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NESTOR Gold - Quarterly Report 4/2021

As of December 31st, 2021, gold bullion closed at US$ 1,829.20 USD/oz., an increase of 4.1% QoQ. For the year 2021, gold consolidated by 3.6% in USD

Review
As of December 31st, 2021, gold bullion closed at US$ 1,829.20 USD/oz., an increase of 4.1% QoQ. For the year 2021, gold consolidated by 3.6% in USD. The Philadelphia Stock Exchange Gold and Silver Index increased by 11.3% (USD) / 13.15% (EUR) during Q4, 2021 and ended the year with -8.1% (USD) / -1.4% (EUR). Nestor Gold Fund (-B- share class) gained 10.1% (USD) / 12.6% (EUR) in Q4, 2021 and decreased by 13.8% (USD) / 6.4% (EUR) in 2021. The fund underperformed in Q4, as well as during 2021. This underperformance is due to the small and mid cap tilt. This segment substantially lagged the larger producers during Q4 as well as during the year 2021.

While Q4 was relatively uneventful, there are some major changes going on, unnoticed by most investors. Physical gold demand has been rising further, especially in India. Investment demand stayed low with further ETF selling. Unlike what happened in the past, gold was however able to combat that pressure and rose, as did the gold miners. Gold also ignored the continued US Dollar strength, as the US Dollar index rose to intra-year highs in Q4. While expectations towards tapering and faster and more than expected interest rate hikes during 2022 rose, gold’s underlying strength was much different to similar periods in the past (2015/2018). Gold seems to discount that most of these trends won’t be sustainable, looking ahead into what will likely play out in 2022 and the following years.

To summarize, gold and gold miners are starting to ignore the noise and behaving more and more as they should, despite the continued pessimism and disinterest  from the consensus.

The interest normalization- the dream is alive again
By listening to the FED December meeting and reading consensus expectations for 2022, it becomes clear that the market is looking into the upcoming monetary normalization with tapering, followed by many interest rate hikes. As in late 2018, there is hardly any doubt that the economy or financial markets could derail such plans. Currently, given the extreme inflation pressure, there is a broad consensus that interest rates are necessary to combat inflation and possible given the underlying strength of the US economy. On first sight this seems right, but looking into 2022, things will likely change dramatically, as can be seen in the two charts below.
As a matter of fact, China was the weak point in 2021, while the US economy was the key pillar of global growth. This is inversing during 2022. Thanks to starting stimulus, the Chinese economy will likely be the biggest global growth factor, while the US and Europe will react with its typical lag to the negative policy action of China as well as the rising US Dollar and rising commodity prices (Growth tax, Chinese credit impulse) as can be seen below.

“Growth tax” and Chinese credit impulse points to major economic deceleration

 
Source: Alpine Macro

In addition, lower fiscal and monetary stimulus, declining real income and tough comparables (unlike 2020 with easy comparables) point to much lower growth in 2022.

We would also remind investors about the “neutral” interest rate for the US economy (based on a FED model). Due to demographics (overaging), rising debt and the consumer saturation, the “neutral” interest rate for the US economy is currently around -1%. With the now discounted interest rate hikes in 2022 and 2023, the FED would deploy a similar monetary policy as in 2007 and 2018, which led to major declines in financial markets and was followed by a complete turn-around by the FED policy afterwards.

We are convinced that the FED doesn’t want to go down this similar path, as it created many issues for the FED policy. The strong economic deceleration expected during H1, 2022 (after a strong Q4, 2021 in the US) will allow the FED to back off from its communicated path. It will likely get some relief from the inflation numbers. While inflation will be sticky and here to stay for many more years, the likelihood that inflation will stay above 5% for years seems rather low. Such a scenario seems realistic only if investors lose complete faith in the US monetary policy, which would lead to much higher gold prices.

