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Gold has moved steadily higher over the past three years, the price more than doubling, well-outperforming global equities, though few seem to have noticed.
The gold move has been driven primarily by central bank buying, which continues, even if volumes are below the record levels of 2023 and 2024; buying remains well above longer-term levels. Inflows into global ETFs have picked up over the past year, though they remain soft in North America.
Meanwhile, though the gold stocks have appreciated a very respectable 45% over the last 12 months, we are not yet seeing the kind of leverage that the stocks normally exhibit to bullion, and the investing public does not appear to be interested. The largest gold miner ETF (GDX) has experienced $3.6 billion in net outflows this year, and these outflows are continuing. That is a large amount for a $15 billion fund. The dichotomy between prices and flows has never been greater.
WHAT’S GOING ON?
Traditional economic factors have not been the main drivers of gold. Central banks are buying to diversify their assets in the face of dollar weaponisation. Non-official Chinese savers were buying to preserve their purchasing power out of concern for a possible yuan devaluation and a fragile banking system. Wealthy individuals and families in the Middle East and Asia have been buying in the face of unsustainable fiscal deficits around the world, including in the U.S.
So looking at who has been buying gold and why, it is not at all illogical that they have not been buying North American gold stocks. North Americans typically buy gold assets in a certain economic environment: a weakening economy; high and rising inflation; low and falling interest rates (preferably negative real rates); and a weak dollar. Until recently, that was the precise opposite of the economic environment in the U.S., so again it was not illogical that North Americans were not rushing into gold.
Add to this unfavourable economic environment (unfavourable for gold) the fact the the U.S. stock market continues to move up month after month. Yes, the valuations are at their highest in history, the breadth is narrow, and the insider selling-to-buying ratio is at extremes, but the S&P Index just continues to move up fuelled by automatic passive flows. So it is no surprise that U.S. investors have little interest in gold.
That is beginning to change, if slowly, and as the narrative shifts, U.S. interest in gold will increase.
For now sentiment remains very weak, yet global fund managers think that gold is the ‘most crowded’ trade, according to a survey from Bank of America, with 58% of managers choosing gold against 22% naming the Magnificent 7. This is perhaps a reflection of managers who missed the bull move.
S&P investors have lagged not only gold stocks but gold itself the past four-, three-, two- and one-year periods, as well as year to date, and increasingly handsomely so (with gold up virtually 30% this year and gold stocks, per GDX, up over 50% against less than 7% for the S&P). In the graph are gold (white), the XAU (blue) and the S&P (red) year to date.
GOLD STOCKS REMAIN UNDERVALUED DESPITE PRICE MOVE
Oscar Wilde berated those who know the price of everything but the value of nothing. Certainly, the 50% plus increase in the gold indices this year has led many to instinctively think that the gold stocks are expensive. But the stocks are still very undervalued.
As the price of gold moves up, from the low $1,600s less than three years ago, to today’s $3,360, the value of the gold in the ground moves up; the price-to-net asset value has therefore not increased over that period. As the price of gold has moved up far more rapidly than the cost of mining, the margins have expanded and with it corporate cash flows increased; thus the price-to-cash flow multiples have declined. For example, Agnico Eagle, the world’s #3 gold miner, is trading in its lowest quartile of price-to-cash flow metric in over 20 years; while Barrick, the #2 gold producer, is trading in the lowest decile of price-to-NAV in its history.
U.S. ECONOMY NOT AS STRONG AS IT APPEARS
What will change this? Investors are slowly beginning to see gold’s outperformance, and see too the rapid growth in margins, (and thus cash flows) that the gold stocks are generating quarter after quarter. No industry sector has exhibited stronger growth in cash flow over the past 18 months than the gold miners. The trigger, however, may come from a change in the economic narrative.
The labor market, already weaker than headlines suggest, is deteriorating. The latest U.S. jobs report saw downwards revisions to the previous two month’s reports of 258,000 (that’s a revision of more than three times the latest number). The unemployment rate ticked up, despite the labor participation rate dropping. The respected Challenger report shows layoff up 29% in July from June, and 60% from last July. And the last piece of bad news is that the average duration of unemployment––already long–-rose to over 24 weeks, reflecting a slowdown in hiring.
It is clear that the jobs market is far from the ‘solid’ that Federal Reserve Chairman Jerome Powell asserts. Given that the ‘solid’ jobs market has been the main pillar on which Powell was resting his case for not cutting rates, the report adds significantly to the pressure to cut in September. If other economic data come in weak, then the expectations the Fed will cut rates will build, and with it gold will continue to move up.
Lower interest rates amid a slowing economy may also finally see North American investors turn to the well-performing gold equities. It is not only lower interest rates that will drive gold. Another Fed policy shift may be even more significant, and that is a new round of Quantitative Easing.
At nearly $37 trillion, the national debt stands at over 120% of GDP. That the interest of the debt has increased less than the debt itself over the past half century is because rates were declining for most of this period (1980 to 2022). As the shorter-term five-and seven-year Treasuries issued at far lower rates mature, they have to be rolled over at higher rates today, ensuring that the interest payments, in both absolute and relative terms, increase. Debt service is estimated to be 17% of next year’s budget, the largest single item in the federal budget.
Now the debt ceiling has been lifted, the Treasury is on a mad scramble to catch up, with the need to issue about $1.6 trillion over the balance of the year, about 66% more than in the same period last year. There remains the question of who will buy all the bonds, and at what price.
Many of the large traditional buyers are no longer buyers. This includes China and Japan, for varying reasons. Moody’s recent downgrade of the U.S. credit rating, the last of the major rating agencies to do so, limits the ability of many foreign institutions to hold Treasuries. Other traditional buyers, for one reason or another, are less likely to be buyers going forward.
Additional buying will come from a variety of sources. The major banks have been told that they need to keep less money on reserve at the Fed, but in return are expected to buy more Treasuries at auction. The so-called Genius Act encourages the issuance of ‘stablecoins’ fully backed by U.S. Treasuries, creating new demand. And so on.
But all these buyers are unlikely to come close to absorbing the entire Treasury issuance, this year at any rate. (Changes in the SLR and new stablecoins will take time to go through the regulatory process.)
Here is where the Fed comes in. It has been winding down its Quantitative Tightening, reducing the reductions from $35 billion a month to just $5 billion a month, a rounding error for a balance sheet of almost $7 trillion. QT has effectively ended, and once the Treasury resumes issuing new bonds, the Fed may, once again, be in a position of re-instituting QE, creating credit to mop up the Treasuries.
A resumption of QE would be likely bullish for stocks, negative for the dollar, and wildly bullish for gold. EG
