It is increasingly clear that consumers and businesses are facing a period of inflation of a greater magnitude and longevity than predicted by policymakers earlier this year, amid evidence of rising prices globally. As precious metals specialists, we identify three current key trends for investors in this sector:
As the temporary drivers of inflation give way to longer-term trends towards higher prices, investors face the question of how best to diversify and hedge their portfolios from the damaging effects of inflation and monetary debasement. Historically real assets and commodities, particularly precious metals, have thrived during periods of inflation. Precious metals have lagged many other commodities for much of 2021, as investors’ belief that inflation would be transitory and the spectre of rate hikes created headwinds for the sector. Yet a shift in sentiment is now underway as evidence of sustained inflation grows and negative US real interest rates appear likely to remain. Furthermore, precious metals miners are well-positioned to offer operational leverage to higher gold and silver prices, however, some producers also face potential cost inflation which may erode margins, while others have tools and practices which will help limit cost increases. As long-term investors in this sector we consider that selectivity will be the key to capitalise on the next big move for precious metals.
Perhaps unsurprisingly following decades of persistently low inflation, policymakers have been slow to recognise that we may be entering a new era of inflation. Yet with recent US CPI numbers exceeding expectations and growing alarm among businesses facing rising costs, the argument that inflation will persist for some time is gaining traction.
The new era of inflation – Are higher prices here to stay?
The current drivers of inflation are many and varied, including both supply and demand sided factors, as well as economic and political forces. Inflationary pressure is becoming a defining feature of the post-COVID world, as governments take a more central role in economic management through stimulus and intervention, and as central banks’ policies drive monetary debasement and financial repression. It has been a long time since the “Great Inflation” of the 1970s, during which energy crises and US monetary policy mismanagement saw consumer prices surge by double-digits. While there is little indication currently that inflation of that severity could return, a protracted period of higher consumer prices alongside rising commodity prices does now appear likely.
On the demand side, the rebound in consumer demand across developed markets since the lifting of most COVID-19 restrictions has been a core driver of rising inflationary pressure. US retail sales have remained resilient and indicate that the shift towards consumer spending on goods rather than services has continued. Notably, used car prices had gained 38% year-on year at the end of October 2021 (Manheim). On the supply side, post-pandemic tightness is pushing up prices as recovering supply chains face surging consumer demand. Bottlenecks have remained severe in recent months, as illustrated by extreme port congestion, most notably on the US west coast. Furthermore, the labour market highlights an acute shortage of workers, notably once again in the US, which continues to impact supply chains and push up costs. It seems that many workers who left the labour force during the pandemic are proving slow to return, while others will never return, opting instead for part-time work or early retirement.
At first glance, these dynamics appear likely to be short-term; the result of business activity rebounding from the COVID-19 crisis. Yet several further factors indicate inflation will prove to be more than a temporary bout. Firstly, the unprecedented economic conditions of the past two years and the policy response to the COVID-19 crisis will have a lasting impact on demand. US money supply growth accelerated to over 25% year-on-year at the peak of the crisis and today remains at around 12%. Similarly rapid public debt growth during the pandemic shows little signs of slowing, having grown 26% over the two years to October 2021, compared with around 12% during the preceding two years. Big government and heightened levels of government spending seem to be here to stay, as does “easy money”, regardless of projected tapering and modest nominal rate hikes by the US Fed. These factors support the case for longer-term, demand-driven inflationary pressure, which will be compounded in some economies by demographic factors, most notably ageing populations.
Longer-term, supply-sided inflationary factors also indicate inflation will persist. In particular, we consider that a structural shift is underway as the cheap inputs generated by globalisation become eroded. The geopolitical trend towards de-globalisation, which pre-dates the pandemic and is often backed by populist economic policies, has been amplified in the aftermath of the crisis as governments and populations have become increasingly wary of the fragility and risks posed by reliance on lengthy international supply chains. We expect the trend of “reshoring” to continue, pushing up costs for domestic industries and stoking inflationary pressure. Meanwhile, other inflationary elements of the legacy of the COVID-19 crisis may remain for longer than expected. With regards to labour markets in particular, the wage rises underway across many sectors may not be easy to reverse, keeping costs high for businesses for some time.
