Precious Metals at a Crucial Macro Moment
This week, BNP Paribas Senior US Economist Yelena Shulyatyeva told Bloomberg, “At this point, it’s clear. We really need a downturn [recession] to get us where we need to be [on inflation]. The path to a soft-landing is so narrow that it would really be a miracle.”
HAI couldn’t say it any better. This week offered the latest indication that, in response to the outbreak of inflation, the Fed tightening cycle is helping to point the economy towards recession. The tightening is now beginning to break fragile structures that are the scaffolding of the economy and financial system. Those systems have been weakened by well over a decade of financial engineering, liquidity injections, and an artificially concocted near-zero interest rate environment.
This week it was the bankruptcy of Silicon Valley Bank that created fears of contagion and possibly even a systemic breakdown in the banking system. The fears are well founded. At its core, the issue in the banking sector appears to be that funding costs for some portions of the banking system are now or soon will be higher than the yield on a substantial chunk of the banking system’s earning assets. If that proves to be the case and the situation perpetuates, that is as systemic as it gets. Markets are, understandably, rattled.
For a detailed discussion of the SVB situation and the concerns roiling markets, HAI refers the reader to Doug Noland’s Credit Bubble Bulletin. The focus here will be on the impact that recent hot inflation data, potential Fed policy responses, and now concerns over the banking sector may have on gold. This is an important moment for the gold price and the precious metals mining sector, so we’ll also look at important things to consider right now.
The Fed will have to make a tough choice. Option A is to crush inflation with the punch of a recession (one that could be the hardest of hard landings if it definitively pops the credit bubble). Option B is to keep monetary policy too loose or start actively easing in an attempt to delay a recession. The second option will require the Fed to contain breakdowns in the market like SVB, try to prevent further breakages, and attempt to forestall an acute government fiscal crisis—all at the expense of allowing inflation to entrench further and run hot. Walk into that quagmire, and we could get a prolonged stagflationary crisis potentially far more devastating than the one the US went through in the 1970s.
In short, with magic disinflation theory debunked, it’s recession or inflation. Either ends badly. Policymakers will choose.
The unfolding market dynamics offer an extremely interesting set-up in the gold market. The key question for gold is whether the Fed is up to the tightening challenge. If the Fed shies away from the path of sufficient tightening, if it chooses to live with inflation over the alternative, then gold’s recent correction may already be over. In that scenario, the yellow metal may be poised to break out relatively soon from its exceptionally bullish decade-long sideways consolidation, take out remaining overhead resistance, and make a strong run into new all-time high territory.
Conversely, if the Fed is up to the challenge of sufficient further tightening—if it is willing to ride the economy into recession and break things along the way, then we can expect gold to remain capped beneath the $1,950–$2,000/oz. resistance zone for longer. While a breakout may have to wait in this scenario, it may not be for long. Once the recession bites and/or systemic breakages erupt within the financial system, gold will quickly sniff out the start of a crisis-response Fed easing cycle. That’s an energetic catalyst also likely to pave the yellow brick road to significant new all-time highs.
In other words, we are approaching a high-probability win/win moment in the metals market. Sooner or a little later, powerful catalysts are likely to drive a fourth test of major overhead resistance above $1,950/oz. and a subsequent breakout to new highs. The biggest question for gold right now appears to be the timing and exact path to new all-time highs rather than the ultimate destination.
This week’s price action was encouraging for gold, and suggests that at least the initial appraisal of the week’s events by the market may favor the faster scenario for a gold breakout. During intense bouts of market weakness through the summer and fall of 2022, the dollar was strong, bond yields were rising, and virtually all other assets were under pressure—including gold. This week, however, gold bucked the weakness in markets while yields and the dollar dropped. Such market reaction suggests expectations that systemic risks may force the Fed to ease up on further policy tightening, and, if the risks are serious enough, reverse course. That would be an up-side accelerant for gold. As of now, this is all conjecture. We will watch closely to see how events play out.
What is certain, however, is that the near-term path for the gold price looms very large for the precious metals mining sector. Sticky and persistent inflation continues to pressure mining costs sector-wide.
The idea of playing the mining sector is to offer leveraged returns on strong underlying gold price performance. With uncertainty over the short-term gold price and with high production costs a reality, the question becomes how to position optimally in the precious metals sector.
