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Daniel Greenspan, CIBC Asset Management, senior analyst and resource team director.
After a great start to the year, which saw gold rally from around $1,800 an ounce in January to $2,050 an ounce in early March, the price has been pulled back like a magnet back to the $1,850 level, which it has tested and bounced off several times in recent weeks.
While $1,850 an ounce is a healthy price, we are a bit surprised the price hasn’t done better considering all the factors that we see as tailwinds for gold in the current macro environment. We’ll discuss those tailwinds next and where we see risks to gold. But generally speaking, we see upside potential in the coming months as market uncertainty appears to be increasing.
Firstly, inflation, interest rates and macroeconomic risks. Not to state the obvious, but clearly inflation is running hot and is ahead of expectations. In response, we’re seeing central banks making outsize interest rate hikes to try to offset. This was seen most recently with the Federal Reserve increasing its benchmark interest rate by 75 basis points at its June meeting. When inflation continues to exceed market expectations as it has in recent months, and when we see outsize interest rate hikes in response, we certainly get the sense that the Fed is behind the curve of on taming inflation.
And we would expect that kind of environment to be supported for gold, both as a hedge against inflation and as a flight to safety. At the same time, persistently high inflation combined with interest rate hikes to slow borrowing and growth increases recession risk in the market. Again, gold’s role as a flight to safety and a hedge against recession risk should help support the price in the current macro environment.
Another factor that we think can be supported for gold is enhanced market volatility that we have seen in the recent weeks and months. We note that the VIX Index, which is a volatility benchmark for the S&P 500, has popped this month through 30. Well, 30 is not a super high level when compared to periods of crisis like the start of COVID in 2020 or the global financial crisis in 2008/2009 when the VIX hit plus-50. It is still well above the 25 year average of around 20.
We would expect that in a period of enhanced market volatility, gold would benefit as it can be used as a flight to safety and as a bit of a countercyclical hedge in the portfolio to dampen the volatile moves in other stocks. We would also expect to see gold outperform in a period of enhanced political risk.
Key factors that we’re watching here are the war in Ukraine and the zero COVID policy in China. The war in Ukraine creates uncertainty around global food supply and uncertainty around key commodities like oil, potash, steel and coal. Again, we would expect gold to be supported as a hedge against the risk as there does not yet appear to be an off-ramp to the conflict. While Russia-Ukraine creates risks on the supply side for the global economy, China’s zero COVID policy creates risks on the demand side with large scale lockdowns impacting a significant number of its citizens. With these uncertainties impacting the global economy, we would expect the gold price to be supported as a flight to safety.
With that in mind, the key question is why hasn’t gold worked as well as we think it should. Firstly, the US dollar has been quite strong and there tends to be an inverse relationship between gold and the USD. The DXY, which is an index that measures the US dollar against the basket of global currencies, has pushed close to 105, which is a level not reached since 2002. A strong US dollar could remain a headwind to gold.
Secondly, we think global resource-focused investors have generally been able to find better returns in energy in the base metal sectors than in gold. Should the micro-story continue to fade a bit and energy and base metal suffer during a period of uncertainty around inflation, interest rate hikes and recession risk, we think investor attention could shift to gold.
I’ll highlight a couple of our preferred stocks in the gold sector that support our view. Firstly, Agnico Eagle, a Canadian-based large cap producer is our preferred name in the sector. We view Agnico as a high quality, senior gold producer. Company is still digesting the recently completed acquisition of Kirkland Lake. We like that deal a lot and we think the new assets fit well into the Agnico portfolio. We see potential for Agnico to outperform as it integrates the new assets into the company and shows upside potential from these new assets. We also see exploration upside across the portfolio, which can drive longer-term value for shareholders. We continue to believe a premium valuation is justified given the strong asset base, the regional approach to production in relatively safe jurisdictions, and the organic growth expectation.
Second, Franco-Nevada is another preferred name in the gold sector. Franco’s not a gold producer but rather a royalty and streaming company that harvest cash flows from a high quality portfolio of mining output. Given that Franco’s not a producer, it has the unique benefit of having very little to almost no exposure to inflation because it basically has no operating cost. We view Franco-Nevada as a high quality materials company offering investors exposure to gold in a lower risk, diversified vehicle.
We expect the trading multiple for Franco to remain elevated relative to gold-producing peers given the diversification benefit, a strong balance sheet and a quality management team. We think the growth potential of Franco is strong and somewhat underappreciated by the market. We view Franco as an attractive investment in an environment where producers are experiencing inflationary pressures on capital and operating cost.