Inflation is fast becoming a key issue for governments, yet it is clear that policymakers’ ability to control inflationary forces remains limited. Following decades of seeking to restrict and control inflation during the last century, the low rate of price rises during the 21st century has led to a fundamental shift in central banks’ approach to inflation management. Average inflation targeting, as opposed to inflation limits, is being adopted, led by the US Fed. Central bankers’ willingness to allow inflation to run above target levels for an extended period of time is a significant departure from previous policies, and one which may contribute to ushering in the new era of heightened inflation. Recent months have seen a subtle shift in tone by Fed officials away from noting “transitory inflationary pressure” towards recognition that inflation is outpacing expectations and may endure for longer. Investors can increasingly see that policymakers will not step in until inflation is set to get out of control.
The ultimate real asset – Are gold and gold miners an inflation hedge?
The prospect of higher inflation holds a wide range of implications for investors, and traditional portfolios focused on general equities and bonds may have to diversify to manage risk and seek returns. Bonds are negatively impacted by inflation as rising prices erode interest payments, while for equities the picture is more mixed. Equity markets have thrived during the years since the end of the Global Financial Crisis amid easy money and stable economic conditions, but the risks are higher under inflationary conditions. Major equity markets are at or around all-time highs, and general equities are at risk from a margin squeeze due to rising operational costs, inventory build and from higher interest expenses, all impacting the capacity of companies to buy back shares. Real assets appear more attractive under an inflationary environment, retaining value in the face of rising prices, and periods of inflation have historically been positive for commodity markets.
With that in mind, we regard gold to be the ultimate real asset and an efficient inflation hedge. Gold is a store of value, a scarce and unique asset, which is no-one else’s liability and has outperformed all fiat currencies over time. Many commodities have already responded to rising inflation, with lithium, oil and copper having gained 225%, 68% and 26% respectively during 2021 so far (at 11/11/21, in USD terms). The gold price remains down year-to-date (in US dollar terms) yet there are signs of momentum building in recent weeks, boosted by growing evidence of rising inflation.
Having consolidated for much of the past year, we believe gold is poised for a period of outperformance relative to broader commodities. Should the inflationary cycle continue as we expect it to, the recent turnaround may mark the beginning of the metal’s long-awaited move towards new highs.
Significant upside potential for gold miners – But can costs be controlled?
As seen in previous gold sector rallies, precious metals miners can offer significantly higher upside potential relative to an investment in the physical metal. Recent history has illustrated the operational leverage which miners can offer as the gold price rises, however weak investor sentiment during 2021 has left the gold equities sector undervalued on both a relative and fundamental basis. The return of inflation presents an opportunity for gold miners to achieve margin expansion at higher gold prices, but also poses risks. As with general equity markets, rising costs threaten to squeeze profits, eroding the benefits of higher gold prices for some miners.
Operating cost inflation among precious metals miners is currently about 2-5%, driven largely by labour costs, particularly in North America and Australia, as well as by higher oil and steel prices. However quality companies are partially offsetting this with cost improvements in three key areas. Firstly, changes to work practices, in some cases prompted by the COVID-19 crisis, have enabled many miners to operate in a more flexible manner, adjusting shift patterns and operating with fewer individuals on site. Secondly, new technologies are allowing for further efficiencies, most notably through automation, remote mining and driverless vehicles, which enable producers further control over costs. Thirdly, we see continuous improvements across the industry as management teams seek efficiencies. For example, the growing use of renewable energy at mining projects offers further cost benefits. Oil amounts to c.20% of miners’ costs, yet we expect this to continue to be reduced as renewables, notably solar, offer a viable alternative. The growth of renewable use among miners is likely to grow in significance particularly as carbon taxes come into force.
