The Superlative Impact of SupermajorsJoe Foster, Portfolio Manager, Gold StrategyFebruary 08, 2019
Gold breaches $1,300 level amid Fed moves
Gold spent most of January consolidating December’s gains in the $1,280 to $1,295 per ounce price range. On January 25, gold moved through the psychologically important $1,300 level as markets began to anticipate an earlier-than-expected end to the Federal Reserve’s (Fed’s) bond portfolio sales. The market’s suspicions were confirmed on January 30 when Fed comments following the Federal Open Market Committee (FOMC) meeting stated that it is prepared to alter the size of its balance sheet if conditions warrant a more accommodative policy. This suggests the Fed is, indeed, in “pause” mode, and that future market and economic conditions will determine whether the next move is to revert back to easier crisis-era policies. As a result, gold advanced to a nine-month high to end January with a $38.76 (3.0%) gain at $1,321.20. Gold stocks gained as well with the NYSE Arca Gold Miners Index (GDMNTR)1 advancing 7.5% and the MVIS Global Junior Gold Miners Index (MVGDXJTR)2 up 9.5%. Mining news was dominated by the Newmont Mining Corporation-Goldcorp Inc. merger (5.8% and 2.2% of net assets, respectively*), which is discussed later in this commentary.
Signs of softening growth emerge globally
While the Fed is clearly concerned about the health of the U.S. economy, reports released elsewhere in January show mounting concerns globally as well. China’s Caixin manufacturing survey3 posted a contraction reading, German industrial production fell 4.7% year-on-year, while France’s annual GDP growth slowed to 1.5%. The Organization for Economic Co-operation and Development (OECD) Composite Leading Indicator suggests 2019 global growth is losing momentum. On January 28, the European Central Bank (ECB) president said the central bank is ready to use all its policy tools to support Europe’s softening economy.
Central bank purchasing of gold picked up in 2018
While the U.S. dollar index (DXY)4 fell slightly in January, it has not relinquished its 2018 gains due to the growing economic weakness outside the U.S. Accordingly, the gold price advanced across most local currencies as well as the U.S. dollar in January. This is historically safe haven5 behavior when investors sense increasing financial risks globally. The World Gold Council reported that central banks purchased net 651 tonnes of gold in 2018, the second highest total on record. Central banks have been net purchasers of gold since 2010 as more countries are finding a need to diversify their paper currency reserves. China was a consistent buyer earlier in the decade, but has not reported any purchases for nearly two years. However, China reported an increase in gold reserves of approximately 10 tonnes in December. It remains to be seen if this signifies a resumption of regular Chinese buying.
Central banks are out of the time needed to normalize policies as they make preparations to stimulate the economy through the next recession. It looks like the new normal is a Fed funds rate6 that has peaked at just over 2% and a balance sheet that bottoms at $4 trillion. Meanwhile, the ECB can’t get its policy rate above negative 0.4% after purchasing $3 trillion of bonds. What will the financial system look like when the Fed funds rate is zero (or less), fiscal deficits exceed $2 trillion annually, and the Fed bond hoard tops $10 trillion? We may find out in 2020.
Gold eyes $1,365 price ceiling in 2019
The recent shift in Fed policy was the catalyst that moved gold through its first significant price hurdle of the year, past $1,300. It is looking like gold could now test the much more formidable $1,365 level that has acted as a price ceiling for five years now. If further fundamental risks develop around Brexit, the economy, or the stock market, then perhaps gold and gold stocks finally move into a higher price range.
Newmont-Goldcorp joins supermajor class amid focus on profitability
The structure of the gold industry has changed with the announcement of a second blockbuster merger in January. The first was the Barrick Gold Corporation-Randgold Resources (6.6% of net assets*) combination announced last September. Not to be outdone by Barrick, Newmont announced plans to acquire fellow senior producer Goldcorp in an all-stock deal valued at $10 billion to create the world’s largest gold company. Like Barrick, Newmont intends to sell non-core mines to focus on a smaller portfolio of larger, higher quality properties. However, the new Newmont will have 21 mines (Barrick has 13), so integrating Newmont with Goldcorp will be a challenge.
