However, the aversion to risk exhibited by investors was short lived, and outflows from gold flooded the market as equities began a bull run that would last until early this year. The trillions in pandemic government stimulus and central bank interventions from around the world had worked – a bit too well. There were two quarters of high volume outflows followed by three quarters of lower volume activity. But the cheap money wouldn’t last, and right after the Russian invasion of Ukraine rocked equity markets, the very real and now persistent beast that is inflation revealed itself. A mammoth Q1 CY22 was clearly the first time that investors started to worry about inflation, and gold once again got to that 2020 high level near US$2,075/oz. The GDX, a Vaneck Index that closely tracks the performance of gold miners, stacked on over 25% of gains that quarter, almost getting to its 2020 high as well.

Gold’s role in investor portfolios

There are a number of traits of gold that have provided it with a unique status for investors for thousands of years:

• It is scarce. As at the end of 2021, it is estimated that there have only been around 205,000 tonnes of gold ever mined, the volume of which would approximately fill one Olympics-sized swimming pool. The amount of proven reserves left in the ground is just 53,000 tonnes. Unlike fiat currencies and many cryptocurrencies it cannot be replicated. This gives gold a strict limit in its supply which is the reason why it is widely seen as a hedge against ‘money printing’ by central banks.
• Its predominant use is store of value. Gold does not have a lot of uses other than storing value. 46% of it is in jewellery, 22% is in bars and coins, 17% of it is held by central banks and only the remaining 15% includes industrial uses. This isolates the price from certain price drivers such as industrial activity, largely limiting it to supply and demand for the purpose of investment and shielding it from volatility.
• It is widely accepted for its purpose. Gold has been a store of value for thousands of years across the globe. Its universally accepted status as a store of value and safe haven provides liquidity to its market which is essential for efficient price finding and to give investors confidence in its purpose. If the market widely accepts an asset as a safe haven, then investors are more likely to rush into the asset in times of crisis, driving up the price which helps the asset fulfil this very purpose – almost like a self-fulfilling prophecy.

Its assumed ability to hedge risk is part of gold’s attraction, but to understand why an investor would desire to implement this hedge requires further examination of both commodity cycles and market crashes.

A longer-term perspective – what can we learn from past cycles?

Over the past 50 years, commodity cycles have averaged almost six years in duration. Going from peak to peak each time, commodities have usually overshot to the upside more than the downside. Stark examples of this would be oil averaging around four times larger price increases during booms than decreases during slumps, and copper averaging three times larger jumps. Rapid industrialisation and growth of a nation are usually the driving forces of a supercycle – for most commodities. For gold however, as shown in the chart below, it is usually monetary policy in the form of interest rate cuts that trigger a bull run in the gold price.   Volatility during commodity cycles does present more risk, but it is typically an opportunity that can be capitalised on by traders during both boom and bust, with a level of precision and predictability. This becomes infinitely more difficult during a fully fledged market crash, especially when brought on by deeply entrenched fundamentals that have become flawed. It is in this case that investors are seeking not only portfolio diversification, but a safe haven to protect their wealth.

A permanent portfolio hedge or just a temporary safe haven? Or neither?

An important question for an investor who considers adding a new asset to their portfolio is how this asset will behave relative to the rest of the portfolio and what its effect will be on overall performance. Modern portfolio theory suggests that assets with a low (or even negative) correlation to the rest of a portfolio can improve performance by reducing the volatility of the overall portfolio. If a negative correlation lasts over time, such an asset is called a ‘hedge’. If it only exists in times of crisis, the asset is referred to as a ‘safe haven’.  As we near the end of a turbulent year in markets, many investors may be questioning gold’s ability to serve as either – after all, its price decreased from its March 2022 high along with most risky assets. A University of York study found that the average correlation between gold and US equities was -0.0475, a low correlation that warrants hedge status. In fact, the same study compared gold to stocks and bonds from the US, UK and Germany – finding that the average relationship with gold was between -0.18 and 0.1. The low correlation of gold between markets was also proven during the 1987 crash and the 1997 Asian crisis highlighting gold’s special role as a ‘safe haven’ when things get tough and therefore a valuable part in a portfolio. Ultimately, it was determined that gold is both a hedge and a haven because while a portfolio does benefit from gold exposure during a market crash, it also benefits in a remarkably similar way during average times. Despite it not acting differently during the crash, it still technically fit the criteria of a haven.

