Often described as a chameleon asset, (one whose performance can be influenced by ever changing causal factors), bullion has quietly been grinding higher without seemingly attracting much by way of headlines. In fact, having passed 2500 USD for the first time in history, in a resurgent fashion, we’re a little bemused it hasn’t garnered more attention. Our contention is that this bull market still has a very long way to go.
FUNDAMENTALLY SPEAKING
To open the batting, a quick review of how gold’s fundamentals can be understood – like any other asset, it has periods of ‘under’ or ‘over’ valuation.
– An approach shared by Ray Dalio, of Bridgewater Associates fame, the price of gold over the long run will equate to the ‘total amount of money in circulation’, divided by the size of the gold stock – the amount of gold in circulation. That’s to say, should the money supply increase (think QE), given gold has a relatively fixed supply, it will appreciate over time as a store of value even as currencies are depreciated by the printing press.
– Perhaps less understood though, is that gold’s performance is not very well explained by deflation or inflation, (it can perform in both environments, hence the chameleon like characteristics), but its principal driver is the expected ‘real return’ from other long term assets, particularly equities. This also brings to bear the US Dollar and a relationship there too.
Precious metals ‘moonier moments’ habitually occur during periods of US Dollar weakness – it’s not quite a simple as given gold is priced in USD, as the greenback falls, bullion bounces, but there are good reasons for why that does hold as a rule of thumb. (Currently, gold when expressed in many currencies, GBP, EUR, even JPY is appreciating against all of them.)
Gold does not pay a dividend, or generate any income and gains are to be had through price appreciation. In that respect, it has an opportunity cost when compared to holding cash in the bank and picking up a yield. As many countries globally have begun to cut interest rates, this opportunity cost is reducing, which lessens one of its headwinds. Of course, investing in precious metal mining companies can generate income through company dividends, and at certain points in the cycle, it is often a better bet to do so on a risk adjusted basis – more of that later.
However, the broader takeaway is that when equities and bonds are expensive in historical terms, gold’s outlook becomes more brighter. In that light, let’s review different means of assessing the forwards looking prospects.
HOME ALONE
At this point in the cycle, most households who have stock market portfolios, are fully engaged with equities. Both as a percentage of US GDP and a percentage of US assets, US homeowners are heavily invested in the stock market – ‘all in’ to reference a common poker refrain.
It also reflects a position of relative underexposure to other assets such as bonds, gold, commodities…..the following chart shows a clear inverse relationship. As equity market holdings top out, gold tends to find a long term bottom.
Chart 1: US Household Equity Ownership and the Gold Price
Source: Bloomberg, ARIA
This is a condition that will usually coincide with a fully valued stock market – one where the ‘expensiveness’ of, in particular US equities, (the FTSE 100 remains comparatively cheap by comparison), means that we should expect ‘prospective returns’ over the coming 10 year horizon, to be lower than the last decade.
Given the run up we have had, the expectations for the S&P 500.s returns are a poor as they have been in history – that’s not to say we think there isn’t more juice toward year end and into 2025, but over a longer term time horizon, that are better places to put monies to work, at least by this metric.
Chart 2: Forwards looking returns for US Equity Markets
Source: Bloomberg, ARIA
Unusually, gold’s recent ascent has front run these relationships – usually the stock market’s better days are behind it, before the tide turns in the barbarous relic’s favour. However, as we stand precious metals have simply not caught the popular imagination. In fact, as the chart shows below, participation from the retail market has been conspicuous by its absence.
Chart 3: Limited Investor Interest in the Bull Market to date
Source: Bloomberg, ARIA
The chart shows the number of units in issue for Gold Exchange Traded funds – the habitual means by which retail investors would gain exposure. Even whilst Gold’s price has appreciated, the number of units or interest in the ETF’s has continued to wane. This is another sign that the bull market has yet to ignite widespread interest – all that translates into significant investor liquidity that is yet to come to the party.
CAVEAT EMPTOR
That all leads to an obvious question – who is fuelling Gold’s advance? Any tailwind needs to have interested parties providing the propulsion. We need look no further than the vaunted (if not vaulted), institutions that are the world’s central banks. The buying spree can almost be dated to the very beginning of the Russian war of aggression against the Ukraine. Different central banks will have different motivations, but a number will share common cause. When certain emerging markets saw Washington, London and Brussell’s confiscate Russian assets – including foreign reserves, they decided that discretion is the better part of valour and to remove temptation and house their currency reserves elsewhere. Gold is wonderful solution – nobody else’s liability, a commodity that can be housed ‘at home’, globally recognised, accepted as a store of value and deep daily liquidity to facilitate large transactions.
The note from the FT below is now a little dated, but underscores the point:
Chart 4: Central Banks golden buying spree
Source: FT, ARIA
That’s not to suggest that demand has faltered this year either. Sources which track the gold market closely, (see here) have reported significant Saudi purchases this year. If those reports are accurate, and Saudi Arabia has bought 160 tonnes year to date, that marks a very significant increase in their exposure – which seems to have been relatively stable since 2008, having been only at 320 tonnes in total as recently as June 2021.
