1. What role do physical gold, gold-backed exchange-traded funds (ETFs) and gold mining stocks play in the First Eagle Gold Fund and in your broad investment strategy?
Our gold exposure in the Gold Fund consists of investments in gold bullion, gold royalty companies and gold mining companies. We sometimes own small positions in silver bullion and silver stocks, too. In terms of gold bullion, we directly own the physical asset in an allocated account. One of the advantages of doing so is that gold bullion does not have any counterparty risk. We prefer ownership of the underlying asset to financial price participation in the kind of gold-proxy financial vehicle that some ETFs may represent.
We recognise that gold bullion has different liquidity and risk characteristics from gold stocks, but at the right price, we are interested in owning both. We build our overall gold exposure from the bottom up, and we actively manage the relationship between gold bullion and gold mining companies. If we can find undervalued gold mining companies at any given spot gold price, we will own gold mining companies; if we cannot find cheap enough equities, we tend to keep our clients’ capital in gold bullion until we have an opportunity to buy undervalued mining companies.
In effect, gold equities have to compete with gold bullion to be included in the Gold Fund and our diversified funds. While valuation is critical in allocating capital to specific companies, it isn’t the only component of our process. Beyond valuation, we look at three other key attributes in the precious metals mining companies that we invest in:
- Resilience. We try to look at all the factors that can go wrong in a company – financial, political, technical, operational and capital-allocation risks. We also look in detail at the company’s balance sheet and cost structure to determine how low the gold price must go before it may create problems for the company.
- Optionality. We look at the potential rewards of investing in precious metals companies and try to own those that, in our opinion, offer growth, either in production per share or gold reserves per share. We also look for management teams that operate effectively, make conservative capital-allocation decisions and have a good record of exploration success.
- Duration. We seek long-duration holdings – companies that have long mine-lives, solid balance sheets, management team depth and good environmental, social and governance (ESG) and sustainability practices.
We believe that these types of companies, if bought at the right price, have the potential to create value for shareholders over the long term and ultimately grow their free-cash-flow per share, despite possible short-term volatility in the gold price.
2. Which factors/drivers do you use to understand gold’s performance?
We believe that the most important driver of the gold price is the direction of real interest rates. Real rates represent the opportunity cost of owning gold; when they move higher, the gold price (despite some lead/lag effects) will usually move lower – and vice versa. While there can be short-term deviations in this inverse correlation, we believe it is the most important statistical relationship determining the gold price in the medium to long term. Gold’s relationship to the US dollar and the general level of equities (for example, the S&P 500 Index) is far more mixed, but we do look at those relationships closely as well.
We have seen several main factors drive the gold price since September 2015, including:
- Communication from the Federal Reserve regarding interest rate policy. Hawkish comments from the central bank have driven the gold price lower, while dovish comments have driven it higher. The Fed’s 2019 U-turn on cutting rates pushed the gold price to a six-year high.
- Political events and geopolitical developments. We have seen significant volatility in the gold price since 2016 resulting from political events such as the Brexit vote and the US elections. Geopolitical discord has also created significant volatility in the gold price. Tensions arising from North Korea raised the gold price in the summer of 2017, for example, and the price fell as those tensions eased. Geopolitical developments in the Persian Gulf have affected the gold price as well.
- Trade negotiations. These discussions, primarily between the US and China, have had a significant impact on expectations for economic growth and the gold price.
3. How do you incorporate insights from consumer demand or central bank demand into your decision process, as these tend to have less frequent data updates?
Both consumer and central bank demand trends can be useful from a broad perspective, although we are cautious not to read too much into these numbers.
The gold market is a US$9.1 trillion market,2 with significant aggregate global daily trading volume. There are many players involved, including central banks. While we find it very encouraging that central banks – particularly those in emerging markets – have become net buyers of gold since 2009, it is worrisome that many developed market central banks have remained inactive. That said, only limited conclusions can be derived from central bank gold data in the short term, given that it is rarely current. China, for example, has at times reported no changes in its gold holdings for five-plus years before suddenly indicating a dramatic increase.
One important recent development is the decision by the European Central Bank and the region’s other central banks to let the Central Bank Gold Agreement expire in September 2019. This agreement was signed in 1999 to stabilise the gold market by coordinating central bank gold sales. Such sales prompted a steep correction in the gold price in 1999. However remote the possibility that European central banks will become net sellers once again, such a scenario must be considered from a risk management perspective, especially if there is an economic downturn or a banking crisis in Europe.