Different ways to gain exposure

For anyone who agrees that gold has a place in a diversified portfolio, there are different investment options with exposure to gold that come with their own risks. First of all, holding the commodity directly (through bullion or through a physically-backed ETF, for instance) is the pure hedge and probably the most straight-forward way to gain exposure to gold. For Australian investors this strategy would have actually worked in the past year: gold has put on around 7.3% in AUD terms over the past 12 months as at 9/11/22, landing bang on the Australian inflation rate of 7.3% as of Q3 CY2022. Shares in gold producers can provide more leveraged exposure to gold, but with a number of additional performance drivers. Their value is driven by the producers’ operating margin, i.e. the price at which they sell the gold less the cost of getting the commodity out of the ground, the metric of which is the All-In-Sustaining-Cost (AISC). Producers can be extremely exposed to the gold price, and meticulous analysis of the miners’ operations is required to determine if they are not only well positioned to benefit from rising gold prices, but able to withstand a pullback in the commodity as well. It must always be kept in mind that a percentage move in commodity prices will be reflected with a much larger percentage move in producers – to both the upside and downside. Producers’ margins have been recently compressed through cost increases, particularly due to rising energy costs, with the GDX reporting a 19.7% year-on-year rise in the All-In-Sustaining-Cost (AISC) of their top 25 gold producers, averaging US$1,281/oz for Q2 CY22. The market has reacted accordingly, leading to a slump in share prices. This move might be overdone when looking at producers’ free cash flow yields. This can be viewed in the Crescat Capital chart below: There are other potential value opportunities presenting themselves in the Australian market, with the ASX All Ordinaries Gold Index having dropped 26% over the past 12 months.  Finally, shares in explorers offer yet another risk/return profile and require a different skill set from the investor. Due to the early stage of their undertakings, there are higher risks in finding a resource, the ability to advance exploration and mine development as well as the financing of this journey. For those who are willing and able to take these risks, the upside potential offered can be far higher than for mature producers. A timeline chart by Lowell Resources Funds Management depicts this below: Explorers are currently in an entirely different predicament to producers – much of their hard work and good results are landing on deaf ears. This seems to be the trend with brownfield (where a discovery has been made) developments, and investors must be wondering what the point of investing in these projects is when clear value adds don’t get re-rated by the market.  Having provided an overview of the gold market, it’s time to delve a little deeper with a lineup of industry experts who have observed the commodity’s movements over many cycles.

Key Question 1: What drove the gold price to its 2022 high, and what has kept it subdued since?

“The US dollar is at 20-year highs and real yields have experienced their fastest rise on record” – Roscoe Widdup

Roscoe Widdup, Co-Chief Investment Officer and Managing Director of T8 Capital believes it was fear and uncertainty (the war in Ukraine and rising inflation) that drove gold to its 2022 high. He shares some valuable insights on what has kept it subdued since: “Gold’s two sworn enemies are the US dollar and real yields on US treasuries. Entering 2022, the real yield on a 10 year US treasury was negative 1%. Fast forward to today (11/11/22), the real yield on that same US treasury is positive 1.4%. The commentators are calling that shift the fastest on record.” He asserts that because gold doesn’t have a yield, a change in real yields (the opportunity cost) is a serious factor. Real yields falling is a great tailwind for gold, but real yields rising to that degree is an enormous headwind. Roscoe then commented on the US dollar, stating that: “The US dollar at 20-year highs based on the trade-weighted US dollar index which started the year at 95 points, and today (11/11/22) it is 108, having touched 114. This magnitude of US dollar strength has been a major headwind for gold bullion. Despite all of these headwinds, gold bullion has outperformed all major asset classes (bonds and equities) during 2022.” Lowell Resources Fund Chief Investment Officer John Forwood shares similar views, stating that negative real US interest rates are a powerful driver of gold prices, and this spurred on the precious metal earlier in the year. Terra Capital Portfolio Manager Matthew Langsford attributes a lot of gold’s weakness this year purely to the strength of the US dollar. With the recent move up in gold, it is currently unclear whether this is predominantly due to record high Q3 central bank demand data, or China re opening optimism. Director and Investment Manager of Bayantree Investment Group, Zach Riaz shares similar views to the other contributors. He recently noticed that gold was definitely oversold, and managed to catch the bounce back that is currently humming through the market.

Key Question 2: What will be the drivers of the gold price in 2023 and what is your outlook?

