July 02, 2021
The gold price was flat this week at US$1,776/oz and held at around this level for the second week, after a rebasing down from almost a month averaging just below US$1,900/oz, on fears of an earlier-than-expected Fed taper or rate hikes.
This week is a (mainly) macro look at our view on inflation, the Fed's reaction to it and a potential new US housing market bubble (For more on specific junior gold stocks, see our recent reports 'Transition to Production' and 'Newfoundland Gold').
The producers and juniors declined, with the GDX down -1.4% and GDXJ down -2.5% while the Canadian juniors were mixed, as investors saw better short-term opportunities in other sectors given the recent pressure on the gold price.
Gold continues stagnate for second week after rebasing downward
Gold was flat this week, holding at US$1,776/oz, holding around this level for the second week, after rebasing down from three weeks where it was nearing an average of US$1,900/oz. This move down was driven by fears of a sooner-than-expected taper and rate hikes by the US Fed, driven by high inflation from a US economy that in many ways is heating up significantly, which continued to weigh on gold. However, all of these potential Fed moves are targeted by 2022 at the earliest, which gives inflation plenty of room to run. We view the Fed as 'playing chicken' with inflation, which reached 5.0% in May 2021, its highest since the global financial crisis and well above the Fed's target of 2.0%. The Fed has a target for inflation of just 3.4% for 2021, as it sees the rise in prices mainly being caused by the US, and global, economy having operated under capacity, and rebounding off a low base.
We see inflation driven as much by 'monetary mania' as the 'low-base-effect'
This story would seem plausible to us if the Fed hadn't also gone an epic monetary expansion which we view just as responsible (if not more) for the current inflation as the effects of prices rising off a low base in 2020 and supply chain disruptions. We believe that this surge in the money supply over the past year gives inflation significant scope to substantially overshoot expectations this year, and could force the Fed into a very difficult position. We question if the Fed is really willing to drastically hike rates and crush a surge inflation, as it could likely lead to both a major economic downturn and a crash in equity markets.
The last time inflation truly got of control was the 1970s and early 1980s
The last time the Fed faced extreme inflation and took truly drastic measures to curb in was in the early 1980s, when inflation had been high for nearly a decade, peaking with two spikes, at 12.2% in November 1974 and 14.6% in March 1980 (Figure 4). Fed Chairman Paul Volcker, tasked with bringing inflation under control, made a massive hike in interest rates, sending the 10-year US Bond yield to a peak of 15.1% in October 1980. While this certainly curbed inflation, smashing it down to just 2.4% by July 1983, it also drove a major recession. Inflation has never really been high in the US since, and the current period is the only one in 40 years where it truly is in the position to get out control, given the amount of US dollars printed over the past year.
It would be difficult for the Fed to make huge rate hikes currently
Does the Fed really have recourse to inflation-smashing giant rate hikes currently? We don't believe so. The current situation is quite different to the early 1980s, when exorbitant inflation had gone on for so long that the population was willing to accept tough measures to end it. Currently price increases have only been high for a couple of months, not at all enough for inflation fatigue to set in for the average consumer. We believe a major rate hike, even if inflation starts to soar, with the economy in a structurally unsound position after the disruptions of the past year and with stock market valuations at all-time highs, would not be feasibly economically or politically.
Inflation could take off, sending up gold too, 1970s-style
Given all this, we expect that inflation could come in well above expectations for months, while concrete Fed action is unlikely until 2022 at the earliest, and we believe that gold could benefit. We have seen that while there was much talk of reducing stimulus after the global financial crisis, actually there was only a very short period since then when Fed's balance sheet contracted, from mid-2018 to mid-2019, before the epic expansion of 2020 (Figure 5). If this trend of endless expansion continues, we believe that the tsunami of money of the last year will reach consumer prices and wages, and send inflation soaring, sending gold up in tandem, similar to the 1970s.
Signs of inflation surging are everywhere, not just in consumer prices. The US employment situation has been heating up significantly with job openings soaring (see our Weekly from June 11, 2021), and many workers may feel they have leverage with employers to ask for increased wages to offset rising prices. This has in part been cause by the rebound in the economy, but also by an atypical cause, which is that many potential workers are still living well on stimulus payouts, and not in a rush to return to work. Meanwhile, there are signs that many who are still employed, and working remotely, are planning to resign if they are required to come back to the office as lockdowns end. This may continue to cause a sellers' market for employees, who may demand higher wages, which may not be offset by the deflationary effect of the 'unemployed' that have not needed to drastically cut back on purchases because of stimulus checks. This could all further exacerbate inflationary pressures for the second half of 2022, and in turn, support gold.
