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03 Aug 2021

All that glitters is gold as inflation debate intensifies

By Peter Moussa, senior investment specialist for Citi As inflation risk takes on more substance and currency devaluation rises as an issue, gold is a good store of value

Investors turn to gold as a hedge in times of mounting inflation and as a ‘safehaven’ asset in times of turmoil. Economically, we were in unchartered waters globally even before the COVID-19 pandemic struck, as governments and central banks artificially stimulated recession-bound economies.

So, it’s perhaps not surprising gold has outperformed the returns of other defensive assets over the past three years, rising 50 per cent in Australian dollar terms compared to 14 per cent on US treasuries over the same period, according to Bloomberg data.

Inflation has also become an issue this year but debate remains if it is transitory inflation due to supply chain disruptions, or more deep-rooted and persistent.

The majority of economists see it as transitory inflation that will dissipate as the global economy continues its recovery. This has led to a fall in the gold price in recent times and a rise in long duration bonds, indicating an expanding global economy is expected.

However, if inflation accelerates and levels of growth do not match expectations due to continued impacts from the pandemic, it could lead to some key currencies starting to weaken, and in-turn make gold a favoured asset class. This recent dip gives us a great opportunity to add gold stocks as part of a diversified investment portfolio.

Why should I hold gold?

Gold is currently a vital part in portfolios as it can be viewed as a store of value that protects against rising inflation or the devaluation of currencies. In the current environment of low interest rates, gold is likely to provide better portfolio diversification compared to government bonds if there is rising inflation.

Gold or an investment in gold producers also adds to portfolio diversification. This is because gold has a low correlation to both bonds and shares, meaning that gold can go up when other assets are falling. This helps reduce portfolio volatility and, therefore, lowers portfolio risk.

Bonds yields is a vital component

Even in buoyant market conditions professional investors hold government bonds in their portfolio. While the bonds may not achieve the returns of growth assets, they provide reliable income streams and also lower the overall risk profile of a portfolio.

Government bonds are attractive if their yield is higher than the inflation rate. However, when inflation is rising and yields remain low through central bank intervention, treasury investors are taking on credit risk while earning a negative real yield net of inflation. Gold doesn’t pay a yield but because it doesn’t carry any credit risk, gold tends to outperform when real yields are negative.

In 2020 following the pandemic shock, the globally economy entered a period of deflation, the four month period between April to July 2020 saw gold increase by 40 per cent, while treasuries only increased by 4 per cent over the same period. This illustrates the importance of gold as a diversification tool.

Is now the right time to hold gold?

As we have already discussed, gold performs when inflation is rising or in periods of turmoil. But the key to gold is that it is driven by market sentiment. This means it can perform well in times of ultra-low interest rates and even low inflation, as it’s ‘safehaven’ status in times of volatility shields it from downward price pressure. We have seen similar pressures at work maintaining the value of the US dollar.

Also, in the event of deflation or a domestic shock, gold doesn’t have the risk of a country not honouring its debt (sovereign credit risk), and gold isn’t limited by zero interest rates like government bonds, so will also provide better portfolio protection. These characteristics make gold an attractive alternative to government bonds in both an inflationary and deflationary environment.

Buy local buoys gold

Currently, many governments are pushing buy local strategies to boost domestic activity while also seeking to export more product and services to bring in foreign income. A good way to achieve this is to pursue strategies that will devalue a currency, making domestic goods more attractive and exports of greater value.

In a world where everyone wants a lower currency, gold stands out as an insurance policy against currency devaluation.

Gold shares vs physical gold

Gold shares can provide a convenient way to access some of the benefits of gold without having to worry about issues, such as safe storage.

It is important to note that gold shares do not always provide the same defensive characteristics as direct gold, as they have some correlation to the overall market. However, as the price of gold rises, gold miners can generate more profits and are therefore likely to be more resilient relative to the overall market on the downside.

Our preference is to access the benefits of gold shares through a structured note given that it allows investors to profit whether those companies go up, trade sideways or even fall, so long the decline is not more than a predetermined amount. On current trades we offer the decline would have to exceed 50 per cent.

Stand out companies

NCM: Newcrest

A global top 10 gold miner, Newcrest produced 2.2 million ounces of gold in the year to June 30 2020. The company is focused on long life assets in Australia, Papua New Guinea, Canada, and Ecuador. As an unhedged gold producer, NCM is leveraged to the gold price through its world-class reserve base, exploration portfolio and organic growth options.

NCM is the largest gold producer on the ASX; often included in portfolios for a defensive hedge. NCM has low operating expenditure, but relatively high capital expenditure growth options to develop the Red Chris gold mine Canada, Havieron project in Western Australia and Wafi-Golpu advanced exploration joint venture in Papua New Guinea. Delivery of further Tier 1 assets should diversify earnings and provide a path for NCM to regain a premium against other local gold producers that it has traditionally held. NCM's assets are large, long mine lives that provide a stable gold and copper production profile. In contrast to peers, NCM can choose to sit out high-cost inorganic growth.

NST: Northern Star

Northern Star is Australia's second largest gold miner by production. It operates three mining centres: in Kalgoorlie and Yandal in Western Australia, and the Pogo underground mine in the United States. Northern Star recently merged with Saracen Minerals, which added two additional mines in Western Australia and consolidated ownership of the Super Pit (KCGM) in Kalgoorlie. We expect 2022 proforma production of about 1.77 million ounces of gold and reserves of 21 million ounces.

Positive factors include a strong balance sheet, management with a strong operating track record and growing reserves via exploration and potential upside from synergies post-merger. The merged entity now holds significant ground holdings in the Kalgoorlie region, boding well for exploration success. Headwinds include challenges to costs and declining grades at Kalgoorlie, a sizeable gold hedge book and managing business disruption from COVID-19 at Pogo in the US. NST is one of the only few stocks in our coverage to forecast production growth in the medium term, and on balance we see upside at current levels.

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