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Strategy notes – June 15, 2019


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Why we have added to our gold holdings  

Stock market outlook – introduction 

Since this April, we have adopted a more defensive posture in our portfolios. This was partly to nail down some substantial profits made in the first four months of the year and partly to await a more conclusive outlook for the North American and global economy. Three months ago we thought that the risks of a recession within the year were about 50/50 but, as we said in our last Note, “that is still possible but, if we had to put odds on it now, we would reduce them to 20/80. Markets have recovered strongly – both globally and in North America – from the Boxing Day lows but they are not cheap. As we have frequently pointed out the US market is particularly expensive using the Shiller P/E ratio, which is currently at 30.2 times. That is the third most expensive in the last 140 years – exceeded only in 1929 and 2000.” 

We also observed in that Note that “the TSX on the other hand is selling roughly at its 10-year average multiple on a P/E, P/CF and P/BV basis and modestly above those three metrics on a 2018 and a three-year average basis using consensus 2019 estimates (presaging finally outperformance by the TSX versus the S&P 500). As mentioned, we stand ready to put cash to work if we develop more confidence in the global and North American economic outlook. If we had to guess as to at what point, if that did occur, that might happen, we would suggest it might be sometime in September/October when equity markets often reach their interim lows.” 

Have our views changed as we move to the middle of June? The answer is “no”. The real M1 growth numbers – both for the U.S. and globally – have a lead time of six to nine months and suggest that the growth slowdown in GDP in both is unlikely to reverse until the start of 2020 at the earliest. As for the ECRI’s Weekly Leading Indicators, they reversed back down to a negative reading (-1.3%) in the latest reported week. This is well short, however, of the -10% reading that would signify the strong likelihood of recession in coming quarters. 

In a recent interview with Bloomberg, Lakshman Achuthan, COO of ECRI, summarized his latest views by making three key points: 

  • “the U.S inflation cycle downturn is not transitory, and is separate from, but consistent with, the slowdown in U.S. economic growth.” He added that the ECRI’s U.S. Future Inflation Gauge had recently hit a fresh three-year low, signifying that there would be no cyclical upturn in inflation in the next couple of quarters. This would be a harbinger of continued depressed long term bond yields and likely presaged cuts in short term rates by the Fed. 
  • “Trade war developments – while generally negative – obscure the underlying cyclical downturn in global industrial growth that started first.” 
  • “Chinese growth has stabilized some, after a lot of stimulus, but there is an ongoing industrial slowdown that will continue.” 

In combination with Fed Chairman Jay Powell’s statement on June 4 at a conference hosted by the Federal Reserve Bank of Chicago that “the Central Bank stands ready to cut interest rates to sustain the expansion amid the economic impact of escalating trade wars,” depressed inflation and downwards pressure on interest rates should support the fundamentals of gold and gold stocks. We have recently interviewed most of the gold companies in our equity universe and this Strategy Note summarizes our positive stance towards the sector. 

Gold and gold stocks 

In the course of the last 20 years, the price of gold has been in a wide trading range. In 1998, it bottomed at $253 an ounce and then headed almost inexorably upwards to a high of $1,924 an ounce in 2011. Since then, the price of gold has traded between a high of $1,924 an ounce in September 2011 and a low of $1,065 an ounce in 2015. Post 2015, the price of gold has peaked out six times between $1,350 and $1,377. Each attempt at a decisive break through those levels has resulted in failure. It is therefore fair to say that the price of gold likely has to get to close to $1,400 an ounce to declare that a new long term bull market in the price of bullion has started. 

Other than the price of gold itself, a well-known way of assessing gold is in relation to the price of stocks. This is clearly shown in a favourite measure used by some observers: the Dow to Gold Ratio, which measures the number of ounces of gold it takes to buy the shares in the Dow Jones Industrial Average Index. Since the beginning of the 1900’s, the price of bullion has only been cheaper in relation to the Dow twice. Currently, the ratio is 19.6 times while in 1966, it peaked at 26 times and in 2000 at 40 times. It is worth noting that in September 1929 – after the 1920’s stock market boom – the ratio peaked at 17 times. On the other side of the coin, the two major lows in that ratio were in 1933 at 1.7 times and 1980 at 1.4 times. 