Yet another set of indicators showing rising inflation is US housing data. Growth in the US Home Price Index has surged to 13.9% year on year, even higher than the peak of the 2000s housing bubble, at 13.4% (Figure 6). US housing starts were 1,572k in May 2021, which is well below the height of the mid-2000s bubble, when housing starts peaked at 2,273k in January 2006 (Figure 7). However, with the current US administration's policy to considerably expand home lending, housing starts could continue to rise (although this may be held back short-term by surging lumber prices on global supply chain disruptions). While mortgage rates have risen from lows of 2.65% in January 2021 to 3.02% in June 2021 (Figure 8), they are still near historical lows in a long-term context, having declined for over forty years from a peak of 18.5% in October 1980 (Figure 9). This is yet another market where inflation is starting to surge, but a major rate hike to curb it would not be economically or politically feasible.
Where we could be wrong, Part 1) The Return of Volckerian Economics?
We always need to consider the counter arguments to our hypothesis, including a scenario where we are very wrong, and once again gold falls into a long downturn. In this scenario, inflation would take off as we expect, but the Fed would not only holdto its minor planned rate hikes, but go after inflation in true Volckerian-style, smashing it below its target, economy and stock markets be damned. We just don't see that playing out in reality and believe that the Fed, in the end, will need to just keep printing in perpetuity. A major reduction of its balance sheet, or the US money supply or debt stock will just not be practically feasible, as it hasn't been for the past decade.
Where we could be wrong, Part 2) The Market Buys the Fed's Bluff (for now)
Short-term, we could be wrong because the market believes that the Fed will be able to raise rates, while the economy, stock and real estate markets continue to gain. This is the idea of 'beneficial inflation' with the price increases a sign of a strong economy, growing from solid foundations, with a fundamental pick-up in demand. With this belief, already playing out to some degree in recent few months, the markets sell off gold to buy these other assets. We believe, however, that the current expansion is hardly built on solid ground, with the inflation is driven more by extreme monetary expansion than a structurally rooted pickup in demand. Inflation is already well above Fed targets, and if it continues up, the market may realize the situation is not as under control as they thought, which should drive up gold.
Where we could be wrong, Part 3) Inflation really does subside!
Another way we could be wrong is that inflation really has only been driven by the low base effect and global supply chain disruptions and does subside in the second half of the year. If this is coupled with a continued pickup in the economy stock and housing markets, we could see investors leave gold for these other assets. However, given all the signs of inflation already, and the epic monetary expansion of the past year, we do not believe that strong growth can continue without major inflation. One of the reasons that gold remained low in the mid-2000s and the mid-2010s, was that while asset bubbles were clearly developing, consumer price inflation never really picked up, so the Fed was able to get away with very loose monetary policy.
Another miraculous cycle of 'asset-bubbles-without-inflation' unlikely this time
We do not expect to see asset bubbles together with low inflation for this cycle. We are already facing very elevated stock market valuations, a rebound in the housing market and economic distortions caused by global-health crisis. This is a very different economy from post-2003 when the housing bubble started, and post-2009, when the 'everything' (stocks, bonds and real estate) asset bubble started. Both of these periods were after a considerable crash, with economies and markets coming off low levels with a great deal of excess already purged. That is not the case currently, with the economy back to its already high pre-global-health-crisis levels, and the stock market at all-time highs. We are hardly coming off a bottom here.
The major gold producers were nearly all down this week even as the gold price stayed flat (Figure 10). News flows included Newmont's launch of its first Climate Strategy Report and Barrick signing a letter of intent with Scandium regarding studies on the Phoenix mine and backing a decision supporting its Clean Water Certification for Donlin, its 50/50 JV with Novagold. B2Gold began international arbitration in Mali relating to the Menankoto permit, Novagold reported its Q2/21 results and Equinox announced that mining activities were underway at the Santa Luz Gold Mine in Brazil (Figure 12).
The Canadian juniors were mixed this week as gold saw no change (Figure 11). For the Canadian juniors operating domestically, Tudor announced a non-brokered private placement for $6.0mn, with the first tranche of $1.5mn closed, Amex reported drilling results from the High Grade Zone at Perron and Probe will begin a 4,500 m drilling program in July 2020 with JV partner Midland Exploration at the GaudetFenelon project (Figure 13). For the Canadian juniors operating mainly internationally, Rupert reported its annual results for the year to February 2021, Bluestone gave an update on its H1/21 operations and Integra reported progress on its ESG program. Chesapeake reported drilling results from Metates, including a higher-grade component from which to build the foundation for a new plan, and Gabriel announced the pricing of the repayment of its convertible unsecured notes (Figure 14).
Disclaimer: This report is for informational use only and should not be used an alternative to the financial and legal advice of a qualified professional in business planning and investment. We do not represent that forecasts in this report will lead to a specific outcome or result, and are not liable in the event of any business action taken in whole or in part as a result of the contents of this report.