that gold equities provide leverage to the gold price and are typically more volatile than the yellow metal itself. However, the level of sensitivity of gold equities to the price of gold is not over time with factors such as gold miners’ balance sheets and exploration. We therefore favour a selective approach to investing in gold equities, with a focus on businesses with highly capable management teams, a good quality and reasonably diverse portfolio of assets, strong balance sheets, and an intelligent and sensible approach to capital allocation.