Sprott Precious Metals Watch: July 2016
After consolidating first quarter gains during April and May, precious metals resumed their 2016 advance during June. During the month, spot gold rose 8.79% (2016 rst-half gain 24.57%), and spot silver climbed 17.02% ( rst-half gain 35.05%). While June advances in the precious-metal sector occurred during a relatively at period for the U.S. dollar (DXY Index declined only 0.26%), they were accompanied by a 20.38% collapse in 10-year Treasury yields (from 1.8458% to 1.4697%).
In our view, two prominent catalysts for June performance of both precious-metals and Treasury yields were the weak May U.S. employment report (released 6/3/16) and the surprising outcome of the Brexit vote (6/23/16). Versus estimates for a gain of 160,000, May payrolls printed at a stunning 34,000 (since revised even lower to just 11,000). Financial markets reacted decisively, with spot gold rising 2.75% on the day, the DXY Index falling 1.61% and 10-year Treasury yields declining 5%. Market probabilities for Fed rate hikes for the balance of 2016 utterly collapsed. (Interestingly, on 7/8/16, when June payrolls of 287,000 exceeded estimates by 100,000 to the upside, gold traded almost $20 lower but climbed back to close up $5.97 on the day.) Then, as Brexit poll results trickled in during the late evening hours (EDT) of Thursday, June 23, spot gold exploded to an intra-session gain of $108.58 (from its intra-session low of $1,250.50), before settling at Friday’s close up $58.51 on the day.
We offer three observations about May payrolls and Brexit results. First, June events reinforce the adage that fundamental surprises during emerging investment trends tend to be skewed in the direction of the emerging trend. Until consensus accepts the trend, most investors will be left at-footed as events unfold. If the fundamental trends in the gold complex have truly turned, as we believe they have, further surprises along the way have a high probability of reinforcing gold’s established upward bias. (Gold surged on May’s payroll weakness yet shrugged off June’s payroll rebound.)
Second, while most investors view U.S. labor statistics and Brexit as mutually exclusive events, we would suggest they are fairly closely related—as outward manifestations of declining effectiveness (and perhaps even deleterious repercussions) of a near decade of ultra-loose global central bank policies. Suf ce it to say, there appears to be growing recognition that QE and ZIRP have disproportionately bene tted a small minority of nancial-asset owners without bestowing much tangible bene t on the vast majority of citizens in developed nations. In virtually every Western country, there are compelling signs of popular dissatisfaction (and now rejection) of the economic and political status quo, an extremely fertile landscape for precious- metal investments. Finally, aside from direct implications of the events themselves, we would suggest both May payrolls and Brexit highlight for investors a far more troubling development: not a single Wall Street or market participant saw either event coming. Not a single one! Whenever cognitive dissonance becomes this pervasive in broad nancial circles, the potential for investment shock is high and rising.
In our June report, we reviewed ve key fundamentals we expect to lend strong support to precious-metal markets during the second-half of 2016 (negative sovereign rates, eroding central bank credibility, strong Western investment demand, deteriorating U.S. economic performance and relentless global physical demand). We continue to believe these factors bode for significantly higher gold prices by 2016 year-end. In this report, we wish to review how various aspects of precious- metal markets, and Wall Street coverage thereof, can establish a feedback loop which lends signi cant leverage to underlying fundamental developments in the gold complex.
To begin with, as the world’s leading purveyors of paper nancial assets (stocks, bonds and an in nite variety of derivatives thereof), global investment banks simply do not possess the DNA for enthusiastic allegiance to precious metals as an investment class. Indeed, gold is commonly perceived as anathema to most popular investment strategies. Consequently, long-term gold price forecasts from global investment and bullion banks (investors’ primary information source for precious metals) are almost always at or slightly below prevailing prices.
Each year during mid-January, the London Bullion Market Association conducts a comprehensive survey of (mostly European) sell-side precious-metal analysts to collect their gold price forecasts (high, low and average) for the coming year. In this year’s survey, in the context of a rst-half-January gold price of $1,091, the 31 contributing analysts predicted an average gold price during 2016 of $1,103. Interestingly, the average of all 31 low-tick price predictions was $978, and the average of high-tick price forecasts was $1,231. As of midyear, the prevailing gold price is some $240 above the forecast average and some $110 above the average forecast high tick. During late-June and early-July, we noticed the begrudging process of Wall Street forecasts beginning to migrate upward. After clinging to forecasts in the $1,050 to $1,100 range through April and May, bullion banks are now raising their gold forecasts sharply (Brexit providing the perfect exogenous catalyst to do so gracefully).
To lend some context to the feedback loop which Wall Street coverage can impart on gold and gold equities, we refer back to bullion’s precipitous 2013 decline (28%). In January 2013, with spot gold just below $1,700, the LBMA analyst community forecast an average 2013 price of $1,753. However, by January 2014, with gold at $1,225, the LBMA forecasts for 2014 averaged $1,219. Point being, for 30 European investment banks (plus another 30 in the U.S. and Canada) to lower their gold-price forecasts by $500 in the space of twelve months (assuming an average of four incremental reductions along the way) implies some 240 individual news- ow items of falling gold-price expectations during a single calendar year (or almost one every trading day).While sell-side analysts obviously have no more capacity to predict future gold prices than any thoughtful investor, they can in uence short-term sentiment, especially in a market as volatile and emotional as the gold complex.
Further, whenever an investment bank raises or lowers its long-term gold price forecasts, that rm’s equity analysts re exively plug the new “price deck” into their net present value calculations for companies they cover. Because gold mines are inherently long-lived assets, a critical variable in NPV calculations is the long-term gold price assumption. In the case of Detour Gold, for example, with a 21-year mine life, the valuation impact of the gold price in 2016 or 2017 is not insignificant, but it is vastly outweighed by aggregate gold- price assumptions during the following 19 years. Given the powerful leverage of high-quality gold mines (high fixed costs and variable revenues), rising long-term gold price assumptions are the single most potent catalyst for share-price increases.
A nal aspect of market feedback loops for gold miners is the multiple-to-NPV at which these companies trade at any given point in time. At cycle peaks, when prevailing sentiment in the gold complex is robust, a high-quality senior can trade at 2X NPV. At cycle troughs, the multiple-to-NPV can fall all the way to .5X NPV. As of 7/13/16, by way of example, the average price-to-NPV multiple of senior and intermediate gold miners in the Canaccord Genuity research universe stood at roughly its trailing seven-year average (.88X). As consensus sentiment towards gold miners continues to improve in coming quarters, we expect NPV multiples to expand.
In evaluating future prospects for gold and gold miners, it is instructive to consider market feedback loops for valuation. In short, rising long-term gold-price expectations ow through to rising company NPV’s which can improve sector sentiment over time, increasing the multiples-to-NPV prevailing in the marketplace. Given our con dence in gold fundamentals during coming quarters, we would anticipate this “triple whammy” to favor signi cantly higher valuations for gold shares along the way.
Loading PDF
