Follow the yellow brick road?

Precious metal miners have been winners thus far in 2020. Callum Stokeld of Kepler Trust Intelligence asks if there is further to go?

Article updated: 13 August 2020 1:00pm Author: Callum Stokeld

Everyone loves an allegory (except a narrow majority of Floridians in 2000). Perhaps this explains the enduring appeal of 'The Wizard of Oz'. Originally this was written as an allegory for the economic strife between different American spheres: The Lion represented William Bryan (a populist Democratic presidential candidate), the Tin Man the industrial workers, and the Scarecrow the farmers.

We can add onto this that in the book Dorothy had silver slippers, representing the author's proposed solution to the economic hardships he laid at the feet of the Gold standard (which is why they have to reach the end of the 'yellow brick road').

We’re no longer on the gold standard, but globally some of those similar pressures were being felt earlier in the year amidst a dearth of USD liquidity. And gold has once again been dominant over silver in recent months, with the gold/silver ratio at c. 93:1 (Source: Blackrock) against a normal trading range since 2000 of between 50:1 and 70:1, but both have been noteworthy winners in recent weeks and, indeed, this year.

Gold bullion is now up c. 31% YTD (as of 31/07/2020), whilst silver is up c. 32% in GBP terms after some big moves in the last week. Gold miners have been even more impressive, with the FTSE Gold Mines index up an incredible c.49% YTD (and c. 55% since we highlighted the sector in March) (Source: Morningstar).

Gold may now be at or around new nominal highs in price, but it remains some way off its inflation-adjusted high, achieved in January 1980. We have below shown the gold price adjusted by a CPI index provided by the St Louis Federal Reserve (as CPI data has only been published up until the end of May, we have assumed it is flat for the months of June and July. The evidence available suggests this is unlikely and that some price inflation will have occurred, thus we believe this to likely slightly overstate the CPI adjusted performance of gold in the past two months).

837x551_Inflation - adjusted gold price_12 Aug_issue-01.jpg

Aside from the fact that the inflation adjusted gold price looks like a potentially huge ‘cup and handle’ formation, does the strong performance already seen thus far mean it is too late to take exposure? For those of us with existing positions in precious metals, it is certainly sobering to see media attention starting to focus on the performance of these commodities, always a warning sign that we may be seeing overexuberant conditions.

However, whilst it is eminently possible that the latest explosive moves higher in precious metals and miners may well prompt some profit taking and a period of consolidation in the short term, it is surely worth noting that, at the time of writing, the gold mining index remains c. 22% below its 2011 peak in USD terms, and that the fundamentals look far better this time. As the managers of Blackrock World Mining (BRWM) note, capex and costs discipline remains strong despite these moves in the price of bullion. Some reports estimate free cash flows have doubled in the median precious metals miner over the past twelve months.

An explosive move higher in the gold bullion price might reasonably have been expected to see an explosion in capital expenditure and exploration by junior miners, eager to cash in on higher prices with increased production. Yet evidence abounds that managements are more focused on cost discipline, and only green-lighting projects if they can project significant operating margins at conservative estimates of the price of bullion.

Perhaps the most important determinant of where precious metals go next will be real (i.e. inflation adjusted) interest rates. After all, gold bullion does not yield anything, so when positive inflation adjusted interest rates are available there is an inherent opportunity cost in holding gold. Positive real rates benefit savers amongst the population. Negative real yields should allow politicians to reduce heavy debt burdens without having to cut spending. Of course, much of this is ostensibly outwith their control, and determined by the famed ‘bond vigilantes’. But many institutions are obliged to hold the highest rated sovereign debt, and if all major central banks opt to intervene to ensure governments can borrow at negative inflation-adjusted rates (as the US Federal Reserve did in much of the 1940s), then the guns of the bond vigilantes may be spiked.

It was seemingly in this context that Deutsche Bank’s Jim Reid commented recently: “Gold is definitely a fiat money hedge”. The vast monetary creation we have seen thus far in 2020 will not be news to readers, but when we look at the price of gold relative to the supply of money, it seems highly likely this is not anywhere near an irrational ‘blow-off’ top.

837x551_Gold bullion price US M2 money supply_12 Aug_issue-01.jpg

Sharing this optimistic outlook is Evy Hambro, manager of BRWM trust. Whilst BRWM invests across the mining sector, this bullish outlook has led Evy to currently allocate over 35% to precious metals miners (with further exposure through diversified miners). Despite having generated strong positive share price returns thus far in 2020 and offering a yield of c. 5.3% which should remain relatively resilient, BRWM remains on a discount of c. 10.6%.

More direct plays on the mining sector are available, both through a variety of ETFs and through the Golden Prospect Precious Metals trust. The managers of the latter have in recent months availed themselves of the wisdom of Oz, and after noting the high ratio of silver to gold have shifted more of their portfolio towards silver miners. With a focus on junior miners, a relatively small market capitalisation itself, and accompanying relatively low liquidity and relatively high discount volatility, this trust will undoubtedly remain a punchy option for investors

Note: BlackRock World Mining Trust is a client of Kepler Partners.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Callum Stokeld

Investment Trust Analyst, Kepler Partners

Prior to joining Kepler Partners in 2019, he worked as a senior investment analyst on a range of multi-manager, multi-asset portfolios, having previously worked at IFA firms in roles focused on oversight of fund selection and asset allocation.