This quarterly report will address the following themes:
• Review of Q1, 2020
• Why has gold corrected?
• What are the reasons for the sharp correction in gold miners?
• Our base case scenario
• While such a scenario resembles 2008, there are important fundamental differences
• What does it likely mean for future investment returns?
We hope you find our views interesting and wish you good health in this turbulent time. Please also feel free to contact us for a telephone call, where even more details can be addressed.
Review of Q1, 2020
As of March 31st 2020, gold bullion closed at US$ 1,577.18/oz., an increase of 3.9%. The Philadelphia Gold Exchange Gold and Silver Index lost 26.3% (in USD), while the Nestor Gold Fund decreased by 25.5% (in USD). The slight outperformance is remarkable given the fact that small cap tilt did underperform in Q1, 2020. In addition, the resilience of the two largest gold miners (Barrick Gold, Newmont) which are not respectively heavily underweighted in the fund, did have a significant negative effect. These negative factor were overcompensated by a good stock selection. The fact that COVID-19 has the smallest negative effects on the explorer and developer (about 20% of the fund’s assets), the sharp underperformance of this segment is striking and hard to understand.
Gold increased thanks to a significant increase in investment demand. As in previous crises (2000-2003, 2008), gold started to react to the unexpected FED cuts as well as the monetary easing. Gold miners published Q4 reports, which were generally in line with expectations. Production guidance for 2020 was somewhat below expectations, which should benefit the gold price during 2020. Given the extreme low valuation, 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.
Why has gold corrected?
While gold has already recovered most of the losses experienced between March 9th and March 16th, the correction in this period from close to USD 1,700 to USD 1,450 has surprised most investors. Our take is that the liquidity crisis (margin calls, etc.) and the massive increase in volatility have forced investors to reduce their leverage. Gold was, during the whole crisis, one of very few liquid assets which investors could easily sell. From history, we also know that since the end of Bretton Woods (about 50 years ago) gold has always acted very well as a diversifier in years with negative equity returns. However, as seen in 2000 and 2008, it is not the first time that gold has fallen initially with the stock market, but has then started to diverge positively and react together with gold miners as the first asset class to the monetary loosening.
What are the reasons for the sharp correction in gold miners?
Given that gold miners should be one of very few themes which, thanks to higher gold prices and decreasing energy costs, are benefiting from the COVID-19 crisis, it is very surprising to see the industry selling off significantly since Feb. 27th, even if the miners have partially recovered since. To better understand this very hard to explain behavior, we need to go back to 2019. During 2019 gold mining ETFs and most active gold mining funds suffered from redemptions between 10-15%. However, the gold miners rose more than 40% in 2019 (thanks to higher gold prices). The question arises then: who have been the main buyers of gold miners in 2019? In hindsight, it becomes clearer and clearer that gold equities were mainly bought by investors (Hedge Funds, Quants), who base their investment decisions on quantitative metrics (like improving earnings revisions, higher free cash flow, improving ROE/ROAs, etc.). Given the focus on absolute returns (Hedge Funds tend to work with value-at-risk models) and the fact that quantitative models often work badly in a risk-off situation, these investors tend to liquidate their positions quickly, when risks are rising in the financial markets. This was seen between February 27th and March 9th 2020, the initial part of the correction in the miners, when gold was still rising, but so was volatility (which started to spike above 30% on Feb. 27th and then much higher).
The second part of the correction was then a reaction to the falling gold price, dislocation in connection with levered gold mining products, which had to increase their shorts on the way down. This led to a situation that the most well known gold mining ETFs (which are used as a hedge for the levered produces) were trading at discounts of close to 20%, something passive investors never thought of! In addition, fears of mine closures also arose, as some governments (Argentina, Peru, South Africa, parts of Canada) asked the industry to temporary close mines for 2-3 weeks. As of March 31st, less than 15% of the mines in the portfolio did close temporary. While these temporary closures could in the end last 1 to 2 months, it is important to understand that the gold in the ground will just be produced and sold later (most likely at a higher gold price). Unlike many other industries (mainly the service sector), where revenue will not be recouped, this isn’t the case in the gold mining industry. Given the massive improvements of balance sheets and much higher free cash flows than in the past, this short-term burden shouldn’t be a problem to most companies. From the experience of 2014-2015, where balance sheets and the free cash flow environment were much worse than today, we know that banks will be happy to extend credit lines as needed (as they prefer commissions/interest rates to owning mines). To conclude, we consider the negative effects of temporary mine closures as limited. In addition, the higher gold price could easily compensate for this during the rest of 2020 and gold miners should overall face a much better earning profile in 2020 than most other industries.
