Actionable Advice as Gold Glimmers Despite Gloomy Outlook

Is the Gold market Undervalued?

There are signs the market may be currently undervaluing public gold mining companies.

• Gold miners have underperformed bullion over the past year, with the GDX gold miner ETF up only 4% versus gold up over 8%. This divergence suggests miners are lagging behind gold's upside.
• The average price-to-earnings ratio for large gold miners is currently around 16x. Historically, ratios above 18-20x have been common when gold prices are elevated. This implies miners are cheap relative to current gold levels.
• The average price-to-cash flow ratio for major gold miners is approximately 6x. The historical average is closer to 8-10x, signalling miners are discounted on a cash flow basis.
• Trading multiples for gold miners are well below broader market averages. The S&P 500 P/E is around 20x and the average EV/EBITDA is over 12x. Gold miners trail on both profitability metrics.
• Management teams are guiding for strong growth in production, margins, earnings, and cash flow over the next few years at current gold prices.
• Dividend payouts and share buybacks continue to rise across the mining sector, highlighting management's bullishness on cash generation potential.
• Gold mining shares typically outperform bullion early in new uptrends as investors recognize their operating leverage. This outperformance has yet to materialize.

However, miners do face cost inflation, permitting risk, and variable ore grades that could constrain upside. Overall, gold miners appear attractively valued today, but conducting Due diligence on financials and management execution is still critical when investing.

Actionable Advice

Here are some potential actionable steps investors could consider based on the current environment and gold's outlook:

• Maintain an allocation to gold in your portfolio for diversification and downside protection. A 5-10% allocation is generally recommended.
• Consider adding to gold positions on pullbacks. With prices up strongly year-to-date, dips could provide attractive entry points.
• Evaluate reducing exposure to overvalued equities trading at high sentiment levels. Rotating some assets from equities into gold could help hedge risks.
• Look for gold mining stocks that offer upside leverage to gold prices. Miners often outperform bullion in rising price environments.
• Choose physically-backed gold ETFs for liquid exposure. Avoid products with excessive fees or complex structures.
• For sophisticated investors, explore tactical trades using gold futures or options to capitalize on short-term price swings.
• Keep a long-term perspective on gold. It tends to perform well during periods of economic uncertainty and market volatility.
• Discuss incorporating gold into your portfolio with a financial advisor to align with your individual risk tolerance and investment goals.

How Should I View Gold as an Investment?

The key is to see gold as an important portfolio diversifier, rather than trying to time short-term moves. A prudent gold allocation can provide critical drawdown protection when you need it most.

Gold posted solid gains in July, rising 3.1% to end the month at $1,971 per ounce. This brings the year-to-date return to 8.7%, as ongoing economic concerns continue to drive investors toward the safe-haven asset. The July increase was driven primarily by a spike in breakeven inflation rates and a weaker US dollar. Breakeven rates rose sharply on the back of stronger-than-expected economic data, suggesting the bond market sees the data as more indicative of inflation rather than genuine growth. This aligns with the bond market's overall narrative that the economy is heading for a hard landing, while the equity market remains focused on the potential for a soft landing.

The dollar weakened against major currencies, adding further support to gold prices. However, rising Treasury yields and continued outflows from gold-backed ETFs limited the upside for gold last month. ETF outflows persist but futures demand offsets Global gold ETFs shed another 32 tonnes in July, split between North American and European funds. But COMEX positioning data showed managed money net longs increased by 93 tonnes, more than offsetting the ETF outflows. This suggests futures speculators are more optimistic about gold prices than ETF investors heading into the second half of the year. Total known ETF holdings now stand at 3,387 tonnes, down 34 tonnes in July but still up strongly from the start of the year. The combined assets under management for global gold ETFs increased 2% month-over-month to $215 billion despite the outflows, as the higher gold price boosted valuations.

Let's Talk about August

Seasonal trends may not boost August this year. Historically, January and August have been the strongest months for gold price gains. August's strength may be partly explained by seasonal factors like weak bond yields, pre-emptive safe haven demand ahead of September equity volatility, and physical gold purchases in India and China.