From the depths of October’s Q4 lows in gold, mining sector industry average AISC profit margins have improved 70% from $333/oz. to roughly $565/oz. today. However, that improvement has come entirely from higher gold prices rather than an easing in the cost of production. This dynamic leaves the sector vulnerable to volatility and renewed margin pressure in the more bearish scenario mentioned above, in which a continued hawkish Fed keeps gold prices choppy and range-bound between $1,650 – $1,950/oz. for longer.
As of Q4 2022 earnings reports, nearly 90% of producers missed their mid-point on cost guidance. To home in on the cost pressures facing the industry, diesel prices are a huge cost. They are down 25% since June, but remain 11% above their pre-pandemic high. Furthermore, underlying supply/demand dynamics in the energy market create risk that diesel prices could creep higher again.
Labor is the other disproportionate cost, and right now industry labor costs are running at almost twice the long-term average: roughly 5-6% post-Covid vs. 2-3% previously. Unfortunately, the situation isn’t improving much. Increased interest in the mining of copper, lithium, nickel, and other metals is increasing the competition for an already limited number of skilled laborers within the mining sector. Similarly, the bidding war over special contractors has seen their costs increase by over 10% in the most competitive regions, such as Western Australia. In addition, we continue to see higher costs for the steel used for ground support and grinding media, higher costs for spare parts and liners, higher costs for cyanide, lime, and other reagents used for processing, and higher prices for explosives. Some of these cost pressures will ease, but others will likely remain sticky.
Industry all-in-sustaining-costs now appear to be close to $1,285 or even $1,290/oz. According to the companies themselves, 2023 AISCs are expected to drop somewhat. However, to be conservative, if we expect no improvement or an increase of AISCs to around $1,300/oz., then we won’t have the margin expansion in the mining sector necessary to drive a sustained upside breakout in the producers until gold breaks and holds above $1,950/oz.
In addition to short and intermediate-term gold price uncertainty and industry cost and margin concerns, there is a third primary factor to consider regarding precious metal miners at present. That third issue is that the outlook for industry-wide reserve replacement has worsened. It is becoming increasingly difficult for companies to find new, large-scale, high-quality, low-cost deposits to replace already mined reserves. If the industry average reserve replacement rate was roughly 90% over the last decade, we are likely looking at an 80-85% replacement rate for the next decade. A lower reserve replacement rate directly negatively impacts the valuation multiple the market assigns to precious metals mining companies.
In light of these challenges facing the sector at present—near-term gold price uncertainty, producer cost and margin pressures, and an industry-wide dwindling of reserve replacement rates—this is increasingly a stock picker’s market.
When selecting miners in today’s uncertain short-term environment, HAI favors low-cost producers that are best able to keep cost creep in check. They should also be high production growth operations that can both drive free-cash flow growth in the absence of higher gold prices and eliminate the valuation threat related to reserve replacement concerns.
It also makes sense to overweight disciplined management teams with strong balance sheets that have the capability to execute accretive M&A deals to acquire ounces and replenish reserves at attractive prices.
Lastly, in an overall precious metals mining portfolio, this is a good time to increase the size of allocations to royalty and streaming companies. The upside of the royalty and streaming business model is that it’s extremely inflation resistant relative to producers. The negative trade-off for this category of company, however, often comes in the form of slow growth and much higher valuation multiples compared with producers. Careful stock selection in this space, however, can identify royalty and streaming companies that currently negate the typical negatives by offering the superior royalty/streaming business model benefits with both deep value discounts and strong growth. These companies are particularly well suited for the current environment.
These are suggestions for how to build precious metal mining stock exposure with an eye toward capturing upside leverage to gold in what is expected to be an eventual breakout higher in price, while simultaneously tailoring positions to better account for the short-term risks alive in the sector. Smart portfolio construction can help interested investors mitigate risks while gaining exposure to names that will benefit tremendously if gold is getting ready to rerate higher.
Weekly performance: The S&P 500 was down 4.55%. Gold was up 0.68%, silver lost 3.44%, platinum was down 1.76%, and palladium was off 5.98%. The HUI gold miners index was lower by 5.51%. The IFRA iShares US Infrastructure ETF lost 6.01%. Energy commodities were volatile and lower on the week. WTI crude oil was down 3.77%. Natural gas tanked by 19.24%. The CRB Commodity Index was off 3.66%, and copper was down 0.98%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 6.39% on the week, while the Vanguard Utilities ETF (VPU) was down 2.72%. The dollar was down 0.75% to close at 104.15. The yield on the 10-yr Treasury tumbled 27 bps to end the week at 3.70%
Investment Strategist & Co-Portfolio Manager