By Bradley George
As is the case with many commodities, peaks and falls in the gold price draw considerable investor attention. Despite the near-term headwinds, we remain positive towards gold for three key reasons which we will consider below.
First, we look at the macroeconomic factors driving gold; secondly, we note that central banks remain net buyers, a structural trend that we believe will continue to unfold; and thirdly, we look at medium to long-term investment capital which remains stubbornly invested in gold.
Finally, we will look at gold equities, which we believe have significantly de-rated, providing investors with an attractive entry point.
Taking these factors into consideration, we believe gold has paused for breath and continues to exhibit its safe-haven qualities, diversification benefits and insurance protection, making it a compelling case for consideration by longer term investors.
--The macro view
Looking first at the macroeconomic environment, the virtual explosion in central bank balance sheets around the world has potentially far-reaching consequences for gold, and real interest rates in many regions will be negative for some time to come. Central to the outlook for the gold price, in our view, is the fact that globally, policy is still extremely accommodative.
We can expect policy in China, Europe, and Japan, and possibly the UK and Switzerland, to be even more stimulative in the near to medium term. Even with inflation stabilising and nominal bond yields increasing, real rates are low to negative in most areas of the world.
While bond yields have moved higher, policy rates remain on hold. The US Fed is not about to embark on a rate-hike cycle in the near-term, and many will still question whether the Fed will risk the tentative US recovery by hiking rates, particularly if the US housing market shows no signs of improvement and in light of further fiscal tightening in 2013.
The quantity of money deployed in global quantitative easing must be serviced for many years into the future. The absolute level of money will not decrease and central banks will be hesitant to let rates rise too high, and the inflationary consequences of this monetary easing will be felt in the foreseeable future.
Our analysis shows that gold prices have correlated well with US 10 year TIPS where the yield remains negative (approximately -1%) and we would expect gold prices to rally again, closing the gap that has recently opened up following the correction in the gold price.
Central bank purchases
Secondly, we turn to what we view as a structural development which continues to unfold – the on-going net purchase of gold by central banks.
For instance, Mexico along with Russia and some other central banks have been persistent purchasers. This year, emerging market (EM) central banks continue to be buyers of bullion, with the gold buying spree continuing into Q2.
Reports based on the latest International Monetary Fund (IMF) data showed that official sector net purchases amounted to 19.4 tonnes (t) for May. As has been the case previously, certain players were actively seen to be adding to reserves, with Russia buying 15.5t, Ukraine adding 2.1t and Kazakhstan purchasing 1.8t.
In the first five months of 2012, central banks have boosted reserves by 111t, a marginally slower pace than last year’s 128.8t during the same period in 2011.
It is important to note that the official sector has maintained its buying attitude towards gold, and this is currently the type of quality buying that gold requires.
We continue to look for emerging market countries as well as those with large accumulated current account surpluses that are diversifying their holdings into gold through a combination of open market purchases and purchases from domestic producers.
These central bank reserve updates ultimately provide confirmation that one segment of the market is extending the trend of last year.
Central bank purchases should continue to help provide a floor to the gold price and may help compensate for the lack of strategic buying elsewhere.
Finally, while investors remain focused on gold itself, we believe that selected gold equities have de-rated significantly, following the grouping of gold shares in investors' minds with industrial commodity producers, in the belief that the industrial commodity cycle has peaked.
However, given the fundamentals underpinning gold described above, we continue to believe that the gold price will rise, and that gold producers are likely to enter an earnings ‘sweet spot' which will persist for several years.
We expect weak economic growth to depress industrial commodity prices keeping gold miners' input costs in check, while continued monetary debasement deployed to combat economic weakness will boost the gold price and hence their revenues.
Valuations of selected equities look particularly compelling, in particular, companies that have significant free cash generation, a production growth profile, have implemented their austerity measures in 2008/09 and are managing operating costs below $500/oz.
In reaping the benefits of their improving operating margins, some may show significant upside in 2012.
Lastly, if gold companies continue with strong free cashflow generation and remain disciplined on the mergers and acquisition front, certain companies may increase their dividend payments to shareholders.
Pure gold producers with operations in weak currencies, with strong balance sheets and growing production profiles are key examples here.
(Author is the co-portfolio manager of the Investec Global Gold fund, explains why the case for investing in the precious metal remains compelling despite near-term headwinds.)
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