Gold miners corrected sharply yesterday, after US Fed Chairman Jerome Powell dismissed fears that the US economy is heading into recession. While he acknowledged that further rate cuts could be on the table, he said that he believed the US was not going to head into a recession in the foreseeable future.
Powell’s comments caused the gold price to fall by almost US$50/ ounce, a heavy decline for a commodity that now trades at US$1509/ ounce. Gold miners make a profit from the difference between their production costs and the current gold prices. To put that into perspective, a company which mines gold at a cost of $1,000/ ounce, makes $500 an ounce when the gold price is $1,500. If the gold price rises to $2,500 an ounce (66%), the gold producer sees their profit triple even if production is flat.
Gold Producers are selling off heavily today on the back of a deteriorating gold price outlook (Credit: Soyaz)
This is why we have seen bigger declines in the gold price today than what we would expect under normal circumstances. Newcrest mining (ASX: NCM) is down 3.37%, Regis Resources (ASX: RRL) is down 6.42% and Northern Star Resources (ASX: NST) is down 2.10%.
While mining often gets a negative reputation because of outsized price declines relative to the underlying commodity, investors often forget that the leveraged exposure to commodity prices also works on the upside. This is why ASX gold producers like Newcrest Mining (ASX: NCM, +77%), Regis Resources (ASX: RRL, +39%) and Northern Star Resources (ASX: NST, +74%) are all up way more than the gold price this year. Those returns certainly beat the low interest savings accounts that most investors use to ride out a downturn.
Will we go into Recession?
2s10s inversion has been a timely recession indicator (Credit: St Louis Fed)
When investing in gold miners, it is important to have a view on the economic outlook, as the gold price has a strong inverse correlation with investor sentiment towards the economy. This is because the asset class has historically been a reliable store of wealth, before the days of unpegged paper currencies, and is still viewed as a safe store of wealth in downturns. It is particularly attractive in countries where a global recession could result in currency instability and hyperinflation.
Gold is also attractive to people who distrust governments and subscribe to conspiracy theories around central banks. While we are not advocating such an outlook, those people will increase in number during economic downturns, since individuals are more likely to question technocratic institutions when the economy is doing poorly than when it is doing well. All these factors combine to make gold an attractive asset class in an economic downturn
One indicator that is used to see whether the economy will go into recession is the 2s10s spread. When investors worry about the economic cycle, they prefer to buy long term bonds since they go up more than short term bonds. To illustrate why, suppose you held a $1,000 bond paying a $50 a year in interest for the next 10 years. Imagine interest rates suddenly fell by 5%, and new bonds that sold for $1000 now paid a 0% interest rate. Investors will clearly pay a lot more for the first one since it makes more money, pushing the price of the initial bond up. This effect is more muted over shorter time horizons.
This is why investors like longer term bonds as much as shorter term ones when they think the economy will contract. Bond markets have, in the last four market cycles, predicted contractions far earlier than the stock market. The difficulty is that the stock market generally rallies 13% over a few quarters after the first yield curve inversion. If history is any guide, now is not the time to exit the markets completely, but it is the time to invest more defensively.
Global GDP growth is slowing, but not as fast as Aussie growth in the last quarter (Credit: RBA)
Even if a recession looks likely, most investors will continue to hold cyclical assets like shares for their long-term growth potential. Nevertheless, it is important to monitor the state of the economy and adjust the portfolio to position somewhat defensively when the outlook deteriorates, while still leaving some room to profit if the economic outlook improves. This is why gold miners are attractive assets – they offer the same long-term growth potential as other well managed businesses but are countercyclical. As such, investing in gold miners is not just a way to bet on an economic downturn, since the position can also be used to hedge existing investments in other assets.
Where the Gold Price is Heading ?
We have a bullish outlook on the gold price, believing that the precious metal could easily retest it’s 2011 high of US$1889/ tonne in 2011, should economic fundamentals deteriorate. If realised, this is likely to result in the price of gold miners doubling.
The US dollar gold price is up 26.1% over the past year, and most major global economies haven’t even started contracting yet. Investors like Ray Dalio, the founder of the world’s largest hedge fund, is bullish on gold and projected a price as high as $5,000 an ounce (compared to $1,509 today). While we aren’t as bullish as Dalio, we do believe it is a great way to hedge your portfolio and express a bearish outlook on global markets.
Our bullish view on the gold price has been formulated by the fundamentals of supply and demand for the commodity. There are three main sources of demand for gold: investment demand, jewellery demand and industrial demand. All three factors have a large impact on the gold price, although their impacts are felt by markets in very different ways.
The gold price is driven by investor demand, which is countercyclical, since investors typically have an outsized impact on the gold price. Hedge funds often express positions through leveraged futures contracts, which means that a fund with a billion dollars under management could make as large an impact as a producer adding $10bn to the market.
One other investment related source of gold demand is central banks, like the RBA in Australia. These central banks are attracted to the safety of gold and use it to accomplish objectives like currency stability. Gold reserves are often held alongside US dollar holdings since the US dollar is regarded as the global reserve currency.
