by Steve Land, Vice President, Research Analyst Portfolio Manager, Franklin Equity Group, Franklin Templeton Investments
Here, Franklin Equity Group’s Steve Land, vice president and portfolio manager, digs deeper into industry fundamentals that he thinks make for an attractive longer-term investment case for gold or gold stocks.
Physical gold prices moved up to new one-year highs in September, reaching similar levels to those seen in September 2016. Yet many gold equities are trading at prices significantly below where they were trading a year ago. This is especially true for the smaller-cap miners, which have barely participated in the recent gold rally.
It seems to us that gold’s inability to hold a rally over the last 18 months has created fatigue with investors. As a result, many investors have felt they should sell into rallies. However, given the overall global macroeconomic backdrop, this view may be creating an interesting opportunity for longer-term investors.
Why the Current Gold Rally Could Continue
Several key factors can heavily influence the price of gold, including:
- US dollar movements;
- market uncertainty;
- global inflation;
- real interest rates; and
- supply and demand economics.
Considering the overall market, we think the current gold rally seems well supported.
We believe the recent weakening in the US dollar is good for gold, which tends to move in the opposite direction of the currency. The US dollar has been depreciating as investors prepare for higher baseline interest rates in other parts of the world, and further US Federal Reserve (Fed) rate hikes become less certain given the country’s lack of inflation, low unemployment and the impacts of hurricanes Harvey and Irma.
Against this backdrop, we believe it will be difficult for the Fed to continue to raise rates ahead of inflation. That, in turn, could make gold more attractive on a relative basis, because when real rates rise, investors in physical gold do not receive any yield and the opportunity cost of holding bullion compared with yield-paying investments increases.
What’s more, gold tends to have a very low correlation with other asset classes. It typically attracts investor interest during periods of global uncertainty because it is not tied to any one country or economic system. Rising global trade tensions and aggressive posturing out of North Korea are just two examples of current catalysts. Although we remain hopeful that tensions die down, North Korea remains a highly unpredictable wildcard in the global scene, especially as it seems to be distancing itself from China while more directly antagonizing South Korea, Japan and the United States.
Falling Gold Mine Supply Could Support Prices
On the demand front, China and India are the largest buyers of physical gold, and India’s demand was very strong in the second quarter. We also see other supply-side dynamics at play.
Gold-mining profit margins peaked in 2010. Despite the fact that gold prices rose for an additional two years, mining companies had lost control of costs, which rose faster than the price of gold. By the time miners collectively regained their cost discipline, gold prices began to fall, with each year of lower prices forcing deeper and deeper cuts.
During this challenging environment, many mining companies slashed exploration budgets and reduced the number of new projects. Lower assumed gold prices also resulted in reserve cuts, as new mine plans left previously economic gold in the ground.