This quarterly report will address the following themes:
• Review of Q2, 2020
• Macroeconomic outlook – the “new normal”
• Monetary policies – the “new normal”
• Behavioural Finance: interesting and important observations
• Technical outlook – successful retest of the multi-year breakout
• Have we finally reached the sweet spot of our investment style?
• Conclusion
We hope you find our views interesting and continue to wish you good health in this turbulent time.
Review of Q2, 2020
As of June 30th 2020, gold bullion closed at US$ 1,780.96/oz., an increase of 12.9%. The FTSE Gold Index gained 52.3% (in USD), while the Nestor Gold Fund increased by 67.3% (in USD). The outperformance is thanks to successful stock picking as well as the small cap tilt, which finally started to outperform in Q2, 2020.
Gold increased thanks to strong investment demand. Gold continued to react to unprecedented monetary policies implemented by the FED. The gold miners published Q1 reports, which were generally in line with expectations. After many announcements of COVID-19-related temporary mine closures in the previous quarter, the mines reopened in Q2, 2020.
The quarterly results to be published at the end of July/early August will be positively affected by higher gold prices, lower oil prices and tailwind from weakening currencies in the producing countries. For most companies, this should more than compensate for any COVID-related costs (tests, masks, distancing etc.). The temporary mine shut downs and the reduced production were well communicated by the companies and should not result in any surprises (Q2 results) respectively are already priced in. Subsequent quarters are expected to be in full production, lower costs (energy and currency tailwind) and higher gold prices. Given the very low valuation, the operating and financial leverage as well as continued industry discipline, we continue to consider gold equities to be in the sweet spot of the industry cycle and therefore they are expected to outperform physical gold significantly in a rising gold price environment.
Macroeconomic outlook – the “new normal”
While we correctly forecasted in our Q1 report the V-shaped recovery of gold miners and the general equity market, we underestimated the duration of the COVID-19 pandemic. This is leading to a slower economic recovery than anticipated three months ago. While this is short-term positive for gold, we don’t consider the speed of the recovery as very important to the future gold price development and see the “new normal” as far more important. To assess how the “new normal” will look, we have to look backward, i.e. how the economy developed since the global financial crisis in 2008. The average growth in the US was slightly over 2% p.a., the weakest recovery after any recession since the 1950’s. Taking into account the very positive wealth effect (rising real estate and equity prices) which contributed according to Empirical Research about 1% to growth per year, the real structural growth without wealth effect would have been just above 1%. Even if central banks manage to create a wealth effect again, economic growth would be reduced by the massive debt burden and the potential declining globalisation. In addition, many empirical studies are proving the fact that large fiscal deficits have led to a significant increase in the saving rates. This will be another important driver of lower economic growth in the future. Taking all that together, investors will have to accept in the next few years a US economy which oscillates around the zero growth line as the “new normal”!
Monetary policies – the “new normal”
The key question is how central banks will react to the massively increased debt burden in a zero-growth environment. Increasing evidence is that central banks will try everything to make sure that
• the heavily indebted countries and corporates will survive by providing ultra-low interest rates
• the middle class and the poorer classes survive by providing helicopter money
• nominal interest rates won’t go up by ceiling the mid to long-term interest rates
All these actions, i.e. the monetisation of debt/deficits, will soon be the “new normal” and will likely last for many years. This will lead to even lower real interest rates, one of the most important drivers of higher gold prices. In addition, confidence in the more and more extreme monetary policies has started to weaken. As a result, a confidence crisis towards the central banks Is developing, which increases the risk of an upcoming monetary crisis!
Behavioural Finance: interesting and important observations
While the macro and monetary environment is very positive for gold and gold miners, we want to check if gold miners are already a “crowded” investment. Having been – after many years of disappointment - one of the best investment themes since early 2019, one would expect investors to have piled into gold miners. As can be seen below, surprisingly the contrary happened, with large outflows of 15 - 25% in the most common gold mining ETFs!
Sources: Bloomberg, Konwave AG
While most investors will have well-founded reasons, the fact that such a large number of investors are exiting is a very constructive sign.
Technical outlook – successful retest of the multi-year breakout
A picture tells more than many words and we leave the chart below to your interpretation. However, the recent investor behaviour increases the probability that the consolidation since mid-May either has already ended or will be much shorter and shallower than what gold mining investors have experienced in the last few years.
Sources: Bloomberg, Konwave AG
Have we finally reached the sweet spot of our investment style?
Given our tilt to small caps (30% - 40% of the fund) the significant under-performance of this segment did hurt the fund performance in 2018, 2019 and YTD. Thanks to successful stock picking, we were able to compensate this tilt-based underperformance of the smaller segment.
Just two months ago, the two largest gold miners (Newmont and Barrick) traded at the highest ever valuation premium versus the other gold producers. However, since then, we have started seeing a complete change of behaviour in the smaller cap names, which we haven’t seen for the last 10 years. Apparently, more and more investors start to realise that the large gold miners have not invested in new projects and have to buy smaller peers to maintain their production level in the coming years. If this trend is sustainable - which is likely in the current gold price environment – we would not be surprised to see the Nestor Gold fund significantly outperforming passive products, as happened in comparable previous periods!
Conclusion
The “new normal” macro environment and the “new normal” monetary policies are perfect ingredients to a sustainable gold bull market. The recent investor behaviour in gold mining funds supports the case that the recent consolidation was/will be much shorter and shallower than generally expected and might already have ended.
Gold miners were, in the last 9 years, a frustrating experience for investors, and the reluctance as well as selling of investors in the last 1½ years is understandable given the disappointing experience since 2011. However, given that the gold bull market is finally back in full swing, investors from now on face one major risk, and this is “selling too early”, as we are still in the early inning of the bull market!
Walter Wehrli and Erich Meier, Konwave AG