Aug 11, 2020

All That Glitters

Technology stocks have been leading the way in the markets for 2020, but another theme that has come to the forefront has been the move in precious metals, such as gold.

  • Negative earnings; positive stock moves
  • Gold hits all-time highs as safe haven sought
  • Why invest in gold, why be wary of investing in gold

 

In July, corporations started to report their financial results for Q2 – the first full quarter where COVID-19 impacted our lives – thus giving investors a glimpse into how businesses fared during such a disruptive period.

 

The results are encouraging for the most part. Almost two-thirds of S&P 500 companies had reported results by the end of the month and, although earnings were down more than 35% from the previous year, the results were better than expected. The market reacted positively, with major stock markets up for the fourth month in a row. It may seem counter-intuitive for stocks to be up when earnings are significantly down, but market participants are always anticipating and the negative earnings this quarter were already “priced in”.

 

More companies are scheduled to report in the U.S. and much of the Canadian market still has to report in August (including banks). Earnings are forecasted to be challenged for the remainder of 2020, but we think investors will continue to look through the weakness as long as: the economy continues to gradually open up; sufficient government assistance remains available; and progress on a COVID-19 vaccine continues. Accordingly, we remain overweight equities in client portfolios.

 

Moving Metal

We have written a lot about how narrow markets have been this year, with technology stocks leading the way at nosebleed valuations. Another theme that has come to the forefront in 2020 has been the move in precious metals such as gold. The price of gold hit a record high in early August as it crossed the $2,000 an ounce barrier. On August 5, the price of gold was up over 30% from the start of 2020. Looking back further, gold started to move higher in late 2018 as central banks started to lower interest rates after fear that prior rate hikes were hurting the economic expansion. Overall, the rally continued in 2019, but really started to accelerate as COVID-19 spread across the globe.

 

Gold has two main uses: jewellery and as a store of value/currency or safe haven. However, jewellery demand is fairly constant, and does not adequately explain the ebbs and flows of gold pricing.

 

Can’t Touch This

Owning physical gold is an interesting proposition. It pays the holder no return in the form of interest or dividends and if you own enough of it, you will need to pay someone to store it for you thus generating negative cash flow. Many investors simply will not touch it, finding the commodity price impossible to predict and therefore the stock of miners that produce it impossible to value.

 

Warren Buffett once wrote that gold investors have the “belief that the ranks of the fearful will grow”. In other words, when times are tough or uncertainty is high, gold can really move. As Figure 1 shows, it happened in the 1970s when inflation was very high on the back of spiking oil prices and geopolitical tensions. It rose through the 2000s, but caught a major tailwind during the Global Financial Crisis as the economy slipped into a brutal and long-lasting recession followed by a tepid recovery. Of course, it recently caught another huge tailwind earlier this year as uncertainty ratcheted up.

 

Figure 1: Gold Price

Source: Bloomberg

 

Better Safe Than Sorry

The price of gold is largely driven by sentiment: a belief that things are out of balance in the economy so a safe haven is sought. Today’s economy is like the Global Financial Crisis on steroids: a huge shock to the economy driving ultra low interest rates and lots of stimulus and money printing. There is fear that inflation will rise and interest rates will stay low, which is a powerful environment for the commodity.

 

We do own gold stocks in our U.S. and Canadian portfolios. However, as with anything in investing, it is important to be diversified. What if interest rates start to rise or inflation never materializes? We could see the price of gold fall back rapidly – just as it did about eight years ago when anticipated inflation never materialized. It is important to own higher quality companies that operate in stable political jurisdictions with multiple projects and proven management teams. We follow this approach for all companies, but for miners it is even more important. One accident on site or a change in government in a foreign jurisdiction can lead to devastating results for companies that are not diversified.

 

We can’t, with any degree of confidence, predict that gold will keep moving towards $3,000 an ounce, nor if it will retreat towards $1,000. That is the challenge in owning something that is only marginally driven by supply and demand for the consumption of its product. Instead, we are focussed on the underlying economic conditions (noted above) that are supportive of the price, and looking for any cracks in these conditions that will change our thesis.