Nowhere to Go but Gold
This week, following the recent breakout of gold to new all-time highs, HAI will detail the set up for gold and gold mining stocks. Let’s get to it.
The Fed has raised the interest rate from 0% in March of 2022 to over 5% currently. Gold is an asset with no yield, and, as such, the opportunity cost of holding gold increases with higher interest rates. The mainstream view is that this sharp increase in interest rates should have absolutely crushed the gold price.
Instead, in the face of not only dramatically higher interest rates, but a strong dollar, and a “higher for longer” Fed policy stance through the end of 2023, gold remained extremely resilient. It appears something is changing in the gold market. The primary drivers of price, it seems, may be shifting. Gold may now be reacting more to what increasingly looks like the coming breakdown of effective monetary policy.
In December, at the Fed’s FOMC policy meeting, Fed chair Powell delivered surprisingly dovish commentary that seemed to herald the unofficial end of “higher rates for longer” as the default monetary policy setting. At the same time, Powell’s comments appeared to pave a path to Fed rate cuts in 2024.
But inflation isn’t dead, and hasn’t been defeated. We’ve had two consecutive hotter-than-expected CPI and PPI prints, and the Fed’s preferred “supercore” measure is now spiking. Similarly, inflation expectations are marching higher again, and we also have dangerously loose (inflationary) financial conditions in place. Nevertheless, since December, the Fed has continued to guide the market in the direction of three 2024 rate cuts.
In short, inflation is still alive and well, but policymakers look increasingly likely to cut interest rates into that elevated inflation anyway. That’s an extremely important development. It suggests that monetary policy may indeed be compromised by the extremely high levels of government debt. If so, the era of the use of interest rates to curb inflation may be over.
Perhaps most importantly, regardless of if, when, and by what quantity the Fed cuts rates into still-elevated inflation, the recent breakout to new all-time highs in gold seems to suggest that market participants are starting to appreciate the increasingly compromised nature of monetary policy. By extension, they are also increasingly appreciating the need for increased financial insurance in the form of gold allocations. As BofA chief investment strategist and HAI favorite Michael Hartnett told Bloomberg this week, referring to gold’s breakout to record highs, “I think that’s representative of a feeling that the Fed is losing credibility, that the Fed seems very determined to cut interest rates before it reaches its 2% inflation target.”
That may be the key to the historic disconnect between higher interest rates and a stubbornly resilient gold price, and it may ultimately be the key to pulling the Western investor back into the gold market. As Western investor confidence in the inflation fight and in monetary policy falls, conversely, Western investor appetite for gold as financial insurance rises proportionately.
With wartime-like deficit spending at a run rate of $1 trillion every 100 days, ballooning government interest payments, an inflation problem, and the breaking down of effective inflation-fighting monetary policy, HAI believes the Western investor’s financial insurance bid for gold is just getting started. In that light, we think gold’s breakout is also just getting started.
HAI has long anticipated the breakdown of effective monetary policy. Now, however, that breakdown looks to be rapidly transitioning from theoretical to real. In short, awareness among market participants seems to be growing that the Fed has nowhere to go. It can’t cut rates because of inflation, while simultaneously it can’t not cut rates because of a debt spiral. As David Stockman, former Director of the Office of Management and Budget under Reagan, said this week, “we’ve hit a fiscal and monetary dead end.” In other words, to borrow from the great economist Henry Hazlitt, it now appears that “Today is the tomorrow which the bad economist yesterday urged us to ignore.”
Now, at this point, as the Western investor’s financial insurance bid starts to kick in for gold in response to a trapped Fed, HAI expects the bias for gold prices to remain higher. Hot inflation data and any resulting hawkish talk from the Fed may slow gold’s rally or trigger a temporary correction, but the underlying financial insurance bid should continue to support gold. That should remain the case as long as investor focus increasingly shifts towards the Fed’s nowhere-to-go bind.
Even if the Fed delays rate cuts, the market seems to be catching on to the notion that the hawkish pretense is little more than an extend and pretend delay tactic. The new reality for the market to digest is that it’s—take your pick—inflation or a debt spiral. Goldilocks just isn’t on the menu. The more the market locks in on that reality, the more HAI expects gold’s rally to pick up steam. After all, when the Fed has nowhere to go, investors go to gold. HAI expects exactly that.
Adding fuel to the fire, gold’s underlying supply/demand fundamentals also swing the bias in favor of higher prices. On the demand side, the World Gold Council recently reported that total world gold demand in 2023 hit a record with a 3% increase over 2022. So far, however, it’s been Eastern demand, specifically Chinese demand, combined with voracious central bank buying that’s underpinned gold demand and helped establish a higher trading range for gold at over $1,800/oz since the start of 2023.
