by Joe Foster – Portfolio Manager and Strategist
Gold’s wild ride in August
Gold finished August trading at US$1,813.62 per ounce, nearly unchanged from its July finish at US$1,814.19 per ounce. It may seem August was an uneventful 31 days for gold as it only fell 57 cents (0.03%) but in reality, it was actually a rollercoaster. Gold experienced its first big price drop early in the month when July’s US jobs report came out and exceeded expectations. The dollar-positive news supported the case for continued strength in the US economic recovery, sooner-than-anticipated tightening by the US Federal Reserve Bank (Fed) and a decline in gold prices to a close of US$1,763.03 on Friday August 6.
At the start of Asian trading on the following Monday, at around 7:00 AM local time the gold market was flooded with massive sell orders. The selling appeared indiscriminate, as it ignored low liquidity on a day when Japan and Singapore were on holiday. Gold dropped US$60 in a matter of minutes, trading as low as US$1,690.61 per ounce, causing a breach in important technical support levels and, likely, triggering stop loss orders that further exacerbated the sell-off.
The “flash crash”, as the press referred to it, certainly called into question the market’s ability to block or prevent what has been interpreted as either a malicious attack on gold prices or a serious trading error. While these moves have the potential to be damaging to the gold market, this latest incident was priced out quickly. By the end of that same week, gold’s price had returned to levels that we believe reflect current fundamentals.
Climbing back to US$1,800
Following the “flash crash”, gold managed to climb back above US$1,800 per ounce, supported by mounting concern around COVID Delta variant’s impact on growth. A Michigan consumer sentiment reading was the lowest in almost a decade and US retail sales printed below forecast. On August 27, during his remarks at the annual Jackson Hole Economic Conference, Fed Chairman Jerome Powell indicated that reducing the Fed’s US$120 billion in monthly asset purchases could be appropriate in 2021, but signaled no rush in making any decisions related to raising interest rates.
Powell stated that the decision to lift rates was subject to a “substantially more stringent test”. The market interpreted this as more expansionary than the anticipated stance. The impact was it pushed the US dollar lower and drove gold higher, through important technical levels, as we approached the end of the month-long rollercoaster ride. Gold traded above the 100-day and 200-day moving averages, right back to where it started, to a close of US$1813.62 per ounce on August 31.
Miners still feeling the effects
Unfortunately, there were some stranded passengers on the August rollercoaster ride, namely gold stocks, which did not recover from the fall of the gold price earlier in the month. Gold equities, as represented by the NYSE Arca Gold Miners Index was down 6.11%. Larger cap miners had been outperforming the metal this year, but gold’s pullback in early August sent them much lower, without the corresponding recovery by month end.
Industry inflation also an issue?
During the second quarter reporting season, gold companies highlighted some of the inflationary pressures affecting the sector. Similar to other sectors of the economy, gold mining has been feeling the impact of supply chain disruptions and tightness, along with higher fuel, energy and material prices and, in some regions, higher labor costs. Higher steel prices, prices is often cited as an important source of cost inflation as it is used for construction, grinding media and underground supports. However, labour represents, on average, approximately 40% of the sector’s operating costs, the largest cost center, and some producers in Australia, Canada and, more recently, Brazil, have reported skilled labour shortages are driving up labor costs.
Estimates on expected cost inflation, when provided, vary from company to company. However, one of the largest gold mining companies in the world estimates costs could rise 3-5%, with some inflationary effects this year driving costs towards the high end of its 2021 guidance. On the project capital side of spending, the picture looks a little worse too. A few companies have indicated potential double-digit percentage increases in the capital estimated for their growth projects.
Combating cost pressures
Though the industry is clearly facing inflationary cost pressures, not all companies are feeling the squeeze and most companies are actively looking for ways to offset these cost increases.
Large companies tend to benefit from their purchasing power in negotiations with suppliers and service providers, helping to offset at least some of the pressures that may be felt more significantly by smaller producers. In addition, larger companies often pre-order materials well in advance or establish fuel contracts (hedging) to reduce the impact of higher fuel prices on their operating costs.
A CEO of one of the larger companies stated during their Q2 earnings conference call that his company will not use inflation as an excuse for higher costs; rather, he stated that it is their job to manage costs. This is very positive coming from one of the sector’s leaders. While we continue to monitor cost trends closely, we are encouraged not only by the fact that operating cost increases seem contained, but also by companies’ pro-active approach to offsetting cost pressures.
Industry approach still unified, disciplined
We believe that, in recent years, gold companies have consistently demonstrated a disciplined capital allocation approach focused on delivering attractive return of capital. The sector has reiterated an ongoing focus on cost reduction based on optimization and increasing efficiencies of their operations as part of their commitment to maintaining healthy margins.
Gold companies’ operating margins have expanded significantly in recent years. Not only has the gold price reached record highs, but companies have also reduced and controlled costs, allowing margins to increase to record levels.
Gold miners are succeeding at controlling costs, improving operating margins
Source: Scotiabank. Data as of August 2021.
Gold companies are able to generate substantial free cash flow at current gold prices. While markets may be concerned about rising costs, we believe gold companies will remain disciplined and continue to defend margins. As far as capital spending increases go, while this is concerning, it mostly just raises the investment hurdle rates for these projects. Production growth is targeted as long as it preserves or improves margins and translates into higher shareholder returns.
The gold mining sector of today is well positioned to weather these cycles, sustain profitability and demonstrate its appeal for those seeking gold exposure but also to earn its place as an investable universe within the broader equity market.
Gold going forward
When the gold price is declining or consolidating, gold equities tend to underperform. Even when gold rallies, gold stocks can sometimes lag during the early stages of the rally while markets digest the new outlook for the metal. Something similar is happening during this recent bounce back in gold prices. The revenues and earnings generated by the companies at the end of August is essentially the same it was a month ago, yet the stocks are trading at lower prices, creating a value opportunity.
Gold has been consolidating its gains since reaching all-time highs of US$2,075 per ounce a year ago. It nearly broke out a couple of times this year but failed and, in early August, dipped below its bull market trend bottom of US$1,760. Since the current trend began in 2019, gold has always bounced higher when testing the bottom of its range.
We have been disappointed by the failure of gold to hold at such a critical support level and subsequently believe that, in the shorter term, it may spend longer than anticipated consolidating around the US$1,800-US$1,900 per ounce range. However, the upside is that gold was quick to rebound from this “flash crash” and so a show of continued resilience should help reestablish the bull market trend and allow us to look back on this event as just an insignificant blip.
In the longer-term, once this consolidation has run its course, we still see plenty of tail-risk drivers that have the potential to drive gold to US$2,000 per ounce and beyond. We believe inflation is a longer-term problem and will persist into 2022. Economic growth is at risk once the massive fiscal spending has run its course and is further threatened by the potential removal of monetary stimulus. Finally, extreme debt levels and asset bubbles may not be sustainable, creating a risk-off environment that favours gold.