The PBOC, China’s central bank, has over $3tn in assets, around double the GDP of Australia, and is rapidly adding to it’s gold reserves. The central bank added 10 tonnes to its gold holdings, an amount worth half a billion dollars, in a single month. While this already seems huge, China’s central bank also holds over a trillion dollars in US Treasuries and wants its own currency to replace the USD as the global reserve currency over the long term. With total global gold demand slightly above 4000 tonnes, China alone could double gold demand for half a decade if it cashed in their US treasury holdings. China’s gold buying spree might just be getting started, lending a bit more credibility to Ray Dalio’s $5,000 price forecast discussed above.
Gold is commonly used in technology and is required for circuit boards. This is why companies like Mobile Muster exist to encourage recycling of smartphones – the gold they recover pays their marketing expenses a few times over. With the advent of autonomous cars and IoT enabled devices, which would lead to significant growth in the number of high-tech devices available globally, the demand for gold is set to rise from yet another source of demand.
The only aspect of the gold price outlook which is mixed is jewellery demand. With the global economy slowing down, consumers are likely to reduce jewellery spending since it is viewed as a discretionary purchase. Additionally, jewellery is often not a substitute for bullion since it sells at many times the value of the underlying gold due to design features, brand recognition and production costs.
Nevertheless, despite a mixed outlook for jewellery, several more important factors for gold demand are pointing up. We do not anticipate that supply will increase accordingly, and hold the view that risks are weighted to the upside.
As any student of economics will tell you, prices rise when demand outstrips supply. This is a positive sign for the gold miners and makes them attractive in light of recent gold price weakness.
Is the ASX Well Positioned for a Downturn?
While the ASX has a lot of attractive defensives, the index as a whole is heavily weighted towards cyclical industries, with half the index in financials and mining. Since we have not had a recession in three decades, many investors seem to have forgotten how cyclical financials are. This can easily be seen in continued media assertions that banks are “safe” investments, which clearly ignores waves of bank collapses every decade or two in major economies around the world.
One possible source of a downturn is the US-China trade war, which the ASX is particularly exposed to since China is by far our largest trading partner. Companies in Australia can be directly exposed to the Chinese growth story through either the daigou channel or direct business relationships. The daigou channel has been hit in recent times, with China now requiring people operating daigou businesses to acquire licences to operate daigou businesses in both China and the other country the operate in, meaning those companies are subject to the same taxation as normal businesses. This has hurt Australian businesses reliant on the daigou channel, since it increases the average effective rate of tax consumers in China pay on their goods, pricing some consumers out of the market.
This has resulted in particularly bad effects for milk companies such as A2 Milk (ASX: A2M), Bellamy’s (ASX: BAL), Bubs Australia (ASX: BUB) and Blackmores (ASX: BKL). A2 Milk sold off earlier this year, as China ratcheted up regulations on the importation and advertising of foreign infant formula. A2 can no longer advertise infant formula in the 0-12-month-old market segment, and China is set to favour domestic producers which it wants to obtain a 60% market share.
Blackmores has also been hit heavily after announcing a disappointing quarter of Chinese sales. Their sales in Asia excluding China rose by 30%, along with flat sales across Australia and NZ. China was the only weak spot in their recent results, with the increased regulation of the daigou channel driving a 15% decline in Chinese sales. This brought overall sales growth down to 1%, along with a profit decline. The result capped a ~70% decline from the company’s share price at its peak, highlighting the risks of overreliance on the Chinese market at the present time.
If the trade war expands to other countries and products or leads to an economic slowdown, the big miners like BHP Billiton (ASX:BHP), Rio Tinto (ASX: RIO) and Fortescue Metals (ASX: FMG) could come under pressure. Treasury Wine Estates (ASX: TWE) is also heavily exposed to Chinese imports and will also lose out from broader protectionism and tariff rises. While these stocks are not reliant on the daigou channel, which is coming under increasing pressure, they have direct sales contracts with Chinese companies. These could put pressure on share prices, should the Chinese government puts tariffs on countries other than the US in an escalation of the trade war.
Domestically focussed Chinese businesses however have less trade war related risks, because their products will not be subject to tariffs in the Chinese market. This makes investing in companies that are based in China or Hong Kong a great way to play the Chinese growth story, whilst minimising exposure to trade war related risks. With 98% of listed investment opportunities offshore, it makes sense to invest internationally.
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Luxury goods (+4.82% LTM): Luxury goods producers have high profit margins and sticky customer bases, making them excellent long-term investments. They are particularly well positioned to take advantage of growth in China, given the high levels of luxury goods expenditure amongst the nation’s booming middle and upper class. Many of the companies in this view have significant family ownership stakes, including Hermes and LVMH, protecting them from short term biases in decision making.
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This article has been prepared by the Australian Stock Report Pty Ltd (AFSL: 301 682. ABN: 94 106 863 978)
(“ASR”). ASR is part of Amalgamated Australian Investment Group Limited (AAIG) (ABN: 81 140 208 288 Level 13, 130 Pitt Street, Sydney NSW 2000).
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