Global central banks have now added over 1,000 tons to their holdings in each of the last two years. One of those years was a record for central bank buying, and both years saw buying at approximately twice the pre-pandemic rate. HAI expects strong central bank demand to continue as gold reasserts itself as a fundamentally core global reserve asset.
A recent and unusually candid press release from the Central Bank of Hungary illuminates the dynamics motivating such strong central bank gold demand globally. That bank attributed recent additions to their gold reserves as a “risk mitigator” during what they expect to be “disruption during a period of transition in the international monetary system.” In other words, central banks are aggressively diversifying their assets ahead of a disruptive monetary transition. In HAI‘s view, that transition referred to by the Central Bank of Hungary is only accelerating.
As for Chinese gold demand, HAI also expects it to remain strong. As a Bloomberg article recently described, precious metals are the “hottest investment” for the Chinese people following the collapse of the apartment bubble that had previously been the best means of wealth preservation and appreciation for citizens of the country.
December retail sales of gold and silver in China hit a six-year high, and January data from the Shanghai Gold Exchange registered withdrawals of 271 tons, for the biggest single month in over a decade. Importantly, to underscore the scale of that demand, 271 tons annualizes to 3,200 tons. That’s a little more than the estimated full-year total global gold mine production in 2022.
On top of that aggressive central bank and Chinese demand, as previously noted, HAI believes the Western investor may be about to stage a comeback as they chase a breakout higher in the gold price and recognize the need for increased ownership of gold as financial insurance. When the Western investor returns, HAI expects that will be the last piece in gold’s demand-side puzzle. If the Western investor returns to the gold market on top of the strong demand already in place, HAI has little doubt it will supercharge gold’s breakout.
In fact, the latest Commitment of Traders (COT) report may already suggest that the Western investor is just now starting to creep back into gold. This last week, open interest in the gold futures market (a market largely dominated by Western investors) exploded higher from five-year lows with a massive increase of nearly 65,000 contracts. The return of the Western investor is a crucial component to the continued breakout of the gold price, but it’s doubly significant for the mining stocks. While Easterners buy physical gold, it’s the Western investor—almost exclusively—who buys gold mining stocks.
As the demand story is record-strong and looks set to strengthen further, on the supply side, we see mounting evidence of a market teed-up to tighten—meaningfully. The big story on the supply side is that the number of major new gold discoveries of over one million ounces in reserves have been crashing over time. According to S&P Global, there were roughly 180 major discoveries in the 1990s, 140 in the 2000s, 40 in the 2010s, and there’s been next to none since 2019.
To adequately address the issue of dramatically tightening supply-side dynamics over the years ahead, the industry needs much higher gold prices to incentivize a significant increase of industry investment in exploration. At present, despite a stronger gold price, we’re still seeing exactly the opposite. Industry investment in exploration is still tanking.
Unlike major producers that have sufficient cash flows to support their exploration expenditures, juniors and small intermediate producers rely on financing to fund their exploration programs. Over the past three years, these companies accounted for more than half of total gold industry exploration budgets.
But with the higher interest rate environment and stiff competition for funding from other “hotter” sectors, exploration funding for juniors and small intermediate gold players has dried up. As a result, we’ve seen the total annual gold industry exploration budget in 2023 drop by 16%. Specifically, initial resource-related exploration budgets fell 19% to the lowest level since 2020. In addition, in 2023 the total number of drilled projects was off by 24%, while the total number of drilled holes industry-wide collapsed by 36%.
Not surprisingly, total newly reported initial gold resources for the industry also followed these downtrends to a new four-year low. At this point, the supply outlook has now soured to the extent that, according to their latest research, S&P Global now “expects mined gold supply to peak in 2026 and decline shortly after.” The strong implication is that, at this point, we’re past “peak cheap gold.” Significantly higher prices will be needed to adequately refresh supply going forward.
As Canaccord Genuity mining analyst Tim McCormack told conference delegates in February, these dynamics will “feed into a real supply crunch for gold.” HAI has been monitoring the tightening supply side outlook for years, and couldn’t agree more with Mr. McCormack.
If China continues to soak up over 100% of annual global mine production, central banks keep buying, and a Western investment bid returns to the market just as industry production is set to decrease, we can fairly expect tightening supply/demand fundamentals to catalyze a sustained breakout of the gold price deep into new all-time high territory.
Now, despite a resilient gold price and despite years of newly disciplined management teams, fundamental financial repair, and now outright financial health, precious metals mining companies have continuously been sold off relative to physical gold. That said, as gold’s breakout higher gains traction, HAI believes the performance of the mining shares will change dramatically and margin expansion will ultimately power a rally with the potential to stun on the upside.
