While the gold price has been volatile over the last year, it has remained above the lows reached in 2015. In this brief commentary, Portfolio Manager Thomas Kertsos and Research Analyst Max Belmont offer their insights into current trends.
What have been the most important recent trends in the gold market?
In 2016, the gold price was a story of two halves. In the first part of the year, the gold price rallied by 28.73% to peak at $1,366.38 an ounce on July 8, 2016. Thereafter, it declined to $1,152.27 an ounce at year end. For 2016 as a whole, the increase was 8.56%.1
The gold price was volatile in 2016, and we believe that in every instance, the primary driver was the inverse rela-tionship of gold to real interest rates (Exhibit 1).
Because gold bullion does not generate any yield, real interest rates represent the opportunity cost of owning it. When real rates move higher, the opportunity cost of holding gold rises and investors sell the metal. This drives down the price. When interest rates fall, the pattern is reversed. During the year, changing expectations for economic growth—spurred in some cases by comments from the Fed and in other cases by events such as Brexit and the US elections—drove changes in real interest rates and created volatility in the gold price.
During 2016, strong global investment demand for gold (especially for ETFs and gold futures) was largely offset by relatively weak demand from jewelry markets. According to the World Gold Council, central bank demand was marginally positive, although to a lesser extent than in 2015. Gold mining supply was basically unchanged in 2016 (from 3,233 tons in 2015 to 3,236 tons in 2016, according to the World Gold Council). This reconfirms the view of several industry consulting firms that gold mining supply is approaching a peak or plateau.
Why does the Global Value team use gold as a potential hedge against disruptions in the stock market?
Gold bullion has unique risk/reward characteristics as a potential hedge: It can help preserve purchasing power, in real terms, in periods of both inflation and deflation. Commodities can provide a potential hedge against inflation, and cash can provide a potential hedge against deflation, but gold has the rare quality of playing this role, in real terms, under both conditions. In our view, this characteristic makes gold very useful as a potential hedge against macroeconomic environments in which equities do not perform well.
Put options can also be used for hedging, but investors have to roll them over on a monthly or quarterly basis, and this can be expensive. Gold, by contrast, is a long-duration potential hedge, and, unlike options, it is an asset that is no one else’s liability. In other words, it generally does not entail counterparty risk. These are important investment qualities. Because returns from gold have been uncorrelated with stock market indices (Exhibit 2), gold can provide diversification and potentially maximize overall returns through a cycle—not just on a reward basis, but also on a risk/reward basis.
Have gold-mining stocks moved in line with the price of gold?
At the end of 2015, gold stocks were generally cheap relative to the gold price, which was at a six-year low of $1,051 an ounce.2 As the gold price rose in 2016, the operational and financial leverage of many miners led their stocks to rise much faster than the price of bullion. This has occurred before, and the miners’ outperformance has generally diminished over time—especially miners led by managers who are not effective in their operational execution or disciplined in their capital allocation.
In 2016, many gold-mining companies recapitalized their balance sheets as the gold price rose and, especially in the earlier part of the year, as they also raised equity through stock offerings. While some mining companies are still carrying substantial debt, the overall financial health of the mining industry has markedly improved, in our view.
What trends have you seen at the royalty companies?
On average, shares of gold royalty companies outperformed gold bullion during 2016 but generally lagged gold mining stocks. This was not surprising, as the royalty companies generally have less operational and financial leverage than the gold miners, and their valuations did not start the year in as deep a trough. From a business perspective, gold royalty companies were not particularly active in 2016, largely because gold miners—able to raise capital more easily in the stock market—had less need for gold-royalty-company financing. Rather than trying to compete with the equity market, many gold royalty companies exercised discipline and, throughout the year, accu-mulated cash flow and strengthened their balance sheets.
Do you think it will be important to hold gold as a potential hedge in 2017?
We own gold because of macroeconomic and geopolitical risks—both known and unknown—that cannot be fore-casted. We believe, likewise, that the price of gold cannot be forecasted. Our attitude in the face of these uncertain-ties is one of humility.
In 2017, the US government may take steps to lower personal and corporate tax rates, start rebuilding the country’s infrastructure, deregulate businesses and stimulate greater investment spending. If these policies are enacted and do, indeed, have the desired effects, they may support financial asset classes such as equities and weaken the price of gold. On the other hand, if the results of these policies are not what the market wants, or if there are economic shocks—say, from future Fed monetary policy or from European elections—it may be good to have gold in the portfolio as a potential hedge. We are all-weather investors who believe in preserving our clients’ purchasing power. In 2017—as in virtually every period—we think it will be important to hold gold as a potential hedge for equity portfolios.
1 Source: Bloomberg.
2 Source: Bloomberg
The commentary represents the opinions of Thomas Kertsos, portfolio manager of the First Eagle Gold Fund and senior research analyst, and Max Belmont, research analyst, as of April 2017, and is subject to change based on market and other conditions. The opinions ex-pressed are not necessarily those of the entire firm. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any fund or security. Past performance does not guarantee future results.