Although clearly theoretical, if the DJIA reverted to its average ratio in relation to gold over the last 199 years (9.8 times), the current price would be $2,667 per ounce. Were the gold price to revert to the low ratio experienced in 1980, the price of gold would be $19,321 per ounce. However, it would be fair to counter that these relative calculations could simply lead to the conclusion that the DJIA is incredibly expensive relative to gold which could be described as just fairly valued. However, we suspect that gold bullion itself is in fact cheaply valued at current prices. 

Our reasons for this conclusion include the following: 

1) In recent years, declining interest rates have proven to be bullish for gold prices as gold pays no interest. Rising interest rates increase the opportunity cost of holding gold and have generally been bearish for gold prices. Reflecting our comments above on the Federal Reserve’s pivot on interest rates since the end of last year as well as the continued downwards pressure on inflation (which the Fed only regards as temporary), we believe that short term rates will decline over the balance of the year and form a tailwind for the gold price. 

2) Central banks are increasing their purchases of gold. In 2010, central banks started being net buyers of gold rather than net sellers. The World Gold Council calculates that in 2018, central banks bought 618 tonnes of gold – a record and a 75% increase from 2017. Central banks are the single biggest factor in the global gold market. 

3) In 2017, in the rising crisis in North Korea, inter alia, the Trump administration threatened to cut China off from the U.S. dollar payment system (subsequently it did indeed cut off Iran and also Venezuela from the U.S. dollar system). In the first instance, China responded by launching a crude oil futures contract denominated in Chinese yuan and exchangeable into gold bullion. This vehicle thus bypassed the U.S. payments system and allowed the purchase of oil by China without the use of dollars. It has been estimated that the amount of such payments for oil could ultimately reach $600-$800 billion, a goodly portion of which could flow into the gold bullion market whose annual trading value is only about a quarter of those oil payments.

4) In April 2019, Basel III took effect. As we have reported in our Notes on banks, Basel III redefined Risk Weighted Assets in calculating the levels of equity that banks need to carry. The risk treatment of gold bullion was changed under Basel III so that it could be considered to carry a 0% risk weighting under certain circumstances. We regard this as an initial step in granting gold bullion a degree of official recognition in the international financial system after being excluded from such consideration since Nixon’s annulment of the partial gold backing for the U.S. dollar in 1971. 

5) In a previous Note, we commented on the growing political attraction in the U.S. of MMT – Modern Monetary Theory. Undoubtedly, this theory will get more exposure as the U.S. election cycle moves towards November 2020. To the extent, that the political attraction of “free money for free spending” gains momentum, our view that it would be a recipe for inflation would likely attract a growing interest in gold bullion, which has always held its value in the face of inflation. 

In sum, we have stated before that we are concerned that the year to date gains in equity markets have been partially founded on the belief that the second half of the year would see re-acceleration of GDP growth in the U.S. and globally and with it earnings for equities. We see no evidence of this as yet. If it does indeed occur, it is not likely until 2020. Thus, we have retained our recent defensive posture: in our equity oriented portfolios (other than the Infrastructure portfolio which continues to do well in a low, long term interest rate environment), we carry cash positions currently of 25-28%. In addition, we have increased our exposure to gold stocks in the last two weeks from about 6% to 9% except in the High Income portfolio which holds no gold stocks. 

Portfolio changes 

While we liked the improvement in Yamana’s balance sheet as a result of the announced sale of the Chapada mine to Lundin, we were somewhat disappointed in the price to be received from the asset. We decided to replace Yamana with Franco Nevada which although a royalty company has no debt but good growth prospects with concomitant growth in cash flow over the next three years. We also added modestly to our Wheaton Precious Metals holding. Also, we added to our Newmont holding. If we are right on the gold price improving over the coming months, the fact that Newmont is the only gold stock in the S&P 500 should help improve its P/CF valuation. 

Nick Majendie 
Director, Wealth Management
Senior Portfolio Manager