However, this year those typical August drivers look unlikely to materialize to the same degree. Here are some of the key factors suggesting a more challenging August for gold this time around:

• High local gold prices and weak economies in India and China will likely dampen physical demand
• Equity markets have so far shrugged off weak internals and high sentiment, buoyed by a strong Q2 earnings season
• Lower implied volatility has made protective put options highly affordable, reducing hedging demand for gold
• Treasury yields could trend higher on favorable inflation/growth outlooks and Japan repatriations

On the other hand, some dynamics still look supportive:

• Japan's yield curve control tweak may increase volatility and weaken the dollar
• COMEX positioning is not overextended and leaves room for more investment inflows
• Risk of a second wave of US inflation remains as wages and leading indicators rise
• Stocks still look overvalued and sentiment remains elevated with risks ahead

Economic risks outweigh data optimism

July data releases painted an optimistic picture of solid growth and cooling inflation in the US economy. This likely contributed to the ongoing ETF outflows and softer coin demand that month. The Fed also delivered what is expected to be the final rate hike of this hiking cycle, further boosting hopes of a soft economic landing.

However, many leading indicators continue to flash warning signs about the road ahead. For example, the recent debt rating downgrade and massive increase in government borrowing limits are the latest negative signals, on top of:

• Declining commercial/industrial loan demand
• Widening credit spreads
• Falling LEI economic indicator
• Lower state and local tax revenue
• Slowing real wage growth
• Rising bankruptcies
• Deteriorating retail sales

This suggests the overall balance of risks remains tilted toward the downside, despite some short-term data improvements. And historically, high inflation periods almost always come in waves rather than steadily declining straight lines. The key investment takeaway is that economic concerns and market volatility are likely to escalate again over the next few months. And during such periods of uncertainty, gold has proven itself time and again as an attractive safe haven asset and portfolio diversifier.

Let's examine the key regional gold markets

China

• Average gold price hit a new record high of 456 RMB/gram in July.
• But physical demand remains lackluster, with daily trading volumes declining month-over-month amid seasonally weak Q3 demand and the elevated local gold price.

United States

• Growth and inflation data releases were positive in July, likely contributing to ongoing ETF outflows.
• July also saw the expected final Fed rate hike of the current cycle, further boosting economic optimism.

Europe

• The ECB and BoE hiked rates again in July to combat inflation.
• But peak rate expectations are now shifting earlier to October as the economic outlook deteriorates.
• European gold ETFs saw another $1.3 billion of outflows in July.

Central Banks

• June purchases of 55 tonnes marked the first significant monthly net buying since February.
• Purchases from Turkey, China, and Poland offset minimal sales elsewhere.
• This reinforces the underlying positive central bank buying trend seen in 2022.

safe-haven

• Global gold ETF outflows continued in July but slowed from June levels.
• Outflows were concentrated in Europe and North America while Asia saw minor inflows.
• Falling holdings were offset by a higher gold price, leading to a 2% increase in total assets under management.

In summary, gold demonstrated its value as a resilient asset class in July, posting solid gains amid a deteriorating economic outlook. While speculators trimmed their gold exposure, overall investment demand remains robust based on elevated ETF holdings and COMEX positioning. Gold may face some seasonal headwinds in August, but looming economic risks should drive a renewed uptick in safe haven demand as 2023 progresses. For investors seeking assets with both growth and defensive qualities, gold remains a compelling portfolio addition at current levels.

The current elevated gold price level should be beneficial for gold mining companies

• Higher gold prices directly boost miner revenues, earnings and cash flows. Most miners can generate profits at lower price levels, so current prices provide an earnings tailwind.
• Improved profitability enables miners to pursue growth activities like expanding operations, developing new projects, and acquiring additional assets. These moves can further ramp up production and earnings.
• Stronger balance sheets allow miners to increase exploration budgets to replenish reserves. More spending on drilling and deposits can support long-term output.
• Some miners may use the profit windfall to pay down debt, bringing leverage ratios down to more comfortable levels. Lower debt reduces risk and financial costs.
• Shareholder returns can be enhanced in a higher gold price environment through increased dividends and share buyback programs.
• Higher cash flows support stronger credit profiles and improved access to capital on attractive terms. This provides financial flexibility.
• Greater profitability makes gold stocks more appealing from a valuation perspective, especially compared to miners operating in a low gold price environment.

Of course, cost inflation and supply chain issues may pressure miner profit margins. But overall, the current gold price gives quality gold producers significant earnings and cash flow upside compared to recent years. The long-term outlook appears very favorable for well-run gold mining companies.

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