MONETARY MATTERS
Having established the locus of demand, it’s just as important to understand whether current ‘monetary’ and ‘fiscal’ conditions are supportive of further gains. As referenced in the introduction, Gold benefits from ‘falling real rates’. That means whilst interest rates fall, inflation holds firm. There has historically been a strong inverse directional relationship between falling real rates and gold prices. Moreover, after a long period where the US Federal Reserve was draining liquidity from the system, in order to slay the inflation dragon, money supply growth is now positive again. As liquidity begins more prevalent, it is usually supportive of the gold price – this and the monetary spigots have only just been turned on again.
MIND THE GAP
The glaring opportunity may not be in Gold itself, rather its miners. Gold mining companies seem to offer compelling value on account of just some of the developments highlighted in this article.
Between 2020 and 2024, central banks are suspected of having bought over 106 million ounces of Gold. However, they have not be patrons of the gold mining companies, as their interests are best served by buying a de facto reserve currency. So whilst the central bank activity has been driving the underlying commodity higher, both institutional and retail investors have been offloading gold shares – as evidenced by the falling number of shares in issuance in Chart 3. That hasn’t necessarily been irrational – during that period of time (real) interest rates have been rising at a clip, on account of the fastest rate rising cycle in history in the US. This is typically catnip for the gold price and investors have responded accordingly.
Therein perhaps lies the opportunity – after a sharp correction between 2011 to 2015, gold has continued to rise – currently 30% above its 2011 peak. Yet a benchmark for gold stocks, the NYSE Arca Gold Bugs Index, languishes more than 50% below its September 2011 high. All that set against a backdrop where the earnings of the companies that make up that Index are expected to quadruple relative to 2016. Moreover, operating margins are now much higher than they were then too – starved of capital, mining operations become ever more efficient and have reduced their cost of production. Much of those costs are energy related – as we stand, we have an oil price that looks distinctly timid, with further supports profit margins. In April this year, valuations in gold mining companies were as cheap as they’ve ever been – and whilst having rallied significantly since then, there remains a glaring disconnect between the price of the good they sell, and the price at which they themselves sell at.
ROOM TO RUN
Gold is currently extended by many measures. The price run up now requires a little a period of consolidation, and a fall of nearly 300 US Dollars would still mean the trend is intact. But there’s ample reason to believe the tailwinds to date, could become a sustained gale in the months and years to come.
Chart 5: Under allocation to Gold is systemic
Source: ARIA, Bloomberg
For many investors, Gold has featured little in their portfolios for over a decade. Even now, after such a run up, the percentage weighting that Gold ETF’s account for (when compared to all equity ETF’s), is still 25% under its 10 year historical average. Perhaps Gold has anticipated a (geopolitical) storm, a US fiscal debt burden as a percentage of GDP that will become a talking point once more in a global slowdown, or another inflation spike – all of which would become obvious in hindsight and meant that the gains were not given back easily. Alternatively, at this juncture, a pause would be healthy for the bull run and would do little to dim its shining longer term prospects. Similar to Crude Oil, the DXY finds itself on the precipice — keeping US Dollar bears and asset allocators alike in suspense. The impending next phase of the US dollar bear market will likely bring easier global financial conditions and tailwinds for global equities…
As a quick bearish technical check-list first: long-term US$ market breadth has collapsed, the DXY has taken out its 200-day average, notched up lower highs (after a failed upside breakout late-2022), and is now attempting to break down through a major longer-term support level.
In my view this is part of a larger and longer topping process as the USD transitions into bear market mode (given that it started from a point of overvaluation, policy divergence, consensus bullishness, and an extended bull run).
The Fed pivoting to rate cuts should be a key part of this picture (more on that below), but it may not be a simple and straightforward path… Much like crude oil, breaking down is one option, but bouncing is also an option. A rebound in the US dollar could be problematic for risk assets in the short-term through tightening financial conditions (likely also reflecting a potential change in path for the Fed e.g. if inflation resurgence risk reared its head).
But that also serves to highlight the upside from US dollar downside — a weaker dollar boosts returns of foreign assets for US dollar denominated investors (e.g. global equities). That can trigger self-reinforcing flows effects and provide a key tailwind to emerging markets and developed ex-US equities (among others).
In other words, some of the most watched, most anticipated relative (and absolute) value opportunities in global equities may finally be about to receive the catalyst they need for the value case to kick-in.
So definitely a chart to keep an eye on both for the direct opportunities as USD weakness broadens out, and indirect opportunities as a weaker dollar eases global financial conditions.
Chart 6: US Dollar Index vs G10 Breadth
Source: ARIA, Bloomberg
Key point: The US dollar looks set to enter the next phase of its
