Review
As of September 30th 2021, gold bullion closed at US$ 1’756.95/oz., a increase of 3.7% in the reporting Quarter (June 30th, 2021 to September 30th, 2021). The Philadelphia Stock Exchange Gold and Silver Index lost 15.7% (USD), resp. 13.7% (EUR) during the reporting quarter, while Nestor Gold Fund (-B- share class) decreased 14.9% (USD) resp. 12.9% (EUR). The fund’s slight underperformance in Q3 is due to the small cap tilt, which underperformed during this quarter.
Gold miners published generally in-line Q2 results. The industry continues to act in a disciplined way. Further dividend increases and share buy-back were proof of high capital discipline. In addition, we observed quite a few ESG upgrades, confirming our view that the industry is taking ESG matters seriously and acting accordingly. The rock-solid balance sheets, the extreme undervaluation vs. the equity market, vs. physical gold and vs its own history bodes well for the next quarters. We therefore expect gold miners to outperform physical gold in a stable or rising gold price environment. M&A activity stayed relatively calm in Q3, 2021, but we recognize increased interest by the larger/medium-sized producers to do low-risk bolt-on acquisitions. A positive sign is also the zero premium merger between Agnico Eagle and Kirkland, as similar mergers (Newmont/Goldcorp & Barrick/Randgold) took place during the gold doldrums in 2018, just ahead of the resumption of the structural gold bull market.
Déjà-vu / already seen before
The last few months feels like during the doldrums of 2015 and 2018, when the gold market was weak and nervous about the upcoming monetary normalization (tapering, interest rate increases). It took a while before the market realized that such a normalization isn’t feasible given the huge global indebtedness and leverage in the financial system. While disappointed about the recent history, we also remember well how the Nestor Gold Fund performed when the market was waking up to reality (2016 & 2019/2020).
For the time being, we are, however, frustrated – like then – and ask ourselves how long the market can play such a scenario, which seems impossible and which would have dramatic negative implications for the equity, credit and real estate markets. In addition, there would be a spillover effect on the economy (more than half of the economic growth between the 2008 and 2020 crises was due to the positive wealth effect). After the pandemic, the situation is much worse and according to our model the “neutral” interest rate for the US is right now close to -1.0%! Therefore, already tapering will likely have devastating effects on financial markets. Early indicators have been observed over the last few weeks and confirm our view that a monetary normalization is unlikely to happen.
FED tightening, while the economic outlook worsens?
During the last few months, the market started to price in an economic slowdown. This seems reasonable given the much lower fiscal stimulus in 2022, the deterioration of real income (due to higher inflation), the lower monetary stimulus (lower growth rates in monetary aggregates) and the much higher comparable. To summarize, while we are unlikely to head into a recession next year, economic growth will likely slow down significantly during 2022 and fall back during the next 2-3 years to the structurally low level of around 1% in the US and even lower in Europe and Japan. Therefore, while the FED would like to normalize its monetary policy, they already see the negative effects (interest rate increases, toppish equity markets) and will likely change policy quickly, as they did in 2018/19. In that sense the recent comments by FED Chair Powell, a strong believer of the transitory inflation thesis, are worth reading: “The biggest mistake the central bank could make is to tighten monetary policy now, while the US economy will weaken of its own due to declining purchasing power and less fiscal stimulus.” According to Powell, “wage increases and inflation will fall back of its own and if the FED were to tighten monetary policy at the same time, this could knock the economy into recession.”
Our base case scenario for the next few years
The structural growth issues facing the industrialized nations have gotten even worse vs. the pre pandemic period. Over-aging, very high debt levels (much worse after the pandemic) and the oversaturation of the consumer have not disappeared, but actually gotten worse during the last two years. While the fiscal stimulus and easy comparable from 2020 are helping this year, this won’t be the case next year. Inflation is still considered transitory by consensus and 10-year inflation expectations are still very low. However, we observe that the inflation pressure is moving to wages, rent and services, which are generally considered much less transitory than the good price inflation exhibited during the last 1½ years.
If you are interested in the arguments of sustained inflation pressure and where we differ from consensus, we advise you to read the appendix of this quarterly report, which goes into more details on that subject.
While central bank and government will be happy about somewhat higher inflation (as it allows the reduction of debt/GDP given the negative real rates), the combination of sustained low economic growth with sustained inflation is pointing to a stagflation environment, as exhibited in the 1970s. Based on the experience in the 1970’s, as gold went up from USD 35 to USD 850, this should bode extremely well for gold and even more so for gold miners.
Given the global debt situation, central banks will opt for inflation and stay well behind the curve. Should the bond market start discounting sustained inflation, the FED will also have to move to yield curve control, like other central banks practicing already (Japan, Australia, etc.), to avoid a major financial crisis. It is tricky to forecast when the market will start to discount such a positive gold price scenario (low economic growth, sustained inflation and yield curve control leading to sustainable negative real interest rates). However, given the recent increases in the long-term yields, this could easily happen in the near term, especially if interest rates continue to climb higher.
Physical gold demand recovery, depressed sentiment and seasonality points to a Q4 rally
Physical gold markets have been recovering this year and we expect further improvement during H2, 2021. Especially in India (second biggest gold consumer in the world), where the wedding season is starting, we expect an additional pent-up demand, as many weddings had to be postponed last year due to Covid. The traditional positive seasonality will therefore likely resurface this year. Central banks have also been much more active than last year. The weak point in 2021 was investment demand, with many tactical players selling. Given the expected view change on inflation expectations, the mood of investors can quickly change. Currently, sentiment is very pessimistic again, historically a very good counter-indicator. All this speaks for a rebound in Q4, after the disappointing YTD performance of gold and gold miners.