“The World Gold Council estimates gold buying by central banks at 400t in the September 2022 quarter; the highest in over 20 years. Central bank buying in the first three quarters of 2022 is estimated to be higher than any full year total since 1967.” – Matthew Langsford

Roscoe sheds some light on the current inflationary environment, and reflects on how this has impacted gold in the past: “Inflation has the potential to be a major positive catalyst for the gold price. Inflation is at 40 year highs in most major economies. Our thesis is that gold doesn’t do well in the first phase of an inflation cycle because you have rising rate expectations and therefore rising nominal US treasury yields. Inflation expectations (the difference between nominal and real yields) over the medium term assume inflation normalises (back to the target range of 2-3%), so real yields also rise. However, inflation is complicated and history tells us that it has a habit of being sticky and more secular in nature once it gets going. Under this scenario (and especially where central banks have stopped hiking rates because it’s crushing the economy), real yields come back down as markets become fearful that inflation could remain elevated for much longer than expected. Gold is the best safe haven for many investors at times like these .” Highlighting what happened during the 70’s inflation-shocks, Roscoe states: “We should look at the periods 1972-74 and 1979-80. We had oil shocks, inflation shocks and stagflation. A number of the characteristics we’re observing in the current macroeconomic environment are similar. We are believers that history doesn’t repeat but it does rhyme. We are in the worst energy crisis since those periods, inflation is at levels which haven’t been experienced (beyond a blip) since that time and central banks are telegraphing a recession. Back then, the gold bullion price went up by 320% in the first period and 160% in the second and our view is that unless ‘this time is different’, inflation remaining elevated for another 6-12 months has the potential to be an extraordinary positive catalyst for gold once more.” Jewellery is a significant demand driver of gold, and Matthew Langsford highlights the potential for this to increase if China re-opens:

“China reopening is a positive for the gold price through the wealth effect as China is the world’s largest gold consumer market. We estimate that, based on the relationship between domestic jewellery sales and the prior impact of lockdowns, that in the event of a 2Q23 reopening,  Chinese gold demand for next year should be 70 tonnes higher. That said, financial flows still tend to drive the gold price action.”

He also picks central bank gold buying as an important factor: “The World Gold Council estimates gold buying by central banks at 400t in the September 2022 quarter; the highest in over 20 years. Central bank buying in the first three quarters of 2022 is estimated to be higher than any full year total since 1967.” Founder and CEO of Pilar Gold, Jeremy Gray makes an interesting point about the potential vulnerability between the gold contracts being traded on exchanges and stockpiles that are able to be physically settled. He thinks there could be an inflection point in the market if there is a rise in demand for physical delivery, estimating that only around 1%-2% of gold traded on the COMEX is physically settled, as opposed to gold traded in China potentially being around 75%. Another factor he states needs to be considered is the amount of short positions in gold, and what would happen if they are called back – especially if it needs to be delivered physically by a hedge fund that has never even held an ounce of gold before. John Forwood believes it’s quite difficult to determine an outlook on the price of gold, but over the short term it is volatility that is the biggest factor.  He notes a seasonal nature of the gold price on a 12 month basis, typically observing stronger gold prices over December and January. Over the long term, he has a strong view that gold will be substantially higher. He states the possibility of a strong gold price jump on the back of similar economic conditions to the 70’s is very real. Zach Riaz shares his view on the monetary policy side of things:

“We do expect inflation to moderate but we do believe it is much more sticky than people expect, but at the same time – no central bank or prime minister or president wants to lead their economy into a deep recession or depression. So I think the will of central banks would be to slow the pace of tightening, at the first sign of moderating inflation, which we have started to see in the US.”

He highlights how fast the tightening has been in this cycle compared to the last, and recognises that when this occurs – you don’t know what is breaking underneath the plumbing of the financial system. 

Key Question 3: What are the best ways to invest in gold in this environment? (bullion, producers, explorers, royalties)

“Ultimately, if you think the market (gold price) is going to go up, you’ve got to buy every high cost producer there is, and forget about the low cost producers.” – Jeremy Gray