We also follow consumer trends closely and find it interesting to see a dichotomy in this market similar to the one we see in central banks, namely that consumers in Asia exhibit much more appetite for gold than those in the West. It is also interesting to see how contrarian these markets can be; consumers in China and India, in particular, have been buying gold on price declines. This doesn’t happen always, but it does seem that gold is moving from weaker hands to stronger ones that have higher conviction in the value of owning gold – a trend supportive of the price.
4. What developments are you watching most closely over the next six to 12 months in terms of their impact on gold’s performance?
We don’t forecast the gold price; we approach the gold market as we do every other asset class, with the humility to recognise that it is part of a complex non-linear system that is hard to predict. But within our risk management process, we do try to understand the dynamics of the gold market. We believe that the key development to monitor currently is the possibility of a US or worldwide recession, as this would likely have a significant impact on the gold price.
Although recessions historically have been favourable for the gold price in the medium to long term, they have often led to short-term price corrections. We saw this in both 2000 with the bursting of the dot-com bubble and in 2008 with the bursting of the real estate bubble. In 2008, for example, the gold price rallied at the start of the recession and reached US$1,002.95/oz in March 2008, only to decline to US$712.30/oz in November of that year, following the bankruptcy of Lehman Brothers. After all the countercyclical monetary and fiscal policies used to battle the Global Financial Crisis, gold rallied to US$1,900.22/oz in September 2011.3 Maintaining resilient gold exposure during inflection points is critical to reaping the benefits of the price appreciation that might follow.
While we saw a lot of volatility in asset prices in 2000 and 2008, the epicentre of the 2000 asset bubble was in stocks, whereas in 2008 it was in real estate. Today, in our view the most egregious example of asset price overvaluation is in the bond market, where there are bonds trading at negative short- and long-term yields. This is highly unusual by any historical standard. And the most extreme example of this is in Europe, followed by Japan. The share prices of many European financials have also been very weak. We are keeping a close eye on financial, monetary and political developments in Europe.
Another area that needs to be monitored very carefully is communication from the Federal Reserve, whether hawkish or dovish. In June, there was a simultaneous increase in the prices of almost all assets – gold, stocks, commodities and bonds – which suggests to us that asset prices were responding primarily to the Fed’s easing rhetoric. In the past few years, we have seen the Fed change its stance on monetary policy in light of changing economic circumstances in the US and around the world.
The most characteristic example was in April 2013, when the central bank signalled that it was nearing a decision to start winding down its bond purchases and end the third round of quantitative easing (announced in September 2012). This news, coupled with the simultaneous rumour that Cyprus was about to sell its approximately 10 tonnes of gold reserves, caused the gold price to drop sharply from US$1,561.45/oz to US$1,347.95/oz in roughly two days. Such events can have a powerful impact on the gold price and can be exacerbated further by speculative positions in the futures market, which have risen substantially since June 2019.4
Although renewed hawkishness at the Fed currently seems unlikely, it must be taken into consideration from a risk management perspective, as such a change could have a significant negative impact on the gold price.
Although the recent move in the gold price has been encouraging, we continue to diligently execute our investment management process, and we participate in this move with caution. We do recognise that gold fundamentals have been improving steadily as global sovereign debt continues to rise and signs of an economic slowdown mount, but the gold price can be quite unpredictable in the short term. While it might be demoralising to see the gold price decline from current levels, such a pullback could present an excellent opportunity to buy more gold at a reasonable price.
5. What developments may change this perspective (on the upside or downside)?
Historically, gold has not done well in periods of strong economic growth. Strong growth is exactly what has driven gold lower since 2011 and during the 1980s and 1990s, while pushing assets such as stocks and real estate significantly higher. However, it is important to distinguish between liquidity-driven increases in asset prices, as we experienced in June 2019, and increases that are due to real economic growth, which can raise the prices of assets with more leverage to an economic upturn at the expense of less economically sensitive asset classes, such as gold. With the US economic expansion appearing to have reached a late phase, we assign less probability to the latter scenario.
Given increasingly high sovereign debt levels, an increasingly complex political and geopolitical backdrop, and the continuing rise in the price of some risk-on assets, it makes sense to be cautious about projecting the relatively good economic conditions of the past few years too far into the future. Despite possible short-term volatility in the gold price, we see this as an important time to maintain a strategic position in gold as a potential hedge.
This is part two of a two part article, read part one "First Eagle Investment Management on gold’s contribution to an investment portfolio".