The gold factor

12 June 2020

With the world mired in debt and economic despair, the price of gold precious metal has rallied to nine-year highs and could soon surpass its all-time high as systemic financial risk grows with every dollar spent by governments trying to stimulate economies.
Gold could reach over US$2,000 ($2,874)/ounce within the next 12 months, with huge debt burdens and bankruptcies potentially overwhelming economies, forcing even more capital into the relative safety of gold, potentially benefitting listed Australian gold stocks.
While gold has consolidated around US$1,700 in recent weeks, trading at its highest levels since 2011, the precious metal could surpass its all-time high of US$1,895, as economic risks mount. The main areas of systemic risk are deflation, debt, inflation and loss of confidence
Negative real interest rates in the US are also positive for gold. When real rates are negative, gold becomes competitive with interest-bearing assets.
In terms of deflation, the COVID-19 pandemic is a deflationary shock of the highest order, where demand for almost everything has collapsed virtually overnight.
Global gross domestic product (GDP) has fallen sharply and global recession is likely. If this were to be an average recession, it would not trough until April 2021. However, a myriad of factors make it easy to imagine a recession with deflationary pressures that lasts longer than average. 
The IMF has forecast that global GDP will contract 3% this year, compared to a 0.1% contraction amid the global financial crisis. While growth may return in 2021, the IMF has warned that many countries face a multi-layered crisis comprising a health shock and economic disruptions, including falling external demand, capital flow reversals and a collapse in commodity prices. 
This would exacerbate the length of any recession.
While economic downturns are not necessarily drivers of the gold price, or high debt levels, the financial stress that accompanies recessions could trigger large scale debt defaults in the US and elsewhere as companies’ cashflows freeze up. 
Globally, debt has ballooned. The bailout efforts for the COVID-19 pandemic are the most significant in the G7 history and global debt to GDP is now over 300%. All of this stimulus, all of these bailouts and support is creating an incredible amount of systemic risk, which could benefit gold over the short and longer term.
In the US, Goldman Sachs has forecast the US budget deficit will reach US$3.6 trillion this fiscal year and US$2.4 trillion in 2021. This is on top of US$17.9 trillion worth of existing debt, which now exceeds 100% of GDP. Based on these figures, it appears unlikely that the US government will ever pay back the money it owes.
At zero interest rates, money is free, and sovereign debt keeps piling up. The US Federal Reserve may never be able to raise rates for fear of a ruining rise in debt service costs. Anyone who owns a business or runs a household knows intuitively that this is unsustainable. Nonetheless, no-one knows whether it can persist, end in failure, or whether government debt eventually gets pared down in a cycle of inflation.
According to Rosenberg Research, the volume of business debt in the US has roughly doubled this cycle to over US$10 trillion. Many businesses are now taking on more debt to deal with the lockdown collapse in revenues through bond offerings, revolving credit lines, and new government lending programs. All corners of the private debt markets are under acute pressure.
Another area of systemic risk is the possibility of inflation. While the global economy will be mired in deflationary pressure for the foreseeable future, inflation could eventually follow. Central banks have been trying unsuccessfully to generate wage and price inflation for years. Instead, their policies have brought asset price inflation – bubbles in stocks, bonds and real estate markets. However, if economic growth ever returns to historic norms, complacency towards inflation, coupled with the massive pandemic stimulus, could bring high levels of wage and price inflation.
The world is on a war-footing to fight the COVID-19 pandemic. Past wars have brought double-digit inflation in the US, as the table below shows. The end of WWI also coincided with the Spanish Flu pandemic when inflation peaked at 24%:
The COVID-19 war might end with another cycle of unwanted inflation. 
As this systemic risk mounts, confidence in the US dollar may diminish. After WWll, the Bretton Woods Agreement created a global monetary order in which US dollars were convertible to gold by foreign governments. The Bretton Woods system ended in 1971 as the US was spending heavily on social programs and the Vietnam War. Some countries lost confidence in the US dollar, demanding more gold than the US was willing to provide. Thus, the gold window was closed and the current system of fiat currencies and floating exchange rates was adopted.
Now, that system is being trashed by rampant QE and government borrowing. Call it monetisation, helicopter money, or modern monetary theory; no financial system has survived such currency devaluation. If investors lose confidence in the US dollar-based system, it will be time for a new Bretton Woods, a new global monetary order. Gold would be the last currency standing.
These four areas of systemic risk will continue to support gold price well into the future. That should lift the price of gold miners, whose price typically rises more than the metal itself. As gold shares can pay dividends, gold equities also provide income, something gold bullion does not.
Against this economic background, the gold industry is thriving while dealing with COVID-19 protocols. During the pandemic, gold miners have taken all precautions to continue running their businesses. Although we anticipate that some operations will be impacted, the discussions we have had with gold companies indicate that every effort is being made to ensure inventories, supply lines, employee health and back-up redundancies are in place to sustain production. 
We expect limited to no credit problems in the gold mining sector. The lengths to which gold miners have gone to reduce costs and capital expenditures and to avoid mistakes of the past could translate to a significant increase in free cashflow from current levels if the gold price moves to US$1,800 and then beyond to US$2,000.
We see the Australian gold miner sector as standing toe to toe with international gold miners, including mid-tier miners Northern Star, Saracen Mineral Holdings and AngloGold Ashanti, which have gained around 55.3%, 62.8% and 107.5% respectively over the year to 31 May 2020. The prices of other gold stocks listed on the Australian Securities Exchange have run to multi-year highs or all-time records this year. Yet gold companies continue to exhibit, we believe, truly compelling fundamentals and valuations, including Australian firms. 
Russel Chesler is head of investments at VanEck.

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