Gold bugs have been in full voice as renewed volatility in global equities sparks calls that gold bullion is a new bull market. I would not chase precious metals higher at these prices, even though I am bullish on the Australian-dollar gold price in the medium term.
Gold has rallied from about US$1082 an ounce in January to US$1,271. It briefly cracked US$1,310 last week as fears about Britain’s possible exit from the European Union intensified and as concerns about the strength of US economic recovery intensified.
Chart 1: US$ Gold
Source: Kitco
The precious metal’s reputation as a safe haven during financial volatility, and as a beneficiary of a potential deferral of US interest rate rises, came to the fore.
Gold looks even better in Australian-dollar terms. It has rallied from A$1,450 to $A1,701 an ounce.The falling Australian dollar has boosted Australian gold producers in the past three years.
Chart 2: A$ gold price
Source: goldpriceoz.com
Gold equities have responded. The S&P/ASX All Ordinaries Gold index has a year-to-date total return (including dividends) of 77%. Strong gains from Newcrest Mining, worth about half the market capitalisation-weighted index, explain its soaring outperformance. But several larger ASX-listed gold producers and explorers have outperformed this year.
The question is whether this trend can continue and if the gold price, in US and Australian-dollar terms, has run too far, too fast because of excessive investor pessimism.
All too often, gold rallies hard during real or perceived market volatility and is sold off as conditions ease. Commentators swing from gushing about gold as a “store of value” in global currency wars, to the inevitable fact that expectations of rising US interest rates tend to drive gold lower.
Moreover, portfolio investors are encouraged to buy and sell gold bullion or gold equities as conditions change. Far better to have a small, permanent allocation to gold bullion in portfolios (from 1 to 5%) in the interests of diversification.
Investors in the retirement drawdown phase who need income have reason to overlook gold bullion, given it has no yield. And active investors and traders will find more leverage to a higher gold price through shares in Australian and offshore producers. Portfolio investors who want gold exposure, with market and company risks, should use exchanged-traded funds (ETFs) over gold bullion.
Gold has rallied too far, at least for now, because of two reasons. First, the market is justifiably concerned that Britain’s possible EU exit would lift market volatility and increase demand for safe-haven assets, such as gold. A Brexit possibility has already boosted precious metal prices.
As I write this column, Britain is still to vote in the referendum. I favour the Remain case and believe economic rationalism will eventually win over idealism, in a tight vote. If that happens, a sell-off in precious metals and a lift in global equities is the likeliest scenario. Also, the fallout from the ‘Leave’ scenario has been exaggerated: Britain’s possible EU exit has significant market ramifications, but would take years to negotiate and implement.
Bad US economic data is the second reason for gold’s rally. A terrible US jobs number in May – the lowest jobs growth since 2010 – implies the US economic recovery is losing steam. If so, the US Federal Reserve will be forced to delay interest rates rises, which is good news for gold.
But the market is too bearish on the US economy. The terrible employment figures look more like a one-off than indicative of overall labour market trends or a precursor to a US recession.
Higher US interest rates would be accompanied by a higher US dollar. Gold bullion historically has a negative correlation with the US dollar; it rises when the greenback falls and vice versa, although the relationship is not always clear-cut, and is changing as demand for the greenback as a ‘safe haven’ asset grows.. Granted, the US economy has plenty of challenges, but not enough to support continued strong gains in gold in the short term.
A potential sell-off in precious metals in the next few weeks or months would be an opportunity to buy into this trend. Or put another way, standing aside in the current rally and waiting patiently for better prices to buy back in, when market conditions stabilise.
Gold will shine brighter in next few years
I am bullish on precious metals with a medium-term view (one to three years). It’s becoming clearer that central banks worldwide, including the US Federal Reserve, will have to defer interest rate rises given persistent economic weakness and an absence of inflation. And that the Fed will take longer to raise rates, even as inflation there starts to rise, such is the economic fragility.
Gold has been viewed as a hedge against rising inflation, but interest rate expectations are the key. Real interest rates will remain lower for longer, and perhaps go lower still as the global economy loses momentum and inflation falls further. That will be supportive for higher precious metal prices in 2017 and 2018.
Moreover, I expect the Australian dollar against the greenback to be lower in the next few years. Our currency is ripe for larger falls as commodity prices continue to fall and the Reserve Bank is forced into another interest rate cut this year, and possibly more next year.
I do not subscribe to the argument for an Australian dollar at 40 cents, aired in an excellent recent analysis by BT Investment Management. But the direction of our currency is south and a higher Australian-dollar gold price will continue to be a tailwind for our gold stocks.
Then there is rising demand for gold bullion from China and India as more of its citizens join the middle-class and purchases of gold and silver jewellery rise. This trend will take much longer to play out, but there’s a lot to like about gold’s medium-term demand prospects.
Finally, gold will be in stronger demand during periodic releases of bad new economic news, and as bouts of market volatility increase demand for gold and other safe-haven assets. The next few years are critical for global markets as the great experiment of quantitative easing heads towards an ugly resolution. Having some gold exposure in portfolios as insurance makes plenty of sense for most investors.
As mentioned, long-term portfolio investors should gain their gold exposure via ETFs over gold bullion. Gold equities have their place, despite too many of them being chronic wealth destroyers in years past. But they come with company and market risk. Investors buy gold equities for gold exposure only to watch those shares fall in line with broader equity market volatility.
I favour gold ETFs that are unhedged for currency movements, such as the popular ANZ Physical Gold ETFS Gold ETF. Unhedged ASX-listed ETFs with US-dollar denominated assets benefit when the Australian dollar falls, all other things being equal.
Those who want pure gold bullion exposure, and no complications from currency movements, could use the BetaShares Gold Bullion ETF (currency hedged). The unhedged variety appeals if, like me, you believe the Australian dollar has further to fall against the greenback over one to three years.
The ANZ ETFS Physical Gold ETF has rallied from $14.50 in January to $17.20. It would look more interesting around $16, where there appears to be price support in its chart.
Chart 3: ANZ ETFS Physical Gold ETF
Source: ASX
Among gold equities, I favour the well-run Evolution Mining, which continues to break production records. After more than doubling over 12 months, it looks fully valued and is in need of share price consolidation. Any sustained price weakness would be a buying opportunity for long-term investors, given Evolution’s impressive production gains and leverage to a higher Australian-dollar gold price in the next few years.
Dacian Gold is another with good medium-term potential, with strong drilling results from its promising Mt Morgan underground gold prospect and this week promising assay results at its Jupiter open-pit prospect. After strong price gains this year, Dacian, like other well-run gold companies, is probably close to full value but it remains one for long-term investors to watch.
- Tony Featherstone is a former managing editor of BRW and Shares magazines. This feature does not imply investment recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at June 21, 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.