The current management of Goldcorp was a disappointment. Since taking charge of the company three years ago, they have missed earnings expectations half of the time and the stock has underperformed the GDMNTR by 72%. As a result, Newmont is acquiring an excellent suite of assets at a discount and Goldcorp shareholders will get the quality management they have long been waiting for.
There are a number of implications this transaction will have on the industry that we find interesting:
- These mergers create an exclusive class of majors that no other company or combination of companies will be able to replicate. Supermajors Barrick and Newmont will produce between five million and eight million ounces per year. Majors Agnico-Eagle Mines Ltd. (4.8% of net assets*), Kinross Gold Corporation (2.2%*), Newcrest Mining Ltd. (1.0%*), Anglogold Ashanti (not owned), and Gold Fields Ltd. (not owned) have production ranging between two million and four million ounces per year. The supermajors will have unmatched economies of scale and the liquidity to attract the largest institutional investors.
- These aren’t your father’s gold companies. Today’s companies have a streamlined management structure, proper incentives, and the experience of past mistakes to drive value creation. Nonetheless, execution will be challenging for these two behemoths.
- In the gold industry, bigger isn’t necessarily better. From 2001 to 2015, we were underweight or avoiding Barrick and Newmont because they had become too big and unwieldy to create value. History has shown that acquisitions often don’t pay off, and having too many mines becomes difficult for a company to manage. A number of mid-tier CEOs have commented that six to eight mines are optimal.
- Past cycles saw majors merge to get bigger. This cycle they are merging to become more profitable. The managements of Newmont and Randgold believe they can instill proven management structure, efficiencies, and technology in their new companies. They are also looking to divest mines that don’t meet their return hurdles. If successful, they will be smaller (though still supermajors), more profitable companies in a couple of years.
- There are roughly ten mines between the two supermajors with values ranging between $100 million and $1 billion that are now up for sale. The potential buyers are the majors and mid-tiers. We know many examples of aging mines that were neglected or undercapitalized, but later became successful core properties after being sold to a smaller company. We hope to see more win-win transactions that bring a source of growth and value creation to the majors and mid-tiers.
Newmont and Barrick are now in the top five holdings in our portfolio.* Through the low gold prices of the past six years, we have seen financial, operating, and capital discipline that we believe is here to stay. Corporate structures are flatter and more responsive. We expect the supermajors to create value and set new standards for the industry.
IMPORTANT DEFINITIONS AND DISCLOSURES
*All company weightings, if mentioned, are as of January 31, 2019, unless otherwise noted.
Any indices listed are unmanaged indices and include the reinvestment of all dividends, but do not reflect the payment of transaction costs, advisory fees or expenses that are associated with an investment in the Fund. An index’s performance is not illustrative of the Fund’s performance. Indices are not securities in which investments can be made.
1NYSE Arca Gold Miners Index (GDMNTR) is a modified market capitalization-weighted index comprised of publicly traded companies involved primarily in the mining for gold.
2MVIS Global Junior Gold Miners Index (MVGDXJTR) is a rules-based, modified market capitalization-weighted, float-adjusted index comprised of a global universe of publicly traded small- and medium-capitalization companies that generate at least 50% of their revenues from gold and/or silver mining, hold real property that has the potential to produce at least 50% of the company’s revenue from gold or silver mining when developed, or primarily invest in gold or silver.
3China’s Caixin manufacturing survey is based on data compiled from monthly replies to questionnaires sent to purchasing executives in over 400 private manufacturing sector companies.
4U.S. Dollar Index (DXY) indicates the general international value of the U.S. dollar. The DXY does this by averaging the exchange rates between the U.S. dollar and six major world currencies: Euro, Japanese yen, Pound sterling, Canadian dollar, Swedish kroner, and Swiss franc.
5A safe haven is an investment that is expected to retain or increase in value during times of market turbulence. Safe havens are sought by investors to limit their exposure to losses in the event of market downturns.
6In the U.S., the federal funds rate is “the interest rate” at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances.
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