Market Views: Equities
What does Brexit mean for gold?
Gold is on a path back from being a forgotten asset to a core allocation in a deeply uncertain world. Brexit exacerbates trends already firmly in place.
Gold remains an underowned hedge against global central bank credibility and under-appreciated global risks, particularly from China. Potential inflation, currency and financial market outcomes globally are arguably more extreme now that at any point since the end of the Second World War.
More immediately, last week's "Brexit" vote had an instant impact on gold prices, which jumped over 6.5% to an intraday high of US$1,340/oz1 on Friday. In sterling terms gold appreciated close to 20% in a 48 hour period.
When thinking about market impacts, we need to distinguish between short-term fast-money flows and longer-term asset allocations. Short-term safe haven flows are often transitory and contain an element of knee-jerk panic. To understand the longer-term significance of Brexit on the gold market we need to set the event in the context of two key trends. Firstly, real 2 interest rates. Secondly, global political populism.
1. Real interest rate expectations are today a core driver of gold markets in our view.
The deeply entrenched expectation that ultimately a systematic Federal Reserve (Fed) programme of rate hikes would drive up real interest rates and keep the dollar strong has been a key driver of gold price weakness in the last few years. As most investors we spoke to over the past 18 months concluded: “why hold gold in this environment?”
The consensus expectation has been shaken this year. In the US the extent of "normalisation" has been one 25 basis points (bps) rate increase. Central banks elsewhere remain addicted to increasingly (absurdly?) accommodative stances. The European Central Bank (ECB) has recently begun purchasing high grade corporate debt. Brexit feeds and extends this trend. Yet, easier monetary policy is now likely. This is most obviously true of the ECB and the Bank of England.
What of the US? In her last Federal Open Market Committee press conference, Fed Chair Janet Yellen directly referenced Brexit as a risk factor. The reality of a Brexit vote will likely push out even further the Fed’s "dot plot" (committee members’ estimates of future interest rate ranges). “Even lower for even longer” is a sensible conclusion for nominal rates.
What of inflation? As much as Brexit is ringing policy-maker alarm bells, the impact on nominal inflation is less clear. Energy and agricultural prices are showing broad-based recoveries, US labour market conditions, even after May’s dismal jobs numbers, remain firm. Brexit occurs with global central bankers inherently dovish but inflation trends already firming. Against this backdrop the probability of negative real interest rates for an extended period increases, and with it the probability that allocations to gold continue to rise.
2. Global political populism.
Brexit appears to be the first time that populist undercurrents in developed economies (Trump, Sanders, Corbyn, Le Pen et al) have translated into an actual establishment-rattling political outcome. This ratchets up fears over future political disruption, particularly of a domino effect through the EU.
Heightened populism, and policymaker fear of it, also raises the probability of a more populist economic policy response. Discussions around direct fiscal stimulus have moved from the margins much closer to the centre of policy debate. This adds to uncertainty around geopolitical and inflation outcomes, likely increasing portfolio hedge allocations to assets such as gold.
Taking a big step back, we think Brexit exacerbates trends already firmly in place
Even without Brexit gold had already set out on the first steps of a path back from being a forgotten asset to a core allocation in a deeply uncertain world driven ultimately by negative real interest rates and the dawning realisation that any global “normalisation” is a long way off.
Gold remains an underowned hedge against global central bank credibility and under-appreciated global risks, particularly from China
Compelling case for gold equities (shares)
We believe investor allocations to gold should continue to grow. Within the gold investment universe, gold equities in particular could offer a compelling investment case and we believe should outperform the gold price in coming years. This contrasts starkly with the experience of equity investors through the prior gold bull cycle from 2003 to 2011 when rampant cost inflation and management indiscipline saw the gold producer share prices markedly underperform the gold price.
With balance sheets significantly repaired, gold miners have an opportunity to produce gold ounces into an environment of rising prices and contained cost bases. Against consensus opinion we do not believe that a rapid return to the bad old days of "growth at all costs" across the industry is likely (though some poorly-managed companies will not be able to resist)
Even after the year-to-date rally gold equities remain ~60% below previous cycle highs. Cashflow-based valuation multiples3 show significant potential for re-rating.
Companies with the ability to generate organic production upside4, while retaining cost and balance sheet discipline, are the companies which should deliver long-term returns, and perform strongly in a rising gold price environment.
1. All data sourced from Bloomberg↩
2. A real interest rate is the rate of interest an investor receives after allowing for inflation↩
3. Ways of valuing a company based on the cash that flows through a company during the course of a quarter or year.↩
4. Increasing production without relying on mergers and acquisitions↩