Does gold get back to work, with inflation no longer “transitory”?

Early in the month, Bank of England’s surprise decision to forgo interest rate hikes pushed down US treasury yields and nudged gold higher, with the metal moving above US$1,800 per ounce on November 5. Gold furthered its rally on the back of US inflation data released on November 10, which showed the headline consumer price index (CPI) climbing from 5.4% to 6.2% from September to October—the fastest pace since 1990. The news renewed concerns around inflation and added support to the “persistent rather than transitory” argument for inflation. Intraday, gold traded as high as US$1,877.15 on November 16.

While stronger-than-expected US retail sales weighed on gold mid-month, it was the November 22 nomination of Jerome Powell for a second four-year term as US Federal Reserve (Fed) chair, and current governor Lael Brainard for vice chair, which led to another failed breakout opportunity for the metal this year. The Powell-Brainard combination was perceived as favourable for markets: providing continuity, reducing uncertainty, lowering risk during a crucial time and, subsequently, driving the US dollar to fresh yearly highs. Gold fell over US$40 following the announcement, dropping back below US$1,800 and erasing most of its previous November gains.

Gold managed to trade back above US$1,800 at least once more. Notably, news of the COVID-19 variant Omicron sparked a global market sell-off on November 26. Gold managed to hold up, despite almost every asset class being down following the news.

Mixed Bag for Miners

Performance of gold equities strong, with NYSE Arca Gold Miners Index recording a gain of 6.27% in Australian dollar terms in November. For the sector’s most recent reported earnings released in November, although most companies met or exceeded expectations, many companies continued to be impacted by COVID-19 related interruptions that affected their productivity. This, combined with increasing inflationary cost pressures, labour shortages and, in some cases, operational challenges, led to more companies lagging against guidance and consensus estimates compared to last quarter and previous years. However, in aggregate, we believe the sector remains in great shape—enjoying healthy margins at current gold prices and trading at historically low valuations.

Uncertainty can be tough…

Last month, we discussed how gold markets have been struggling with uncertainty as investors seek to interpret the potential outcomes of Fed policy over the long-term, while also contending with higher inflation in the near-term. In November, markets signaled that owning gold in a rising inflation environment was favourable. Gold traded up by almost US$100 from the month’s low, on higher-than-anticipated US inflation prints.

However, the market continues to struggle with how effectively the Fed will be able to combat inflation, and to what extent expected tightening plans may slow down or dampen economic growth and increase risks in the financial system. While Powell’s second-term nomination seems to have provided some confidence that the Fed will be able to successfully navigate through a potential storm, it also appears that the markets are now much more worried about having a storm in general.

According to the US Conference Board, consumer confidence dropped to a nine-month low in November, further exacerbated by the challenges that the Omicron variant poses. During a Senate testimony on November 30, Fed Chair Powell said that it might be appropriate to accelerate the central bank’s tapering of asset purchases by a few months, given increasing inflationary pressures, and also pending more data and information on the new variant ahead of their next meeting on December 14–15. The stock market sell-off has intensified on Powell’s guidance for potentially faster tapering. Gold prices also dropped following his statements, despite a much worse outlook for inflation.

…But At Least Some Things Are Certain

During a congressional hearing at the end of November, Powell stated that inflation has proven more persistent than anticipated, running well above the 2% target for longer than originally expected, and suggesting that the term “transitory” is no longer apt to describe inflation. The Fed’s comments did not indicate that rate hikes may come earlier than anticipated, and any acceleration of tapering would still depend on economic conditions. Only one message is certain—inflation is worse than expected.

Improving gold demand

Gold’s consolidation around the US$1,750-1,800 range is attracting improved physical demand this year from China and India, with net purchases from central banks now approaching pre-pandemic levels. Bullion-backed ETF demand has yet to pick up, but we are seeing inflows since mid-November after two months of persistent outflows. As the price action in November demonstrated, gold should respond to increasing or persistent inflation. We believe the Fed’s tools to fight inflation could become a substantial risk to the economy and to the stability of the financial system. In a worst-case scenario, exposure to gold should help weather the storm. In the best case, exposure to gold, especially through the gold mining equities, could prove beneficial.

Why you still want to own the miners

Gold mining equities perform well in a rising gold price environment, because the cash flow generated by gold companies is highly leveraged to the gold price. For example, an estimated 10% or so increase in the gold price translates into about 30% more cash flow for gold producers, which is the reason why equities’ price moves can be a multiple of the gold price moves in any given period. This works both ways, when gold is up or down. The gold price is the most important parameter to monitor when investing in gold equities.

Gold has averaged around US$1,800 per ounce this year. At these gold prices, companies are generating a significant amount of free cash flow. This is because costs, the second most important variable to monitor when it comes to gold miners, are under control. Margins are very healthy and companies have excess cash to invest in their operations and give back to shareholders, even if the gold price stays right where it is today. This brings us to another valid point: Gold equities are attractive during periods of high and sustainable margins. The gold price and margins are historically high presently, yet stocks are trading at historically low valuations.

Perhaps no surprise…gold miners are still trading at attractive valuations

Source: RBC, VanEck, FactSet. Data as of December 2021. Past performance is not indicative of future results

The chart above shows the price-to-cash-flow (P/CF) multiple commanded by gold stocks (as measured by the NYSE Arca Gold Miners Index) from 2006 to present. The average P/CF multiple during the 2006 to 2011 gold bull market period, when the gold price averaged US$991, was near 15x. In stark contrast, today, with a gold price of US$1,800, that multiple stands at around 8x. Other valuation metrics paint a similar picture.

Cost improvements are adding with higher margins for miners today

Source: Scotiabank. Data as of October 2021. Note: All-In Sustaining Costs generally reflect the full cost of gold production from current operations and typically include adjusted operating costs, sustaining capital expenditures, corporate, general and administrative expenses, and exploration expenses. Past performance is not indicative of future results.

Gold miners: lower debt and higher free cash flow

Source: VanEck, FactSet. Data as of September 2021. Note: EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization; FCF = Free Cash Flow. Past performance is not indicative of future results.

Re-rating still seems possible

In our view, to earn back their old multiples, gold miners need to demonstrate that they can sustain this level of profitability over the long-term by continuing to post good results and delivering consistent value creation. We believe that even in a scenario of sustained gold prices, miners’ performance so far justifies a re-rating that brings valuations more in line with historical averages and reflects the significantly improved position of the gold mining sector. However, it may take the resumption of the gold bull market to achieve substantially higher valuation multiples for the gold mining equities.