There are a number of ways to gain exposure to gold, and each alternative has its own risks, opportunities and requires different experience. Buying the commodity outright, for example through bullion or an ETF, is considered the most straight-forward and ‘traditional’ method, while shares in explorers, producers and royalty companies are driven by very different dynamics. Junior explorers have far larger risks around discovery and the ability to finance their exploration journey, while producers’ values are more driven by their gross margin between their production cost and the price at which they sell their product, in combination with the life of the mine.  Modern portfolio theory has been widely implemented because it is a practical method for selecting investments in order to maximise overall returns with an acceptable level of risk.  Roscoe Widdup believes that there is greater upside in gold producers (rather than gold bullion) in an upward trending gold bullion price environment.. The former Goldman Sachs mining and metals investment manager has an interesting way of breaking it down: “Gold bullion and gold producers are very different segments within the gold asset class. A producer has natural leverage to the gold bullion price via its operating margin and reserve ounces. So, what does that mean? If the gold bullion price goes up by one unit, the gold producer goes up by two units (based on the typical gold producer beta to gold bullion of 2-2.5).” The old tale of commodities’ power to generate exponential returns certainly rings true. “It doesn’t stop there. Within liquid institutional-grade gold producers, you have senior producers, royalty companies, mid caps and industrial metal byproduct intensive gold producers. All four of these segments play quite different tunes through different market environments and cycles and this provides a portfolio manager with considerable optionality.” Jeremy Gray has some valuable thoughts on identifying undervalued producers in a rising gold price environment. As the former head of equity mining research at Morgan Stanley, Credit Suisse and Standard Chartered Bank – he has seen his fair share of commodity cycles.

“Ultimately, if you think the market (gold price) is going to go up, you’ve got to buy every high cost producer there is, and forget about the low cost producers.”

He makes a strong point that all the low cost producers are probably already really expensive, and there is much more value left in the miners that are barely profitable and have been heavily sold down, but could generate serious cash flow again as the price of gold moves up – being perfectly positioned for a re-rate. Explorers are not to be forgotten about either, with John Forwood sharing his high level thoughts on picking a project. “If you have a positive general market for the commodity, and you pick the right explorer which makes a discovery that gets the market excited – then you’re going to make exponential returns. The secret is to pick the stocks which have got asymmetric risk – the downside is much less than the upside… The key to that is making sure the companies can fund themselves through the tough times – and the key to that is having good management.” Matthew Langsford shares his thoughts: “At Terra Capital we focus on listed equities from late stage exploration (i.e. post discovery and building a resource) through to producers. We focus on them because analysing these companies is our area of expertise and in periods of gold price strength the equities provide leverage to the outperformance. We typically focus on exceptional assets in favourable jurisdictions run by experienced management teams.”

Key Question 4: The GDX reported a 19.7% year-on-year rise in the All-In-Sustaining-Cost (AISC) of their top 25 gold producers, averaging US$1,281/oz for Q2 CY22. How much further do you see these costs blowing out?

“We could see another spike in the oil price, and if that happens then you certainly will see further cost escalation” – John Forwood

Cost pressures have been weighing on all commodity producers, and gold is certainly not exempt. John Forwood shares some valuable insight on the matter: “I don’t think cost escalation has come to an end, although anecdotally here in Australia you are hearing that things like steel and staff, the pressures on those things are starting to ease. The biggest single input is energy (through oil). We could see another spike in the oil price, and if that happens then you certainly will see further cost escalation” Another important factor to consider is how the operations of gold miners vary depending on the gold price. John highlights this:

“As the gold price rises, lower grade ore, on average, gets treated. That’s higher cost ore, it’s a higher cost per ounce. As the gold price falls, the reverse happens. The gold price has come off 20%-25% in US dollar terms over the last 18 months – 2 years. That is an offsetting factor. If you see the gold price rise again, and you see the oil price rise again – then you will see continued cost escalation”

Matthew Langsford also shares his thoughts, including reserve concerns and: “On the labour side we think we will continue to see cost pressure, particularly in WA, otherwise diesel is off ~10% (but up 30% YoY). So it will likely remain a challenging period for gold producers into next year. For the gold producers, share price performance has been generally poor over the last year. Cost increases and Covid related disruptions resulting in limited cash generation is the main reason for this. It appears that costs are plateauing, meanwhile Reserves are still depleting so replacement of ounces is likely a key consideration in boardroom discussions. Inorganic growth is the lowest risk option for miners to add resource ounces which may eventually convert to reserves so we expect that M&A may be a growing factor for gold equities.” 

Key Question 5: What do you think this will do to the price of gold, and how much of gold’s value do you believe is underwritten by the cost to mine it?

While the price of gold is largely driven by macroeconomic factors, when costs are rising to all time highs, it begs the question of at what point enough supply is reduced because it is not viable to mine that it starts to affect the gold price. Matthew Langsford believes it has very little impact, stating that “The gold price is typically determined by macro factors including interest and exchange rates which impact the relative cost of holding gold as an investment. Despite the strong physical gold buying from central banks, financial flows still tend to drive the gold price action” Zach Riaz shares similar thoughts, and doesn’t believe the price of headline precious gold has got much to do with the cost of individual miners. He states that if there were a continued decline in the gold price, then you would want to be in the lowest cost producers just to be safe.

