“Gold suffered its largest quarterly selloff in the first quarter (Q1) of 2021 since 2016, down 10.0% (to US$1,707 per troy ounce) with prices dropping below US$1,700 for two separate days in March. A rise in the US dollar’s trade-weighted value, a rotation into riskier assets, and selling pressure after US Treasury yields jumped to their highest point in nearly 11 months all weighed on gold early in the year. Rising bond yields generally dimmed the metal’s appeal, with holdings in physical gold exchange-traded funds (ETFs)—a key pillar of support for bullion’s surge to record highs in 2020—extending declines as outflows continued through April. Essentially, last year’s ETF demand became a new source of supply in 2021 as gold bars were liquidated from ETF vaults.
“In April, gold prices edged higher as markets began to normalize and traditional sources of demand such a jewellery began to recover.
“Interestingly, growing inflation worries have not corresponded to higher gold prices so far, although, to be fair, current reported inflation numbers remain subdued thanks to low interest rates and technology-related efficiencies. Despite notable improvement in the United States, China and elsewhere, the global economy is still under extreme stress after a year of pandemic-induced lockdowns, and the path to a full global recovery is unlikely to be smooth in all parts of the world. We believe that inflation will feature prominently in many countries as governments look to deflate their way out of the debt they have had to take on in the crisis. This may drive regional demand for gold as a proven alternative to holding paper money in inflationary environments.
“Aside from traditional currency effects, gold market analysts speculate that Bitcoin and other cryptocurrencies might be replacing gold in some investors’ minds as an inflation hedge. However, we see significant differences in the way many governments view and treat cryptocurrencies compared to gold, and we certainly see government regulations as a major risk factor that does not exist to the same degree for gold given the long history and central banks’ heavy involvement in the gold market.
“In our view, a turbulent 2020 leaves lingering uncertainty in the gold markets but also presents several areas for demand to grow. Indian demand for gold in 2020 was at its lowest level in the World Gold Council’s data series, leaving significant room for increased demand moving forward as the economy hopefully normalizes. Global central bank buying fell off in 2020 as cash was deployed to stabilize economies and provide economic stimulus, but gold may again find favour with central banks if interest rates remain historically low and global currency markets become choppy.
“Germany was a standout market in 2020, as the country’s negative interest-rate environment seemed to increase the allure of gold as a store of value. Germany surpassed India to claim the second-highest retail market in the world behind China.2 The Q1 World Gold Council demand report featured a 52% year-over-year recovery in global jewellery demand — the strongest quarterly start to any year since 2013, and indicative of the economic recovery in many parts of the world.3 Bar and coin investment was also up 36% on a year-ago basis, boosted by gold’s pullback from the 2020 highs and concerns about building inflationary pressures.4 If gold ETF investor interest stabilizes and some of the more traditional markets continue to recover and grow, we believe this could be supportive for gold.
“Gold prices averaged US$1,798 per ounce in Q1 2021 — slightly below the fourth-quarter average of US$1,876 but still at a level that should support strong free cash flow for gold producers, and significantly above the Q1 2020 average of US$1,582. Gold mines have resumed operations following pandemic-induced shutdowns, which we believe leaves them better-positioned to benefit from still-elevated gold prices.
“Although the gold-mining industry’s coronavirus safety precautions (including travel restrictions) have resulted in slightly higher production costs, gold prices moved up much faster than costs over the past year, leaving room for strong margin expansion.
“Other precious metals such as platinum, palladium and rhodium have very different supply and demand profiles, but all of these metals are seeing upward price movement so far this year. Palladium prices pushed to new all-time highs in April, while rhodium, used in automotive catalytic converters to remove nitrogen oxide, ended April very close to its all-time high set in March, with prices seeing a nearly fourfold increase since April 2020 to just shy of US$30,000 an ounce. Moreover, the April-end price level for rhodium — considered the rarest and most valuable precious metal in the world—was almost 40 times higher than it was just five years ago based on higher demand from the automotive industry to meet stricter emission norms.”
A Supportive Environment for Mining Companies
“Gold has had a very low correlation with other asset classes over time, but gold industry equities have remained fairly closely correlated to gold bullion price trends. Many gold producers struggled to generate free cash flow in a US$1,250-per-ounce gold environment, as total costs for many of them are close to that level, according to our analysis. Mining costs tend to be relatively fixed, so the current higher gold prices can flow straight through to the bottom line.
“Given several years of underinvestment by the gold industry, we expect a pickup in merger and acquisition (M&A) activity in 2021, although the pace continues to be impacted in the near term by travel restrictions and other pandemic-induced business impairments. We have already seen several M&A deals in the first four months of 2021 and expect this to continue.
Although the pullback in gold from the 2020 highs is noteworthy, we believe the opportunities in gold - and precious-metals-focused equities are even more compelling, especially if gold prices can hold current levels or move even higher. Many gold companies have seen their forecasted cash flows increase faster than their stock prices over the past year, resulting in contracting equity valuation multiples despite the improving fundamentals.
“Given the metal’s modest selloff thus far in 2021, many gold producers have unsurprisingly underperformed the broader equity market; however, we think gold prices remain at very supportive levels for most mining companies. Additionally, higher by-product copper credits (copper ore is often found alongside gold and other metal deposits) are likely to further support several precious metals producers in 2021. Copper—having more than doubled in price from its March 2020 lows — posted an unprecedented eleventh monthly gain in February before a slight pullback in March only to push higher again in April, coming close to the 2011 all-time highs. The uptrend has been backed by investor expectations that a solid demand rebound in China had further room to run and that the country’s evolving “green” focus on CO2 reduction and electrification will only strengthen from here.
“Most mining companies have maintained a keen focus on improving the cost structure of their operations, debt repayment and asset rationalization, which we believe should result in better business fundamentals and improved stock performance potential as management teams look increasingly focused on generating free cash flow that can be returned to shareholders via dividends (or reinvested in high-return projects).
“In addition, we believe small- and middle-capitalization gold equities may present some of the best opportunities given their generally lower valuations and our belief in the need for further M&A consolidation as mining companies seek to replenish their resources following several years of limited exploration and development activity.”