Gold miners, a rare deep value proposition
The miners currently trade at the highest ever discount to gold (discounting a gold price of less than USD 1’400!), while gold is also significantly undervalued vs. the TIPS (inflation protected securities).
This mispricing of gold miners, which trade at all-time low valuations on most metrics, is even more obvious when they are compared to other asset classes (growth stocks, equity markets). Such asset classes are pricing negative real rates for years to come, while gold miners discount a very unlikely sharp rise in real interest rates. In addition, the balance sheets of gold miners are much better (no net debt) than most other industries and the gold miners still have above average FCF-yields and therefore continue to increase their dividends and initiating share buy-backs. We are convinced that this substantial mispricing will disappear as soon as investment demand starts to come back into the gold market. This will most likely have a powerful positive impact on the deeply undervalued gold miners.
Conclusion
The current environment and sentiment resembles the doldrums of 2015 and 2018, when the gold market was weak and nervous about the monetary normalization (tapering, interest rate increases). It took a while before the market realized that such a normalization isn’t feasible given the huge global indebtedness and leverage in the financial system.
Given that growth looks much more transitory than consensus expects and inflation pressure is much more sustained than generally believed (as inflation moves from good price inflation to wage, rent and service inflation), a stagflation-like scenario will come back to investors’ minds. Such a scenario is not only very positive for precious metals investments, but will also likely bring back yield-curve-control discussion and should bode well for a change of investor appetite for gold and gold miners.
The very supporting physical gold demand and seasonality should be supportive for the Nestor Gold Fund during the next few months. In addition, as managements get comfortable that today’s gold price environment is sustainable, we expect many more small bolt-on acquisitions. Stellar strong balance sheets and healthy FCF, as well as rather empty project pipelines, speak for such action. The Nestor Gold Fund is perfectly positioned for such an outcome. The well-above-average exposure to exploration and development companies is a key differentiating factor of the Nestor Gold Fund relative to active and passive peer products.
Gold miners discount a gold price of USD 1’400 and are substantially undervalued, not only against gold but also relative to their own history and against the general equity market. Sentiment and seasonality are pointing to an end of the consolidation period soon and higher gold prices into year-end.
Walter Wehrli and Erich Meier, Konwave AG
Appendix
Inflation outlook – where we differ from consensus
Recent inflation data (monthly August data) in the US is pointing to a slowdown in inflation, as expected by consensus (US CPI still gained 5.3% YoY, while core CPI rose 4% YoY, still very high numbers). Given most of the inflation rise during the last 1½ years was driven by higher prices for “goods”, the lower m-o-m inflation in August isn’t a real surprise. This confirms – for now - the broadly held view by central banks that inflation is transitory.
We disagree however on the thesis that wage inflation will fall back on its own. The central banks are likely to underestimate the end of globalization (see chart below) and the impact of rents, which contribute to 40% of core CPI.
So let’s address the three major differences, which will likely change the market view on intermediate and long-term inflation expectations during the next few months:
Globalisation
As can be seen below, the rising merchandise trade as % global GDP had a disinflationary effect on US CPI. As globalisation is retreating, we see the contrary happening.
Source: Refinitiv Datastream / ECR Research / Konwave AG
Wages – return of the Philips Curve?
The labour market is, according to US statistics, still very weak, but will improve significantly during the next 12 months and we expect close to full employment by end of 2022. In fact, a pandemic should be compared to a natural disaster (sharp quick initial fall of employment, but also fast recovery to pre-pandemic level, as there was no build-up of excess capacity, unlike in typical recessions). Even more surprising is the fact that - despite the currently weak employment market - the employment cost of inflation continues to rise steadily in Europe and the US, as can be seen below:
Euro area- compensation per employee (% YoY) at 20 year high
Source: MRB Partners / Konwave AG
U.S. wage pressures: underlying trend is up since 2009!
Source: MRB Partners / Konwave AG
There are more and more signs that labour shortages are visible in more and more industries and regions of the world. Wage pressure in certain industries is spreading now to other industries as people are looking for better compensation. Sign-on bonuses and additional “goodies” are getting standard in the US, most of them not even seen in the official wage statistics. Due to over-aging, the wage pressure will likely not abate, as the market and the FED expects, but will likely increase further and get worse. As a result, we expect that the relationship between inflation and unemployment (Philips Curve) will likely have a revival and wage-induced inflation that will be permanent for many years to come. The central banks and the governments might well be happy about wage increases, as it is seen as a tool to reduce the social inequalities.
Rent/Owner’s Equivalent Rent inflation likely to rise (40% of core CPI)
Source: MRB Partners INC / Konwave AG
There is a strong correlation between home prices and rent prices. As home prices lead rents by 18 months, as seen in the chart above, this points to significant inflation pressure over at least the next two years and will likely more than compensate the effect of potentially lower “goods” inflation.
To summarize, we are convinced that the inflation is moving to wages, rent and services, which are generally considered much less transitory than the good price inflation exhibited during the last 1½ years. This will increase the inflation expectations, which is generally very positive for precious metal investments.