Over the course of 2022, a strong US dollar has been a major headwind for gold. Driving the gold/dollar relationship has been an increasing realisation that in taking a hawkish line on interest rates, the Fed is out on a limb compared with other major central banks.
The Fed’s determination to raise interest rates while others are soft peddling has exacerbated inflationary conditions elsewhere, with the Yen, Euro, Pound and even Chinese Yuan weakening meaningfully.
While inflationary pressures have begun to ease, the growing concern is interest rates have risen enough to tip the world into recession, with bank credit now beginning to contract. The policy of threatening continually higher interest rates will likely be temporary. Central bankers have no practical alternative to prioritise the prevention of bank credit deflation over supporting their currencies.
Realistically, a recession must be fought with yet more printing of fiat currency to fund increased government budget deficits and/or through further expansion of commercial bank reserves. It is a reasonable supposition then that a Fed pivot is around the corner, and with it a reduction in the opportunity cost of holding gold.
Gold and gold equities are viewed as a safe haven. As a result, they typically exhibit a low correlation to global equities, which is particularly true during drawdowns. However, this is not what happened in 2022, when saw the correlation between gold and global equities become higher than normal, and even rise throughout the year.
Gold has faced two major headwinds. Firstly, the strength of the US dollar. The dollar has been strong because the Federal Reserve has been running much more hawkish policy compared to other central banks. And given gold is priced in dollars, a strong dollar relative to other currencies increased the cost of gold. Second, the rising real yields in the US. We get paid nothing to hold gold, so if real interest rates rise – that is the risk-free return above inflation – the opportunity of cost of holding gold goes up.
However, with the market becoming concerned about the US government hitting its debt ceiling and on reports central banks around the world have stepped up purchases of gold, the gold price has been on the move since late last year.
At Antipodes, our house view is that the case for owning gold is indeed strengthening. As is often the case in investment cycles, what were once headwinds for gold now look to becoming tailwinds.
The big question for investors is how to play the gold trade? In the early 2000s, the inability of investors to access liquid exposure to gold resulted in a substantial premium for gold producers. The advent of gold ETFs in the late 2000s saw a sizeable de-rating of gold equities, with producers previously trading on 6.5x EV/sales de-rating to as low as 2x.
With the collapse in valuations, management teams and boards reconsidered their approach to capital allocation, focusing on traditional drivers of equity value. Commissioning megaprojects took a back seat to raising returns on existing projects, and more recently a pivot to higher payouts via dividends and buybacks.
Despite the significant spike in inflation over the past 18 months, rising interest rates and a bull market in the dollar, the gold price has largely stagnated in a tight range. The dollar and real yields are likely to subside this year, driven by rising geopolitical tensions and an increasing probability of a Fed pivot as inflationary pressures subside and recessionary risks build. Therefore, the timing for gold exposure is opportune in both a soft and hard landing scenario.
Given generationally low valuations, gold equities offer a very wide margin of safety and, in the case of Newcrest, multiple ways of winning in a highly non-correlated exposure.
By Alison Savas, investment director at Antipodes Partners
