Review
As of June 30th 2021, gold bullion closed at US$ 1’770.11/oz., a increase of 3.7% in the reporting Quarter (March 31st, 2021 to June 30th, 2021). The Philadelphia Stock Exchange Gold and Silver Index gained 5.1% (USD), resp. 4.2% (EUR) during the reporting quarter, while Nestor Gold Fund (-B- share class) increased 3.9% (USD) resp. 3.0% (EUR). The fund’s outperformance is thanks to successful stock selection and the fact that small cap names, especially exploration and development companies, outperformed the larger cap names.
Gold and gold miners performed well into late May, while tapering fears and potentially earlier interest rate increases by the FED led to a correction in June. Gold ETFs holdings – after two quarters of outflows – started to increase again. Gold miners published generally in-line Q1 results. The operating leverage and continued industry discipline bode well for the next quarters and we expect gold miners to outperform physical gold in a stable or rising gold price environment. M&A activity stayed relatively calm in Q2, 2021, but we recognize increased interest by the larger/medium-sized producers to do low-risk bolt-on acquisitions.
Gold outlook H2, 2021
Market participants got nervous recently about tapering and earlier than expected interest rate increases. This seems odd, given the FED’s history of not having been able to forecast interest rates moves six months ahead (we remember well 2019, when the FED changed its strategy within weeks). At the same time, despite the highest core inflation since 1992 (!) and one of the highest inflation numbers during the last 20 years, inflation expectations sharply declined in June. This leads us to write about the two most important surprises likely to happen in H2, 2021.
US Inflation likely to remain much stickier than expected
Market expectations based on the 10-year TIPS (inflation protected bonds) are currently hovering around 2.4%, while headline inflation reached 5% in May (core inflation 3.8%). While the YoY inflation is affected by the base effect, the monthly inflation numbers from January to May 2021 point to an even higher inflation (with no base effect)! Going forward, we forecast inflation to slowly head back toward 3-4%, but far away from the “old normal” of 1.5% (average during the last 13 years). As a result, long-term inflation expectations will likely rise significantly during H2, 2021, when it becomes obvious that inflation is here to stay. We are reiterating that the post Covid-19 period can’t be compared to what happened after the financial crisis, when globalization, falling commodity prices and weak pricing power by employees led to a quick fall back to a low inflation environment. Given the “underachievement” of inflation relative to the FED targets during the past 10+ years, 3-4% inflation might just be “perfect” for the FED. However, the market will not share that view and will ask for higher risk premiums, i.e. rising 10-year rates. This could easily lead to another sell-off in risky assets (equity, credit and real estate markets), the last thing the FED needs, given the importance of the wealth effect for the US economy and the economic slowdown in 2022 due to less fiscal stimulus. We believe that the FED has learned its lesson and doesn’t want to create its next problem, where even more irresponsible monetary instruments might be necessary. Increasing short-term rates will also flatten the yield curve and likely lead to endless QE (as in Japan), something the FED does try to avoid. But what is a suitable solution to avoid such an undesirable outcome?
Do you look for an asset class trading at all-time low valuation?
While many equity indices are valued at historic highs, gold miners are valued close to historic lows. The fundamentals look terrific. Gold miners have high free cash flow yields, no net debt (unlike many of the hyped or financially engineered other sectors/themes) and will likely increase the dividends further going forward. The huge valuation opportunity is shown in the charts below. In sharp contrast to the US equity market, which trades at all-time high valuation on most metrics, gold miners are trading at all-time lows on P/CF, P/E and EV/EBITDA. In addition, gold miners currently discount a gold price that is around 15% below the spot gold price: one of the biggest undervaluations in the last 20 years!
P/CF
P/E
P/EBITDA & EV/EBITDA
Source: Company reports; Scotiabank GBM universe-of-coverage average estimates
Conclusion
There is a high probability that inflation expectations will rise in the autumn when it becomes obvious that inflation pressure will persist much longer than generally assumed. As a result, TIPS will go more negative, a key driver of rising gold prices, and in combination with upcoming discussions of YCC in the US will likely lead to the next major upward move in gold and gold miners.
The Nestor Gold Fund is perfectly positioned for such an outcome. As the pandemic is vanishing and herd immunity is likely reached in H2, 2021, physical due diligence on potential M&A has started to become much easier again. This will allow the larger gold producers to address their rather empty project pipelines, which will likely result in much more M&A, especially the low-risk bolt-on acquisitions. The well-above-average exposure to exploration and development companies is a key differentiating factor of the Konwave Gold Equity fund relative to active and passive peer products.
We are convinced that the sell-off in March ended the consolidation period in gold which started last autumn. Sentiment, COMEX positioning and seasonality are pointing to an end of the consolidation period soon and much higher gold prices in H2, 2021.
We therefore consider the recent correction as a very attractive entry point into the Nestor Gold Fund.
Walter Wehrli and Erich Meier, Konwave AG