Adam Thompson: Hello, and welcome viewers. Today we’re getting an update on the gold market and gold money equities, and I’m very pleased to catch up with Fahad Tariq, who is Vice President of Equity Research in precious metals at Credit Suisse Securities. Fahad thanks for chatting with me again. Good to catch up with you.
Fahad Tariq: Thanks Adam, for having me again, happy to be here.
Adam: Great. So thinking back to last time we spoke, we were emphasizing how gold price movements were largely down to what rates were doing and the low to negative interest rate environment that we’ve seen this year has been broadly constructive for gold. And this structural bull market, while it’s had some ups and downs this year, it seems to be a very strong investment thesis. Perhaps let’s just start about where we’re at right now as we enter the middle point of summer.
Fahad: Just zooming out for a second and seeing what has happened this year to date, what we’ve really seen is gold fly for the first half of this year. And there’s a couple of reasons for that because you have conflicting forces really at play from a macro perspective. On the one hand, positive for gold, you have higher inflation. Real-world inflation data that you’ve seen over the past weeks and months indicate that inflation is very high, so that’s been positive for gold as traditionally an inflation hedge.
The other part of the equation, which is a bit trickier, is trying to figure out nominal rates. Obviously nominal rates haven’t changed for some time. They’re near zero in the U.S. But what investors are focusing on is when the Fed will start raising rates and the jury’s out on that, because there are a group of investors that think that won’t happen until 2023. And there are, I would say, growing numbers of investors that think that could happen before 2023. Why? Because the economic growth is actually quite good in the U.S. Now, you take those two kinds of factors together, the inflation and the nominal rates, put that together and you get real rates. If you look at what’s happening with real rates, we’re actually at record lows right now. So as we’re speaking today, the tips yield in the US is -1.1%.
That is actually the lowest it’s ever been. It’s lower than it was at the beginning of this year when gold was over $1,900 an ounce. It’s lower than it was last summer when gold was over $2,000 an ounce. So what we’ve seen more recently is a bit of a decoupling between gold prices and real rates. We would have expected gold prices to be higher today than they are, given what’s happening with real rates. And I think part of it, again, goes back to this idea that the market is very focused on what the Fed is saying and whether or not interest rates can start rising before 2023.
There’s almost like a laser focus on that. And what I think will happen is as investors take a step back and really look at what’s happening, even if the Fed were to decide to raise rates, let’s say end of 2022, which is an optimistic scenario, even if that were to happen, we’re talking about another 18 months of near zero nominal rates, very high inflation, record low real rates, all of that should be supportive for gold prices.
Adam: So looking at investor sentiment, specifically for gold markets, both physical and the equities, I’ve been reading around Asian-based gold ETFs, posting net inflows they share and that’s very much mainland China, as well as India. What’s your assessment of that and in contrast to how the U.S. and EU have had some outflows within precious metals or within gold specifically?
Fahad: So, you have periods where you have these geographic differences between which regions have outflows and inflows. I’m not reading too much into that, other than to think about the fact that traditionally during the year, you have very strong consumer demand from India and China, and in particular during the wintertime when there’s festivals and weddings and things like that. We haven’t really seen that this year, particularly in India. And there’s an obvious reason for that. They’ve obviously been dealing with COVID and quite extreme cases including, obviously, the Delta variant. And so that’s really limited consumer buying of jewelry and that gold demand this year.
The biggest outflows we saw across the world happened in Q1 of this year. Why? Because that’s when you really started seeing nominal rates and treasury yields really start increasing, which was negative for gold. People started thinking the Fed was going to taper a lot sooner. And so when that happens, people have a negative view on gold, and you start seeing quite significant outflows across the geographies.
Adam: Okay. Moving on to gold mining equities then, and situation, there was a sell off at the beginning of summer, back in June, a large drop in valuations there. Are equities still trading in the significant discounts that you mentioned last time we spoke?
Fahad: Certainly, you are seeing that persistent discount there. I talk to a lot of investors and I think that the vast majority of what moves these gold equities is people’s views on gold. And that’s just the reality of it. 80% of what moves the stocks is what gold prices do. The remaining 20% might be something specific to the company, either good or bad. So what I would say is, more recently we’ve seen that persistent discount. So just to put some numbers around it, the average price of gold that’s being priced into these stocks today is about US$1,540 an ounce. So there’s a clear discount.