Capital cost inflation is a more significant issue for the industry, with some companies facing inflation of around 30%, primarily due to logistics costs and supply chain issues. Rising CAPEX is a particular problem for companies under pressure to build large new projects to increase or sustain production. Yet a selection of miners with brownfield development projects, allowing these companies to grow without having to see costs rise to the same degree as for new projects. Companies with these types of assets remain our preference.
Our objective is to invest in producers which will see margin expansion under these market conditions, primarily through controlling cost inflation while benefiting from higher gold prices. Overall, the gold mining sector is in a healthy shape, following years of capital discipline and a focus on costs in the wake of the last bear market for gold. While Q3 2021 operating results were weaker than expected, in part due to rising costs, most companies generated robust free cash flow. There is variation among companies with regard to how explicitly cost inflation is indicated and we expect to have a clearer picture in early 2022. Overall we consider that discipline is being maintained by most mid- to large-cap precious metals miners, which are typically utilising gold prices of USD 1200-1350/oz for reserves and planning. However, we are seeing some junior companies raising price assumptions. Overall producers’ margins have remined strong, given that the average all-in sustaining cost for the gold industry is around USD 1100/oz, shareholder returns are increasing, and we see the potential for significantly higher dividends as margins continue to expand.
Sustainable and growing organic production is being demonstrated by the leaders in the sector, while exploration investment is being increased by many high-quality companies, yielding encouraging results. In contrast, certain lower quality companies face problems of reserve replacement. Selective M&A is coming into focus, with Canadian targets being mentioned most often due to significant tax pools sitting with potential acquirors.
Environmental, social and governance (“ESG”) reporting is now increasingly common throughout the sector and access to high quality data is a key issue for Baker Steel, as active investors in this sector. Our team has been ahead of the pack in adopting a regulated, rigorous and informed approach to ESG, and we see evidence that this approach results in superior potential returns. Baker Steel’s ESG framework covers initial pre-screening of companies, scoring across 38 metrics, integration of company ESG scores into investment decision making, and ongoing monitoring and engagement. We believe our comprehensive ESG framework and active engagement with ESG issues places Baker Steel among the leaders in mining ESG investment.
A turning point for the precious metals sector
For much of 2021 the precious metals sector has remained mired in negative sentiment as gold prices faced headwinds from investor concerns over potential nominal interest rate hikes and the belief that the inflationary forces impacting the post-COVID global economy would fade. While some factors driving inflation do appear temporary, such as rebounding consumer demand and vulnerable supply chains in the wake COVID-19, others such as structural changes to supply chains and unprecedented money supply growth seem likely to persist and potentially grow in significance in the months ahead.
We believe we have now reached the turning point where evidence indicates we are entering a period of sustained higher inflation, with nominal interest rate hikes likely to remain limited in scope and now largely priced in. History suggests that such an economic environment will be highly supportive for gold and silver, primarily due to its impact on real interest rates, which appear likely to remain negative and will perhaps fall further. Time will tell whether inflationary factors persist, but the choice facing investors today is clear. Inflation poses a threat to traditional portfolios, focused on general equities and bonds, and need for diversification has never been more apparent. Real assets are likely to become increasingly attractive and gold, as the ultimate real asset, faces a potentially strong pick-up in demand in the months ahead as investors seek protection from rising prices.
Given the healthy current position of gold miners, which show strong margins and rising shareholder returns, the sector appears poised for a period of recovery and outperformance. As active managers in this sector we consider that the current undervaluation of precious metals equities makes this sector attractive at current gold prices. Yet should a new era of inflation send gold prices to new highs, we believe an actively managed portfolio of gold equities, with a focus on high-quality stocks, robust risk management and ESG, has the potential to achieve returns which are significantly higher than those delivered by a passive investment in gold or gold equities.
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