Review
As of September 30th 2020, gold bullion closed at US$ 1’885.82/oz., an increase of 5.9%. The FTSE Gold Index gained 7.2% (in USD), while the Nestor Gold Fund increased by 19.2% (USD, B share class). The outperformance is thanks to successful stock picking as well as the small cap tilt, which continued to outperform in Q3, 2020.
Gold increased thanks to continued strong investment demand. The gold miners published Q2 reports, which were generally above expectations. Given the still low valuation, the 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 will gold investment demand continue to be high?
While most investors are forecasting, after the increase during the last months, a correction in the gold price, we wouldn’t be surprised to see another acceleration into year end given the following gold positive trends (which are likely to continue):
• Real rates to decrease further
• Asset allocation shifts towards real assets like gold and others in the early innings
• Confidence in the monetary policy to decrease further
Real rates are driven by interest rates and inflation. Central banks have clearly communicated that interest rates will stay very low for many more years to come and we strongly expect that the FED follows the strategy of the Bank of Japan and will soon officially put a ceiling on the mid- to long-term yield curve (as soon as there are signs of increasing long-term yields). While this rather dramatic policy action by the FED is already expected by a small minority, the surprise will likely be even bigger on the inflation. As a matter of fact, we disagree with consensus that inflation will stay low forever.
The consensus belief is a result of the experience following the global financial crisis (GFC) in 2008/09. But what are the key differences between then and now?
1. The amount of money printing is significantly higher than in 2008/09
2. While the money printed in 2008/09 went to the banks (which deposited it with the central banks), this time the money goes into the economy, a key difference! This is already seen in the significant rise of the monetary aggregates (M1, M2) which is significant higher than in 2009.
3. While consensus expected a rise in inflation after the GFC, consensus is currently expecting no sustained rise in inflation, usually a very good contrarian indicator.
4. Unlike 2008/09, the disinflationary globalisation trend looks exhausted today with more and more signs of “deglobalisation” (which tends to be inflationary). We also expect the trade war between the US and China to resume after the US elections.
5. While excess savings based on the demographic trends were still rising until 2015 (increasing global capital provider ratio, i.e. deflationary), the structural (demographic) trend has changed since and is now pointing to more inflation over the next few decades (decreasing global capital provider ratio).
6. Commodity prices have bottomed after many years and are very likely to rise due to significant underinvestment in the past 10+ years.
7. While the labour market is currently weak, the fact that most global labour markets were much tighter before Covid-19 than in 2008 increases the likelihood that they will be much quicker tight again (vs. expectations). This view is supported by the demographic situation and the fact that economic effects of Covid-19 are mostly similar to natural disasters, i.e. will disappear over the next 2-3 years.
During client visits over the last few weeks, our view that asset allocators are starting to consider changes towards real assets like gold is more and more confirmed. Banks, pension funds and wealth managers have or are starting to reduce (or eliminate) bonds from their strategic asset allocation! This emerging trend will likely last 5-10 years, until the whole asset management industry has adopted a modern asset allocation with higher weights towards real assets like gold.
This structural trend will be a continuous support factor for gold and other real assets! Given that currently, the average weight of gold in portfolios is on average only around 0.7%, there is likely a long way to go. We also met with a few institutions which will implement the changes by year end/early 2021. This will likely support the gold price during the next few months.
While most investors aren’t too nervous about the new and even more aggressive monetary policies implemented by central banks, we strongly believe that this will undermine the confidence of investors into governments, central banks and fiat currencies. History shows that the financing of massive fiscal deficits as experienced now through the printing press have always resulted in currency devaluations, higher inflation and finally distrust in fiat currencies. Given that fact, we consider it truly astonishing that such a scenario is still unthinkable for 90%+ of investors and not even considered by most investors as a low-probability or risk scenario!
To summarize, we are convinced that the positive environment for gold will likely last many more years and the still extremely low, but increasing weight in institutional portfolios will likely be a very supportive factor for precious metal investments.
Why are investors starting to look at gold miners?
While gold is still underinvested, gold miners are being even more ignored by investors. Despite outperforming FANG stocks since early 2019, most investors have until very recently still been reluctant to even consider gold mining investments. Outstanding units in the most prominent gold mining ETFs are still down significantly since early 2019!
However, the investor interest is slowly changing given the still very attractive valuation, as can be seen below. Unlike S&P500 and Nasdaq, gold miners are far away from high valuations. Also relative to gold, miners are starting to turn upwards during the last few years.
Sources: Bloomberg, Konwave AG
But why do we start to see a change of investor interest? First of all, as most readers and gold mining investors know, the last few years have been a very frustrating and demoralizing experience for most gold mining investors. The nerves and the patience were tested to the limits. To use the gold miners rally since 2019 to sell this emotionally heavy-burdened investment is a natural reaction. However, we see now that the selling pressure is abating and a new category of investors is starting to enter the gold mining industry.
The stellar fundamentals (most companies will be debt-free by the end of 2020), the healthy free cash flow generation and the continuous discipline by management teams will allow more and more companies to increase dividends to 3-4%! The gold miners will suddenly be first in line for the very popular high dividend yield and/or dividend increase strategies. Given that the remaining gold investors are less and less likely to sell and the fact that the whole gold mining industry has a market cap of less than half of Apple, the entry of such rather loyal investors will likely have a significant positive impact on the development of gold miners.
Another supportive factor over the next months will be the very positive seasonality, as we are entering the most promising period of the year for gold miners. This can be seen in the following chart.
To summarize, gold miners are still extremely cheap (in absolute terms and relative to other equities) and could well become a prime candidate for the powerful yield-searching investors, especially in a world of extremely low to negative interest rates. In addition, gold miners are entering now the strongest seasonal period of the year.
Conclusion
Gold will likely continue to have tailwind based on further declining real rates, beginning asset allocation shifts towards gold and declining confidence in governments, central banks and fiat money.
Gold miners are still extremely cheap (in absolute terms and relative to other equities) and could well become a prime candidate for the powerful yield-searching investors, especially in a world of extremely low to negative interest rates. Seasonality and implementation of gold allocations into year end will likely support the industry over the next few months.
It looks as if the Nestor Gold Fund has entered into the sweet spot of its investment style. Given the still extreme undervaluation of the portfolio holdings vs. the large caps, we expect the outperformance trend to continue in the current gold price environment. As a matter of fact, we would not be surprised to see our fund outperforming passive products by a factor of
2 to 3, as happened in comparable previous periods!
Given that the gold bull market is finally back in full swing, investors from now on face one major risk, and this is “selling too early”, as we are still in the early innings of the bull market! Or to say it differently: While gold miners have been one of the worst investments from 2011 to 2018, they will likely be one of the best investments in the next few years!
Walter Wehrli und Erich Meier, Konwave AG