Those of you who follow this column are likely aware that we at Raymond James have been bullish on gold for some time now.
With gold now hovering around US$1,500/oz. we thought it timely to review our investment thesis.
From a fundamental perspective, little has changed of late to modify our long-term bullish stance. The factors that have the rally in gold including low nominal and real interest rates, monetary reflation, rising debt levels, under-ownership as a reserve currency, and attractive supply-demand fundamentals are still intact. On top of that most macroeconomic scenarios going forward tend to reinforce this trend.
This is not to say that we’re forecasting an uninterrupted ascent into the stratosphere for gold. Indeed if we look back over the past ten years there have been four major moves, each attended by a 50 per cent rally followed by a period of consolidation. The latest breakout took place at the US$1,000/oz. level in September of 2009, and as we hit US$1,500/oz. a period of consolidation would not be unexpected.
In contrast, the story for the underlying stocks is different. As gold has rallied through each major breakout level the gold stocks themselves have tended to lag.
The most recent rally has been something of an exception as the gold stocks have underperformed gold by a wide margin. This can largely be attributed to the lingering effects of the credit crisis as investors remain somewhat cautious regarding equities and leverage.
The situation should reverse itself as the profitability of gold stocks is improving, valuations are at the mid-point of the long-term historical range, and there is limited capital chasing opportunities in the gold sector. While we continue to be constructive on both gold and gold stocks we would recommend buying the equities (particularly the mid and small caps) over bullion at this stage.
Low Real and Nominal Interest Rates
When real rates turn negative or fall below the long-term real cost of capital the opportunity cost of holding gold falls dramatically. Holding cash or T-Bills in such an environment results in an erosion of real values. To protect against this investors increasingly look to hold hard assets such as gold to protect real values.
At the same time, low nominal rates increase the present value of gold companies’ reserves and thereby increase the value of gold mining companies.
The Fed is likely to keep rates accommodative for the near future so as not to jeopardize a recovery.
Monetary Reflation and Currency Devaluation
In the immediate aftermath of the credit crunch, the greatest risk was the onset of global deflation. To avert a spiral into a Great Depression scenario, central bankers lowered interest rates as low as possible and then, as a classic liquidity trap emerged, engaged in quantitative easing to move real interest rates into negative territory. The purpose of this was to try and jump-start the economy. While this strategy appears to be working there are risks.
The first risk is that inflation expectations can become unhinged and the second is that the strategy amounts to currency debasement.
Given the size of the output gap together with high unemployment it is likely that attempted monetary reflation through low interest rates and rising money supply will persist for some time — until deflationary forces subside.
Gold tends to be positively correlated with rising money supply, rising inflation expectations, and a declining U.S. dollar.
Rising Debt
Levels and
Solvency Risk
Rising debt levels over the course of the past decade have yet to be resolved. While consumers in the U.S. have now begun to save, the public debt has exploded.
Other countries continue to see their real debt levels expand, especially Greece, Spain, Italy, and Portugal.
Weak consumer spending, unfavourable demographics, and slow economic growth will likely result in rising real debt levels over the next several years.
Investment
Demand and
Central Banks
China and India, as well as other central banks, have begun to diversify their reserves in recent years, significantly increasing their gold holdings.
Relative Price
and Valuation
Although gold has broken out to new highs in nominal terms, it remains relatively inexpensive when adjusted for inflation.
Comparing the current rally to the last gold stock rally in the mid-1990s, the S&P/TSX Gold sector stocks have only recently broken out to new highs while the price of gold is almost four times higher.
Given the demand dynamics, profitability of the gold sector is likely to accelerate yet the sector is only discounting a profit picture similar to that in 1996 when the secular demand forces were much less favourable.
Gold stocks offer higher potential returns versus gold bullion.
Risks
Gold, like most commodities, is not something to be held blindly.
We are mindful of the risks of recommending a non-income producing asset that is as dependent on investor sentiment as the paper money that it purports to supplant.
Should real interest rates move sharply into positive territory, the global debt position improves dramatically, or growth rebound sharply, we would likely change our view – and change it abruptly.
This material was prepared by Raymond James Ltd. for use by Jim Grant, Financial Advisor of Raymond James Ltd. It is provided for informational purposes only. Statistics, factual data and other information are from sources Raymond James believes to be reliable but their accuracy cannot be guaranteed. Raymond James Ltd. member–Canadian Investor Protection Fund.
For more information feel free to call Jim at (250) 594-1100, or e-mail jim.grant@raymondjames.ca. and/or visit www.jimgrant.ca.
