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- We believe that there is a strong case to expect gold mining shares to outperform the metal in the years ahead…
On September 17, 2019, overnight repo rates spiked 121 basis points,
climbing from 2.19% to 3.40%, providing yet another crucial buttress for
the bullish rationale for gold. The spike signaled that the U.S.
Federal Reserve (“Fedâ€) had lost control of the price of money. Without
subsequent massive injections of liquidity by the Fed into the repo
market, out of control, short-term interest rates would have undermined
the leverage that underpins record financial asset valuations. Going
forward, unless the Fed continues to expand its balance sheet, it risks a
meltdown in equity and bond prices that could exceed the damage of the
2008 global financial crisis. Despite consensus expectations, there
appears no escape from this treadmill.
The Fed must monetize deficits because non-U.S. investors are no
longer absorbing the growing supply of U.S. debt. Ultra-low, short-term
interest rates do not compensate foreign investors for the cost of
hedging potential foreign currency (FX) losses (see Figure 1). The U.S.
fiscal deficit is too high and the issuance of new U.S. treasuries is
too great for the market to absorb at such low interest rates. In a free
market, interest rates would rise, the economy would stall and
financial asset valuations would decline sharply.
Figure 1. Treasury Issuance Goes Up, Foreign Purchases Go Down (2010-2019)
Source: Bloomberg. Data as of 12/31/2019.
The predicament facing monetary policy explains why central banks are
buying gold in record quantities, as shown in Figure 2. It also
explains the fourth quarter “melt-up†in the equity market, even with Q4
earnings that are likely to be flat to down versus a year ago (marking
the second quarter in a row for lackluster results) and the weakest
macroeconomic landscape since 2009 (as shown by Figure 3).
Figure 2. Central Banks Purchases of Gold are 12% Higher than Last Year
Source: World Gold Council; Metals Focus; Refinitiv GFMS. Data as of 9/30/2019.
Figure 3. The U.S. ISM PMI Index Indicates Economic Contraction
The U.S. ISM Manufacturing Purchasing Managers Index (PMI)1 ended the
year at 47.2, indicating that the U.S. economy is in contraction
territory (a reading above 50 indicates expansion, while a reading below
50 indicates contraction).
Source: Bloomberg. Data as of 12/31/2019.
Liquidity injections will result in more debt, both public and private sector, but not necessarily enhanced economic growth:
“As these forms of easing (i.e., interest
rate cuts and QE [quantitative easing]) cease to work well and the
problem of there being too much debt and non-debt liabilities (e.g.,
pension and healthcare liabilities) remains, the other forms of easing
(most obviously currency depreciations and fiscal deficits that are
monetized) will become increasingly likely …. [this] will reduce the
value of money and real returns for creditors and will test how far
creditors will let central banks go in providing negative real returns
before moving into other assets [including gold].â€
– Ray Dalio, Paradigm Shifts, Bridgewater Daily Observations, 7/15/2019
Gold Bullion and Miners Shine in 2019
Though overshadowed by the rip-roaring equity market, precious metals
and related mining equities also had significant gains in 2019 (up
43.49%)2. Gold’s 18.31% rise last year was its strongest performance
since 2016. More significantly, after two more years of range-bound
trading, the metal closed out 2019 at its highest level since mid-2013,
and within striking distance of $1,900/oz, the all-time high it reached
in 2011.
The investment world has taken little notice. Despite gold’s strong
performance, GDX3, the best ETF (exchange-traded fund) proxy for
precious metals mining stocks, saw significant outflows over the year as
shares outstanding declined from 502 million to 441 million (or 12%)
over the twelve months, despite posting a 39.73% gain, well ahead of the
31.49% total return for the S&P 500 Total Return Index.4
We believe that there is a strong case to expect gold mining shares to outperform the metal in the years ahead…
It has been our long-held view that until mainstream investment
strategies run aground, interest in precious metals will continue to
simmer on low, notwithstanding the likelihood that 2020 may be another
very good year for the precious metals complex. The many reasons why
mainstream investment strategies could unravel are not difficult to
imagine. They include the emergence of meaningful inflation, further
slippage of the U.S. dollar’s nearly exclusive reserve currency status,
and market-driven interest rate increases or a recession. Any or all of
these could disrupt the continued expansion of the Fed’s balance sheet,
triggering a rapid reversal in financial asset valuations. Each
possibility deserves a more complete discussion than space here allows,
but evidence strongly suggests that none can be ruled out. While timing
the zenith in complacency is risky, we feel confident that a reversal of
fortune for high financial asset valuations awaits unsuspecting
investors sooner than they expect.
We are even more confident that a bear market will generate far
broader investment interest in gold. Considering that institutional
exposure to gold and related mining stocks hovers near multi-decade
lows, the slightest uptick could easily drive the metal and related
precious metals mining shares to historic highs. Today, the aggregate
market capitalization of precious metals equity shares is $400 billion,
an insignificant speck on the current market landscape.
Investors outflows from precious metals mining stocks in 2019, even
as gold rose 18.31%, suggests skepticism that the current rally is
sustainable — perhaps hardened by the wounds of years of middling
performance. Contrarian analysis would regard such bearishness as
grounds to be very bullish. In our opinion, investors have overlooked
that the 2019 rise in gold prices has restored financial health to
sector balance sheets, earnings and cash flow. Gold stocks offer both
relative and absolute fundamental value and growth potential that
compares very favorably to conventional investment strategies
We believe that there is a strong case to expect gold mining shares
to outperform the metal in the years ahead by a substantially wider
margin than they outperformed in 2019. With continued advances in
precious metals prices, the return potential from these still unloved
orphans and pariahs of the investment universe should prove to be very
compelling.
SOURCE:https://www.sprott.com/insights/sprott-gold-report-no-way-out/