Our base case scenario
The number of new infections of COVID-19 will start to ease off (as seen in China and South Korea, also signs that the situation will start improving in certain European countries) in the next few weeks. Most countries will experience a recession, and will recover in the autumn, before returning to very low growth afterwards (close to zero in the industrialized countries, maybe slightly higher in the US and somewhat higher in developing countries). The fiscal deficits are reaching levels last time seen in the Second World War. The skyrocketing debt can’t be paid back. After a short deflationary wave, inflation will come back in the next 6 - 12 months, given there was no overinvestment ahead of the crisis and labor markets were already very tight before, i.e. will get tight relatively quickly again (6 - 12 months). This – and it could happen very quickly, i.e. in the next few months – will lead to a major problem in the bond market. In reaction to that, as the world can’t cope with higher interest rates, central banks will set a very low maximum on the long-term yields (as the US did from 1942 to 1951).
To conclude: central banks/governments can avoid another banking crisis and a depression. However, the unprecedented action of creating helicopter money, the serious departure from a trustworthy monetary policy, will likely lead to even more negative interest rates, a major confidence crisis in central banks and finally a monetary crisis!
While such a scenario resembles 2008, there are important fundamental differences
The scenario above is somewhat similar to 2008, just a few times bigger and with even more extreme monetary instruments. The key differences are:
• the stimulus is five to ten (or more) times bigger
• the introduction of helicopter money (i.e. covering massive fiscal deficits directly with the printing press)
• the likely fixing of long-term debt to allow massive negative interest rates
• the real businesses (SMEs, etc.) are much more negatively impacted
• the “printed money” goes into the economy (more inflationary) and not only to the banks
• a much worse debt situation than ever before
What does it likely mean for future investment returns?
These unprecedented fiscal and monetary actions will likely have very important consequences for the different asset classes! Our from time to time discussed subject of an upcoming monetary reset has in the last weeks not only become much more likely, but also within a potentially shorter time frame than what we have ever been thinking!
The above facts and the experience in the last two crises since the turn of this century would likely lead to the following outcome:
• Gold and gold miners tend to turn as the first asset class upwards, as a reaction to the monetary actions. Given we are likely heading into a monetary crisis, these should be the best asset classes in the next few years
• Equity markets are likely to follow with some delay and will yield some protection against inflation and monetary reset
• The flight of investors into real assets will likely create unthinkable nominal returns
• If the bond market can be controlled (through fixing the long end), fixed income investments will not face massive nominal losses (at least not initially), but will likely yield quite substantial negative real returns
• All nominal assets (cash, money market instruments, bonds, etc.) will likely face negative real returns
This creates a very tricky situation for investors. The challenging environment for low-volatility strategies is likely to get even more challenging. Investors would have a hard choice. Either accept the volatility of real assets, or lose a substantial part of their real wealth.
Conclusion
The Q1, 2020 was a rather big disappointment for gold mining investors. Contrary to what should have happened based on a higher gold price, gold equities sold off due to selling from hedge funds and quants. The temporary closing (expected to last 2 to 8 weeks in most cases) of some mines will lead to somewhat lower free cash flow in companies, who face such short-term measures. However, the higher gold price could easily compensate for this during the rest of 2020 and gold miners should overall face a better earning profile than most other themes.
The most likely scenario for the next few years resembles 2008. However, given that the new monetary instruments applied are much more extreme, a major confidence crisis in central banks and finally a monetary crisis have become much more likely. The asset allocation of investors should take this into account. The likelihood that gold miners and precious metals will be the leaders in the next few years is very high. But also other real assets should, in such a scenario, be overweighted relative to nominal assets.
While the junior/developer segment has lagged in the last few months, we are sticking to our long-term strategy. As a matter of fact, the effects of COVID-19 are the smallest on the non-producing segment and it has a record high valuation discount. We are convinced that our strategy will pay out and therefore expect that the fund will beat comparable active and passive products significantly, as it has done in previous bull markets.
Walter Wehrli and Erich Meier, Konwave AG