And then when you go into specific groups of these companies, that discount can be quite wide as well. Some of the lower-cap gold companies are trading at a really steep discount to their historical average. Again, a lot of that is driven by market sentiment on gold. What I would say is there’s actually no consensus view out there for gold right now. It’s very dissimilar to last year where the view was, okay, gold is going to go up, we just don’t know how high it’s going to go. This year, half the investors I talked to think gold prices are going to go up, the other half think it’s going to be flat to down.
So when you don’t have that strong view on gold, that persistent discount stays. And in fact, what ends up happening is gold companies that are larger, more diversified with bigger market cap is they tend to trade at better valuations. And then the smaller, or mid cap gold companies, they tend to trade at a steeper discount. Why? Because investors, if they’re not sure about the gold price, they’re going to pick the safest, most liquid, most diverse companies in terms of production and geography. And so I’m seeing a pretty steep discount across the board, but I’m also seeing a pretty big divide between the bigger gold companies and the more mid cap, smaller gold companies.
Adam: Yeah, definitely. It does sound like the buying opportunity at the moment, in this little period, but that leads me to think about M&A. With slightly suppressed valuations, does that open the door to great deals to be done?
Fahad: Last year I would’ve said, because of the high gold price, you’re not going to see much M&A because anyone willing to sell is obviously asking for a lot higher price. Now gold prices have come down a little bit, I think you’re going to see more consolidation. I think, again, the theme hasn’t changed. It’s going to be more in the mid-cap space. Companies looking to get larger, have stronger liquidity and things like that. I don’t really see any of the majors engaging in any substantial M&A. What we’ve seen more recently is mine acquisitions or smaller company acquisitions and geographies that they like versus going out and buying another giant company. So I don’t think you’re going to see any mega mergers among the seniors and the majors.
The other thing I’ll say is, last year a lot of these companies got a pass on reserve growth. Many companies weren’t able to drill because of COVID and pandemic restrictions, and exploration wasn’t quite to the level they wanted. So many of them had either flat reserves or even declining reserves in their year-end statements.
And there was a pass from investors on that. Nobody was really held to account for that. This year, I think there’s going to be a really big focus on reserve growth because you can’t point to the same restrictions that you had last year. So the expectation is higher. And so I think as investors focus more on reserve growth, guess what? That’s also going to spark the discussion on M&A, because you can either explore and if that’s not working, you’re going to have to go out and buy something for inorganic growth. So I do think that the lower gold price, the more discussion around reserve growth will drive more M&A.
Adam: The last point I wanted to make was around inflation and the long-term view for gold. I’m sure you’re bullish on the long-term deal, but just recap the sort of thesis that you keep reminding investors about.
Fahad: We always remind investors that for gold, you can look at a lot of different factors and there’s a lot of noise. And to us, when we try to find that signal in the noise it’s the real rates – so nominal inflation, nominal interest rates, and minus inflation. And so on your point on inflation, you can see in real-world examples around you how much more expensive things have got.
Do I think some parts of inflation are transitory? Of course. There’s some supply chain issues that we’re seeing today as a result of the pandemic. And as a result of restrictions, those will go away over time as things reopen. However, if you have wage-based inflation, which is that minimum wages are increasing in many parts of the world, in particular in the U.S. As wages increase, theoretically the price of goods and services also increases – and that’s permanent. So I think inflation is here to stay for some time. I think the extremely high inflation we’re seeing today, obviously that’s not sustainable for a long period of time. So all that is bullish for gold
The one thing that investors don’t really talk as much about is the fact that absolute levels of debt in the U.S., and everywhere else, are extremely high. There are record levels. So it actually limits how high interest rates can go. It’s not that we can go back to historical interest rates anytime soon. Why? Because we’re talking about those interest rates being applied to an extremely high base of debt that hasn’t existed before.
And if they stay persistently negative or stay below zero, then that is positive for gold. So I think that’s the takeaway here, is no matter how you slice the macro-economic data, I think longer term, or at least in the medium term, you have a situation where gold prices are going to be high for some time.
I’m not saying they’re going to be at $2,000 an ounce forever or close to that, but you can make a very solid argument that they’re going to be at pretty high levels relative to historical levels for quite some time. And that’s very positive for these gold miners. People get caught up in what the gold price is doing without realizing that whether gold prices are at US$1,600 or US$1,900 an ounce, at any price in between, then gold miners will generate significant free cash flow.