Note: in the first article in this series, Adrian Day discusses impending tapering by the Federal Reserve and its potential effect on U.S. markets. The second article discusses the macroeconomic environment in Europe, China, and emerging markets.
Resources: Corrections from previous moves continue
There have been significant corrections in many resources after recent market moves. Lumber is down 72% from its May peak; iron ore is down almost 50% in the past two months. Other than aluminum, up 14%, most metals were down this past quarter, on average nearly 5%. China buys about 50% of most commodities, so a slowing Chinese economy, particularly the property market, will hurt resources.
Energy prices have been the leaders in the past quarter, and year, with U.K. natural gas up 324% year to date, while oil is up over 50% YTD, and coal anywhere from 34% to 238%, depending on the type and location. Restrictions on production of traditional energy sources were always going to have a result; someone (I forget who) commented a few years ago that “we will run out of supply before we run out of demand” and that is happening sooner than expected.
Tight supplies mean continued high prices, though as we have discussed before, there is no shortage of spare capacity in oil from places that are not trying to eliminate carbon fuels (Russia and Saudi Arabia, for example), so oil prices in particular may retreat, particularly if the Chinese and global economies slow. And there are plentiful gas shales in many countries available if fracking is permitted.
Cautious on uranium for now
Nuclear power is clearly essential if economies are to produce sufficient power without emissions, and more people are realizing this after the frenzy to ban nuclear power a decade ago. As with oil, there is no shortage of potential supply, at least in the near term; both Kazakhstan, the largest producing country, and Cameco, the largest private producer, have deliberately withheld supplies to boost the price. This is what has made me cautious on uranium.
The demand has also been artificial: some uranium developers have been raising equity and using the proceeds to buy uranium in the market, while the largest impact on demand in recent months has been the new Sprott Physical Uranium Trust with its “At The Market” equity raise feature. This means that whenever the trust is trading at a premium, Sprott can sell new units in the market and use the proceeds to buy physical uranium.
This they have been doing aggressively, raising the size of the program two weeks ago by $1 billion to $1.3 billion. (For context, the market cap of the Trust ahead of the announcement was less than $1 billion.) Uranium prices jumped 40% in the past month, the result of this buying. In the last week, however, the Trust has been less active in issuing stock and buying uranium, and the uranium price has plunged, by the largest weekly decline since January 2008. been slipping. This demonstrates clearly how much the near-term price of the mineral is dependent on the Trust’s buying. Like all similar attempts to boost prices, whether short squeezes or attempts to corner markets, this makes me nervous. The optimistic view is that the recent price surge will push utilities towards making long-term contracts.
Longer term, the outlook for uranium is very bullish as China continues its nuclear power build, and countries from Japan to Germany realize, a decade after Fukushima, that they need nuclear power as a solution to this summer’s power problems. For now, however, we are standing aside.
Why has not gold responded more?
The big question on gold investors’ minds, for good reason, is why gold is not higher given the unprecedented money printing and rising inflation. The second question is when will it change?
To some extent, gold has simply been in a long consolidation after the extraordinary move early last year, when gold jumped over 30% from its end-March low to early-August high. That kind of move— in four months—is extraordinary for an asset that is intended as a hedge and an insurance. Gold is not supposed to do that. Bitcoin…Tesla…perhaps, but not gold! It has been a long consolidation, as month- by-month more and more people give up, while natural gold buyers feel there is no rush to invest.
Gold is down nearly 8% year to date, and down again in September, which is disheartening. But we should put that in context: gold was up 25% last year, so the pullback is less than one-third of the previous year’s move up. The current gold bull market started at the end of 2015, when gold hit $1,051. Gold cycles, both up and down, tend to be long; indeed the shortest have been the last two, in the 1970s and from 2001 to 2011. And it is not unusual for gold to have mid-cycle corrections, often caused by an extraneous shock. In the 1970s, gold dropped over 40% in a correction lasting 20 months. In 2008’s credit crisis, it fell nearly 30% in eight months. So far, this pullback has taken 15% off gold’s peak price and has lasted just 13 months, well within norms for mid-cycle corrections. I would suggest that gold bottomed in March at $1,685, meaning the correction lasted less than seven months.