Key Question 6: What type of movements are you expecting to see in explorers if the gold price moves up, given the potential for lower small cap liquidity in this market?

“If the gold price moves above $USD1,900/oz for any sustained period of time, I think it’s a psychological level that will get investors focused on the sector again” – Matthew Langsford

Lowell Resources Fund specialises in identifying high quality projects during the exploration phase, leaning on their technical expertise to analyse the geology of a tenement and the likelihood of success. Their CIO John Forwood has experienced a lot of market movements in small caps, he shares his thoughts on the matter: “Yes, it’s a good point. So on the downside, you see those lower liquidy small cap stocks, if things fall out of bed they really gap down on low volumes. Similarly, on the upside you can see them shoot up very very quickly”

“What I always say is that the sentiment in resources, gold stocks in particular and especially junior gold stocks – it’s not so much the absolute level of the gold price – it’s the direction. It only takes a week or two of positive moves in the gold price to really put some confidence and excitement back into the junior sector. Things are pretty beaten up at the moment, lots of junior stocks have halved. Certainly we could see them double quite quickly, if the gold price makes new highs in US dollars then we’re going to see multiples of current average equity prices.”

Matthew Langsford believes that the gold price moving above US$1900/oz for any sustained period of time is a psychological level that will get investors focused on the sector again. Jeremy Gray acknowledges that small cap explorers have been doing it tough, but is adamant that they will have a massive move if the gold price has a decent move up. He is wary of many companies looking to raise as soon as this happens, especially seeing as there haven’t been many major gold discoveries for 20 years and initial capex costs to build a mine are so expensive it is rendering smaller projects unviable.

Key Question 7: When do you see the US dollar weakening?

“The US dollar is very overbought, it’s a crowded trade. I’m not sure how many times investors have to see this story. When something becomes so crowded, you only need a slight change in the underlying mechanics of the broader economy – a stabilisation of inflation or a slight pivot of tone from the Fed – and you will see that crowded trade get unwound.” – Zach Riaz

One of the key drivers of the gold price is the value of the US dollar. With the strength of the American currency, it is worth comparing gold’s performance between currencies. As shown in the Crescat Capital chart below, gold has actually recently hit an all time high in the British Pound: Jeremy Gray doesn’t see the US dollar weakening for quite a while, stating that the Aussie dollar could go down to 50c-55c. Being a non-US based gold miner, a strong US dollar is very beneficial for his operations. He states that: “The ultimate scenario for us is a strong US dollar price, and a strong US dollar gold price. That would be just absolutely Nirvana, right, and I think that’s where we’re headed because the physical market is so incredibly tight, that even if the dollar rallies – you might find that the gold price actually goes up. Then you have massive margin expansion.” John Forwood stated that:  “In pretty much any currency bar the US dollar, gold has been doing pretty well. If you look at it in Aussie dollar terms, gold has been up in line with Aussie inflation over the last 12 months. So it has acted as a good inflation hedge as it is always quoted to be.” He believes that the US dollar will weaken according to when the market thinks the top of the US rate cycle will occur. He elaborates: “The US dollar hit 20 year highs in recent months, but just in the past week or so it has come off quite a bit. So that may represent the top of the US dollar in this cycle.” Matthew Langsford believes the main factors that have been supporting the US dollar are about to reverse:

“Fed hawkishness is at a peak and rising recession risks will lead to more aggressive rate cuts next year. Facing a bigger inflation problem, the ECB should lag the Fed in making a dovish pivot. A narrowing in the policy rate gap will allow the euro to recover. An upturn in the euro will pull the other G10 currencies higher. Finally, a loosening in China’s zero-Covid policy, political gridlock following the U.S. midterm elections, and an early end to the war in Ukraine would also weigh on the dollar.”

Zach Riaz jumps straight into monetary policy, saying: “The US is still expected to go pretty heavy on its tightening cycle. I think once we see inflation moderate, which it has, the Fed will come out and say that they will moderate the pace of their rate hikes.” He thinks that there is so much bearishness built in that it is bound to give the currency some reprieve, and he also makes another good point: “The US dollar is very overbought, it’s a crowded trade. I’m not sure how many times investors have to see this story. When something becomes so crowded, you only need a slight change in the underlying mechanics of the broader economy – a stabilisation of inflation or a slight pivot of tone from the Fed – and you will see that crowded trade get unwound.”