Now, let’s discuss that potential for gold mining sector margin expansion. For reference, approximate all-in sustaining cost (AISC) margins were ~$330/oz in 2015 and 2018. That improved to, and peaked at, roughly $670/oz in 2020 and 2021. Since then, margins fell to a trough of ~$510/oz in 2022 and then improved to ~$550/oz last year. If we conservatively assume $1,410/oz AISC across producers for 2024 and a gold price of $2,040/oz, average AISC margins would improve to $630/oz in 2024. If we assume an average gold price for the year closer to current spot prices at $2,150/oz, margins would improve to $740/oz in 2024. That means that unless we have a major pullback in gold, 2024 margins are likely to increase in line with the 2020 margin peak despite the GDX mining index now sitting 45% below peak 2020 GDX prices.
Again, that assumes that gold prices average lower or hold at current levels for the rest of the year. Obviously, the analysis gets exponentially more bullish if gold’s recent breakout holds and advances to even higher prices. The key suggestion is that, at present, the ingredients are in place to support a dramatic rally, a rally much larger than anything we’ve seen post-Covid.
Buying gold miners in Q4 2015/Q1 2016, Q3 and Q4 2018, and March through May of 2020 proved to be very rewarding from a return standpoint. That said, they were all extremely risky trades from a fundamental standpoint. Most miners were low on cash and high on debt. There was serious risk of write-downs and impairments if the gold price fell any further than it already had. Reserve prices were also sitting near spot levels. That means there was a severe threat of reserve deletions on further gold price weakness, and no room to grow reserves without major optimization work to lower cut-off grades and/or landing new game-changing discoveries or acquisitions.
Today, this situation is night-and-day different. After three years of inflationary pressure, the assets that are still in production are fundamentally much better assets. Balance sheets for the majors are vastly improved, with limited net debt and/or outright cash reserves. Pipelines at the major producers are in much better shape as well. The projects getting approved and developed are brownfield expansions or high-margin development projects. They are not, as was often the case in the past, overly ambitious and risky mega projects that both necessitate high gold prices and carry the risk of going massively over-budget.
Lastly, and of crucial importance, reserve price assumptions for the majors are at $1,200/oz – $1,400/oz gold. That means producers could grow reserves by 5%–15% (depending on the company) simply by increasing their gold price assumptions to levels HAI would argue are still very conservative at $1,500/oz to $1,600/oz. In fact, if gold holds above $2,000/oz into 2025, companies will have to increase reserve price assumptions. That will, by extension, grow reserves with no cost to the mining companies.
This is the exact opposite dynamic from what plagued the sector last cycle when reserves were repeatedly deleted as gold’s price fell under reserve price assumptions that were much too high. To provide perspective on the potential impact, for one large producer specifically, a small increase in reserve prices would translate to an extra 10+ million ounces of gold reserves—for free.
Again, if you believe in the sustainability of gold’s breakout to higher prices, you have to love the best-positioned mining stocks here and give the margin expansion potential time to play out. To underscore the point, we’ve never seen a set-up like this before in the precious metals mining sector. We have never had a major margin expansion episode for the miners occur when the underlying stocks were already fundamentally healthy.
The relative value of the gold mining sector makes it a standout opportunity in today’s market. The next major phase of margin expansion for already healthy companies with improved fundamental outlooks hasn’t even begun to be priced in yet. If gold prices remain strong, there is much more upside ahead as the margin expansion story becomes the new prime price setting variable for the sector. In short, the upside potential in the sector is in line with, or even potentially greater than, the best buying opportunities of the last two decades. However, the risk component for the gold stocks is greatly reduced. In other words, that leaves the best-positioned gold miners with a risk-adjusted return potential that’s historically unparalleled for the sector.
So, in HAI‘s view, if you’re looking for a truly unique opportunity, you’ve found one in gold mining stocks today. That said, strap helmets on and make sure seat belts are securely fastened. It’s bound to be a breathtakingly wild and volatile ride. If the gold price sustains and extends the breakout, however, best-in-breed gold miners may just be the wild and volatile ride of a lifetime. After all, remember that when the Fed has nowhere to go, investors go to gold.
Weekly performance: The S&P 500 lost 0.13%. Gold was down 1.10%, silver was up 3.39%, platinum was up 3.14% and palladium gained 6.34%. The HUI gold miners index gained 1.76%. The IFRA iShares US Infrastructure ETF was lower by 0.79%. Energy commodities were volatile and mixed on the week. WTI crude oil gained 3.29%, while natural gas lost 8.59%. The CRB Commodity Index was up 2.90%. Copper surged 5.89%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 4.37%. The Vanguard Utilities ETF was down 0.48%. The dollar index was up 0.36% to close the week at 103.06. The yield on the 10-yr U.S. Treasury jumped 22 bps to close at 4.31%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