What is holding back gold?
There have been fundamental factors holding back gold, and three are most important. One is the dollar, which has moved up over the past several months as the “cleanest shirt in the laundry basket.” However low U.S. interest rates might be, they remain meaningfully higher than those offered by other major world currencies.
The second factor is that the stock market and other assets—including cryptocurrencies—have been doing well. So long as the stock market moves up, investors believe that gold investments can wait.
The third major factor holding back gold is the Federal Reserve’s constant threat to start tapering. The Fed has a history of talking more than doing, and, for reasons beyond me, the institution still has credibility. It is not only gold that has not responded to money printing and inflation, but other assets such as TIPs, commodities; none is acting the way one might expect, all seem to buy the Fed’s narrative.
Fed talk hurts more than the walk
The fact is that many times in the past gold moved down in advance of Federal Reserve tightening, responding to growing talk, but turned when it actually started to tighten. This is “buy the rumor, sell the news,” only in reverse. Gold acts this way because all too often when the Fed does actually start to act, it is too little too late.
The Fed starting raising rates in August 2005, and again in December 2015, after months of discussion. In both cases, gold bottomed the same month rates started being hiked. Similarly in May 2013, when the Fed started talking about tapering, gold slid for the next several months. It was just before Christmas that we saw the first rate hike, and gold bottomed almost to the day.
The recent action has been frustratingly modest and volatile. However, the longer gold meanders in its current trading range, the faster and stronger the eventual move will be. In the meantime, gold investors can accumulate at prices that will appear very good in a few years’ time. They should not wait too long.
Gold stocks at historical lows
The major miners (per the XAU [Philadelphia Gold and Silver Index]) more than doubled in the end-March to early-August period last year, so they too have experienced a long consolidation. The stocks are now extraordinarily inexpensive, with the senior and intermediate gold companies trading in the lowest 25 percentile of their historical valuations, and more or less the lowest price-to-free cash flow ever. Given the price of gold…given the strong cash flows…given the improved balance sheets (the XAU is net cash positive today)…given the improved discipline among top mining companies, today’s low valuations are a gift.
We all know that gold stocks are volatile. It can be discouraging when a new stock you buy falls 10% in the first week you own it. But that volatility works both ways, and once gold starts to move up convincingly, then the gold stocks will respond very strongly. It is worth noting that flows into gold ETFs and other investment vehicles are very procyclical, so we can expect flows to increase as the gold price moves up.
Seniors and juniors inexpensive
Although the major miners will be the first to move when gold turns, as well as the more certain to move, the exploration stocks are now at very low levels; we may yet see lower levels if tax-loss selling continues into year-end. This period will prove, I believe, to be an extraordinary buying opportunity for the juniors and explorers as well.
Silver has been far weaker than gold over the past couple of months. Part of this is due to seasonal weakness as electronic and jewelry manufacturers—which combined account for about half of 2021 demand—take a summer break. The resurgence we frequently see in September, as jewelers buy gold and silver for the upcoming holidays, has not happened. In addition, we have seen investors who bought into the “silver squeeze” story get exhausted and sell as the price has continued to decline.
We believe gold and silver both represent very strong buying opportunities and gold in particular has the best risk-reward profile. We also are buying selective resources, notably copper and agriculture, where the supply side of the equation is as compelling as the demand, but are near-term cautious as China’s economy slows, particularly of specific resources where the near-term supply situation is not as strong.
Overall, we are increasingly concerned about the possibility of a near-term pullback in global equities markets, particularly given the overvaluation, as the Federal Reserve and other major central banks move, hesitatingly, towards some form of tightening. The global economy and debt situation are not secure enough to withstand too much tightening. This is temporary, and we are confident that they, and particularly the Fed, will start easing again within a year or so, favoring combatting economic weakness over fighting inflation. This will be very positive for gold and silver, which we believe are close to strong moves up.
Adrian Day, London-born and a graduate of the London School of Economics, is the founder of Adrian Day Asset Management. His latest book is "Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks."
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