Gold is Back

2022 was meant to be the year when normality returned to the world economy. Workers would be back at the offices, consumers in the shops and container ships ferrying cargo across the world economy. But then Russia invaded Ukraine. And as Vladimir Putin’s tanks rolled across the eastern steppes, they set off an economic chain reaction that is being felt far beyond Kiev.

The gold price reacted immediately, reaching a peak of $2,070 per ounce in March, just a few dollars off the all-time record it set during the pandemic. After all, one of the main reasons for owning gold is that it acts as a safe haven is crisis.

The dramatic uncertainty of the early weeks of the war has faded into a grim realisation that the conflict will grind on, ending in either a bitter stalemate or brokered peace deal. While that’s not pleasant for the combatants it does take some of the more extreme scenarios – such as a direct confrontation between Nato and Russia – off the table. Analysts expect that stalemate to reduce gold’s ‘war premium’. Indeed, it has already dropped back to the mid $1,900s. But while the direct impact of the conflict on the gold price may dissipate, the indirect effects will continue for years.

One of the subtle consequences of the war is that it finally demonstrated the differences between the yellow metal and its most recent competitor, digital gold. Crypto currencies plummeted on the outbreak of war, while gold saw record inflows. Bitcoin fell 28% during the run-up to war, while gold – the ultimate store of value that has withstood thousands of years of human folly – steadily gained over the same period. Purchases of gold exchange-traded products hit an all-time high in March, attracting $11.3billion of capital in one month alone.

Inflation fears

Even if the war finishes soon – and hopefully it does – investors won’t abandon gold just yet. That’s because the invasion, coming so soon after the pandemic, has created an inflationary, low-growth environment that is ideal for the yellow metal. Russia is the world’s third-largest crude producer, but if you include gas-derivatives such as LPG, it is the largest exporter of oils to the global market. And, together with Ukraine, it also accounts for 25% of world wheat exports. So the war, and resulting sanctions, have pushed up prices across the world economy.

As Merryn Somerset Webb, points out in the Financial Times, the 2020s are starting to feel worryingly like the 1970s. “The 1960s saw one of the longest expansions on record. That emboldened policymakers to both prioritise full employment over low inflation (inflation did not appear to be the relevant risk) and to develop more activist fiscal policy. This was the backdrop to a fabulous bull market. The FTSE All-Share index doubled in the two years to January 1969, when it peaked on a record price/earnings ratio of 23 times. Then came a huge energy shock which built on previous inflationary rumbling, wages started rising and the money supply surged. Policymakers blamed temporary factors — and stripped them out of the inflation numbers they used as their reference point.”

If stagflation – stagnating economic growth and high inflation – does come back, then the yellow metal will be one of the few ways investors can protect the real value of their capital. That explains that why total gold ETP holdings are less than 2% below the all-time high recorded in October 2020. The war fears are fading but the inflation worry is growing. It’s not just gold ETFs that are in demand. Physical gold is being snapped up by retail customers, mainly in China and India, where gold has typically given savers more peace of mind than fiat currencies. There is also an increase in central bank purchases, for example, Russia will buy all of its miners’ output this year, to bolster gold reserves in its sanctioned economy. Indeed, many countries will have taken note of how the US and its allies have unleashed financial warfare on Russia and will be bolstering – either officially or unofficially – their gold purchases as a result. Indeed, Goldman Sachs cited all of these factors, when it raised its gold target price for 2022 from 2,050 to $2,500.

Restricted gold supply

Latin America’s gold miners will play a crucial role in meeting this extra demand for the yellow metal. Peru and Mexico are top ten producers, while Ecuador and Argentina have incredible potential. But it won’t be easy. Mined gold production was lower in 2021 than it was in 2018. Some of that can be blamed on the pandemic but structural issues are also at work. Lower ore grades reduce the output of existing mines, while increasingly complicated social issues slow the development of new ones.

If we look at the period from 2010 to 2019, so that we strip out any pandemic or Russia-Ukraine impact, the structural challenges in gold production are clear. Analysis from S&P Market Intelligence found that 16 of the world’s largest 20 gold miners saw their overall remaining years of production fall over the period. That includes some of the biggest names in the sector: Newmont Corporation, Barrick Gold, AngloGold Ashanti and Kinross.

That doesn’t mean that we have reached ‘peak gold’ or that production will fall year-on-year. However, the clear restrictions on ramping up gold production against a scenario of rising demand, will likely push prices higher. In turn, those high prices will provide the economic incentives for projects to be developed over the medium to long-term and Latin America can play a key role as it is home to some of the world’s largest potential gold projects.

In the Dominican Republic there is a $1.3billion project to increase output at the Barrick and Newmont joint venture, Pueblo Viejo, to 800,000 ounces per year. A $2.5billion sulfides extension at Newmont’s Yanacocha mine in Peru, would deliver production of 525,000 oz/y. While if Equinox Gold builds a new processing plant in the Los Filos mine in Mexico for ‘just’ $250million it would increase the existing production of 200,000 oz/y to 300,000 ox/y. The projects are forecast to deliver around 1.4Moz/y gold or gold equivalent in the coming years.

Traditionally gold miners have offered investors a leveraged way to play the gold price. That is to say, when gold goes up, the share price of a good miner should enjoy even bigger gains. That explains why the gold miner index has outperformed the S&P500 for the last three years. The current production challenges with community relations and ore grades will increase the premium that investors are willing to pay for a successful gold miner operating in a time when the world wants more of the yellow metal.