Gold increased thanks to recovering end markets and political tensions. Gold miners underperformed physical gold without a special reason. Gold miners published Q4 reports which were generally in line with expectations. Production guidance for 2018 was also as expected. Positive is the fact that cost guidance for 2018 is generally in line with last year. Given the low valuation, operating and financial leverage, stable costs and 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.
Why is the macroeconomic situation getting more serious?
The unsustainable combination of rising interest rates and rising debt is leading to a very critical economic situation, which will likely allow gold to finally break the very important USD 1,360/1,370 key resistance level. Once this happens, gold miners will likely start rising sharply and reverse the underperformance relative to gold over the last 1¾ years. To define what will be the trigger to allow the next big upward move in gold and gold miners is difficult to forecast, but our indicators point to a resolution within 2018! We suggest that it will be one of the following triggers
- Escalation of trade war (US/China). This will increase inflation (US), but is unlikely to increase interest rates, i.e. net lower real rates
- China is America's biggest foreign creditor. An escalation of the trade war increases the risk that China sells US treasuries, which weakens the USD and could result in market turmoil.
- Increase of inflation (short to mid-term) given higher import prices (weak dollar), rising commodity prices and very tight labour market.
- Increase of structural inflation as a result of behaviour change in the three countries being mainly responsible for the low inflation of the last 20 years (China, Japan, Korea)
- Change of the FED inflation model to allow a short-term overshooting of inflation without policy action
- Due to quantitative tightening, the FED loses control of financial markets (equity markets & bond markets)
- Fixing of long-term yields (similar to the US from 1942 to 1951 and Japan today) to allow deleveraging thanks to financial repression
- End of quantitative tightening and renewed quantitative easing, negative interest rates (if necessary) and potential helicopter money (guaranteed income for people)
- ECB after Draghi. Who buys the government bonds of close to bankrupt countries like Greece, Italy, Spain, etc.?
- The structural weakness of the US dollar accelerates due to the twin deficit.
- Switch out of overpriced asset classes (bonds, equities, real estate)
Why the expected break of the USD 1,360/1,370 resistance level is key
For gold miners the break of this level is very important. The sector can easily survive at the current gold price level (trading range USD 1,240 to 1,360), but in the end, this environment doesn’t allow the industry to massively increase cash flow, profits and dividends. The real operating leverage will only be felt when gold breaks that key level. Once that level is taken out, gold will likely go back to the high in 2011 (at least) and gold miners will exhibit a massive operating leverage to such an increase, i.e. will likely exhibit multiple times the return of gold.
Other reasons making us confident that we are at the edge of a resolution to the upside
Besides the macroeconomic situation, we would also like to draw your attention to the technical situation. As can be seen in the chart below, the weekly Bollinger band of gold miners is very tight; in fact, much tighter than early 2016, when the NESTOR Gold Fund bottomed and experienced a rally of around 200% in less than seven months. The key question is: will the resolution of this tight Bollinger band be to the down or upside? Given the recent investor behaviour, i.e. massive outflows out of gold mining ETFs over the last 12 months and general disinterest in the sector - which compares very well with late 2015/early 2016 - a resolution to the upside seems far more likely. Obviously the long list of potential triggers (see above) and the record low valuation are also pointing to a bottom, rather than to an intermediate peak in the cycle. While timing remains difficult, the recent investor behaviour suggests a high probability of resolution in the short term. Given the long, demoralizing consolidation since August 2016, any upside break will likely lead to very significant gains.
Chart: NESTOR Gold graphic 1
Conclusion
The patience of the investors has been tested for the last 1 ¾ years, as the trading range of gold and the underperformance of gold miners relative to physical gold have understandably demoralized investors. However, as often happens when this demoralization reaches a maximum (like recently), the frustration ends and the market catches up with reality. Our models suggest that we are at that point now, and gold is finally able to break out of the trading range, and gold miners will reverse the underperformance since the intermediate peak in August 2016 and start the next intermediate bull market leg.
We were able to take advantage of this 1¾ year consolidation period and to position the NESTOR Gold Fund for the next bull wave (as we did in 2015). We therefore expect that the fund will beat comparable active and passive products significantly in such a wave, as it has done in previous bull market periods. The significant added value for investors in the NESTOR Gold Fund during bull market periods is shown below.
Chart: NESTOR Gold graphic 2