Since May 2019 we’ve seen gold prices rise over 20%, from below $1300/oz to break through $1550 before settling around $1500 in recent days. Over the same period, gold equities (listed gold mining and producing companies) have seen an even stronger increase, with the NYSE Arca Gold BUGS Index rising almost 60% between May and September. The index is currently more than 40% higher than in late May.
What is driving this strong increase, and what is the outlook for gold?
The biggest driver is gold’s proven status as a “safe haven” asset. Investors want to protect their portfolios from increasing geopolitical and macroeconomic risk. Geopolitical risk is very high at present – with no real end in sight to the US-China trade conflict, Hong Kong protests, Brexit uncertainty, and the Yemen conflict. Tensions have also escalated in the Middle East, with Turkey’s incursion into Syria and recent attacks on both Saudi and Iranian oil targets.
Economically, there are multiple risks weighing on investors’ minds. Record levels of debt – particularly corporate debt, which has now started making headlines but has been the case for some time. Auto loans and student loans are also at highly concerning levels. Increasing concern about a new financial crisis is one driver of the high demand for gold.
Another important factor driving demand for gold and gold equities is the very low yield environment. Negative yielding debt within the bond market has now reached a global total of USD 17 trillion. Bank deposits are a similar problem for Eurozone institutional investors.
Historically, physical gold’s zero yield was a drawback – now it’s an advantage compared to many north European government bonds, and to Euro bank deposits. Gold equities are at greater advantage still – positive dividend yield albeit less than some other sectors. However, the outlook for gold producer dividends is positive – with strong financial discipline across the sector and many mining companies looking to return cash to investors.
There is a strong inverse correlation between interest rates and gold prices. With the US Fed expected to cut rates for a 3rd time in 2019 before year end, Eurozone rates remaining negative, and UK rates below 1%, gold prices look set to remain high in the short and medium term. With this outlook, we would see a portfolio weighting of at least 5% in gold or gold equities as justified. Both gold bullion and gold equities have low correlation to other assets, and have proven to hold their value in turbulent times.
In an era of increasing demand for environmentally and socially responsible investment – and somewhat counterintuitively for mining companies – gold equities tend to score highly in ESG terms. Gold mining companies are nowadays very strong on ESG – and pressure from investors, regulators and unions will help ensure they remain so. Water recycling by mines has become a major focus within the sector, likewise malaria reduction programs for local communities.
Despite the strong price rises of recent months, gold equities are still quite low compared to their historical valuations. Price to earnings and price to cashflow ratios across the sector are significantly lower than their historical averages. According to their fundamentals, gold stocks are well positioned to outperform strongly versus the wider market. Provided the gold bull market continues, which it should for multiple reasons as outlined above.
Should investors favour physically-backed gold products, or gold equities?
Both have their pros and cons. Often the choice comes down to two key questions: is gold in a bull or bear market, and does the investor need the security of a UCITS fund or not?
In a rising market for gold, gold equities tend to outperform gold bullion. Analysts speak of a leverage effect, since in a bull market period for gold, gold mining stocks tend to rise by more than the price of gold itself. For gold producers who have their costs under control, incremental gains in the gold price are effectively extra profits.
Certain gold equity indices – such as NYSE Arca Gold BUGS – only select gold producers who do not hedge their production beyond 1.5 years. This aims to ensure that the index benefits from this leverage effect, by only including companies whose stock prices can benefit disproportionately from incremental gains to the gold price.
In a bull market for gold, both the earnings and cashflow of the constituent gold stocks tend to increase by significantly more than the gold price. After much hard work in recent years, most major gold mining companies have succeeded in reducing their cost base substantially. Which serves to increase this leverage effect in rising gold markets. And also positions gold stocks well for increased dividend yield in the future.
UCITS or non-UCITS is another driver of many investors’ choice of gold equities or physically-backed gold products. Physically-backed gold products offer efficient and low-cost exposure to the gold price, but they are not UCITS compliant.
And usually not funds: outside of Switzerland, most European products offering physical gold exposure are collateralised certificates or notes. By contrast, gold equity funds on the European market are generally UCITS, making them eligible for investment by virtually all European investor types.