To summarize, the dream about interest rate normalization will likely dissolve during H1, 2022 given the huge global indebtedness, the importance of the wealth effect for the US economy and leverage in the financial system. Investors will realize that very negative real rates will stay here for many years and interest in precious metals investments will come back, given the deeply negative real yields combined with the conclusion that monetary normalization isn’t likely to happen for many years

What happened after the “normalization dream” vanished into thin air?
During the last ten years, there were two circumstances when a broadly held consensus view (interest rate normalization) had to give way to the “monetary reality”. The first time was in late 2015, when consensus had to adjust their expectations for an interest rate cycle from “normal” to “well below normal”. Gold rose by around 30%, while the Nestor Gold Fund rose by around 200% (USD) within a few months. The second time this happened was in late 2018, when consensus had to adjust from further interest rate hikes to interest rate cuts. Following this well telegraphed scenario in late 2018 by ourselves, gold took out the USD 1’370 key resistance and rose to an all-time high, while the Nestor Gold Fund gained around 100% in the following 15 months. Similar to today,  consensus views on gold were very negative in these two circumstances, gold ETF holdings were in decline and disinterest and pessimism were widespread.

Therefore, looking into 2022, we are convinced that the market will have to give up its normalization dream. This has the potential to create a massive increase in demand from general investors, i.e. becoming buyers again, after having reduced their precious metals allocations sharply during 2021. While we can’t forecast if the gold and gold miners returns will be as high as in the past, following such dramatic repositioning by investors, we are convinced that in such a scenario, gold will surpass its all-time high. This should bode extremely well for the Nestor Gold Fund given the massive undervaluation of gold miners, which currently discount a gold price of about USD 1’400!   

Gold miners: unloved, unpopular, under-owned; but with very precious features
While gold currently gets very little attention, investors’ interest in gold miners is even lower, often non-existent!

We maintain that this is wrong, and that gold miners deserve much more interest. Balance sheets are in stellar shape and much better than the general stock market. FCF are abundant, while management teams continue to be disciplined with a focus on shareholder returns (dividend, share buy-backs, etc.). Valuations are close to an all-time low on most metrics and even more intriguing when compared to other asset classes (growth stocks, equity markets). 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.

Looking forward a few months, we would not be surprised to see that gold miners have the best balance sheets (this is already the case now), the highest free cash flow yields (above average now), among the highest dividend yields (above average now) and the best earnings revisions (so far lagging due to pessimistic gold price forecasts for 2022). If our scenario plays out, quants, algo and retailers (now making up 30%+ of North American trading volume) will all be busy buying gold miners in a few months, likely at much higher levels, a truly promising outlook into 2022.

Conclusion
There are some major changes going on, unnoticed by most investors. Physical gold demand has been strong and rising further, especially in India. Investment demand stayed low with further ETF selling in Q4, 2021. Unlike what happened in the past, gold was however able to combat that pressure and rose, as did the gold miners during Q4, 2021. Gold also ignored the continued US Dollar strength, as the US Dollar index rose to intra-year highs in Q4. While expectations towards tapering and faster and more than expected interest rate hikes during 2022 rose, gold’s underlying strength was much different to similar periods in the past (2015/2018). Gold seems to discount that most of these trends won’t be sustainable, looking ahead into what will likely play out in 2022 and the following years.

We are convinced that the market will soon have to give up its normalization dream. This has the potential to create a massive increase in demand from general investors, i.e. becoming buyers again, after having reduced their precious metals allocations sharply during 2021. In the previous two circumstances, when such a drastic change in monetary policy happened, investors in the Nestor Gold Fund were rewarded with stellar returns. While we can’t guarantee such an outcome, the prospects are truly precious given the deep undervaluation gold miners are trading today, combined with the widespread disinterest observed in the theme right now.

We have seen a small increase in M&A activity in Q4, 2021. As management teams 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.

While we are disappointed about the 2021 performance of gold and gold miners, we also remember well how the Nestor Gold Fund performed when the market was waking up to reality (2016 & 2019/2020). As such, we believe that 2020 proved a healthy, albeit unwelcome pause in the gold bull market and we are looking forward to a more promising 2022.

Walter Wehrli and Erich Meier, Konwave AG