Mining Markets spoke with Frank Holmes, CEO and chief investment officer of US Global Investors late last week about the prospects for gold, which started out the year around US$1,700 per oz and was at US$1,282.80 on Tuesday afternoon.
While gold has lost ground this year due to fears that the U.S. Federal Reserve would begin to taper its US$85-billion a month QE3 asset-purchasing program, those fears have since abated. While the debt ceiling and government shutdown impasse in the United States should be feeding the so-called “fear trade” in gold, Holmes explains that what he calls the “love trade” in gold – demand from Asian countries with a cultural affinity for gold – has experienced challenges this year. He also outlines what he sees ahead for the yellow metal.
Mining Markets: Let’s start by reviewing what’s happened with gold this year. The sentiment has turned sharply – if you look at the one-year chart for gold, it looks pretty ugly. So what’s been happening?
Frank Holmes: There’s two factors that drive the demand for gold and that’s the fear trade and the love trade. The fear trade gets the most attention, but the love trade has had some real problems this year, especially with India. The government there is doing everything they can to stop the consumption of gold – that’s had a big impact. There’s no doubt that the Indian government is doing everything to try to help their current account. But I think it’s important for investors to recognize here with this huge bear market in gold, over the past three years, it’s still up almost 10%. And in rupee terms, it’s up 58%.
The other factor with regard to India is GDP per capita. During the big run that took place from 2001 when all the emerging markets bottomed, we saw a rising GDP per capita every year. The past 18 months it’s seemed to have slowed down, and that does have an impact on the consumption of gold.
MM: You do often talk about the love trade and the fear trade and the fact that they both support gold. It would seem that they are both in place right now since the fall is a period of seasonal strength for gold because of Asian demand (the love trade) and then on the fear side, we have the political impasse in the U.S. So should that make for higher gold prices going forward?
FH: On a historical basis, there is this wonderful pattern that gold bottoms every summer and rallies until Chinese New Year. It starts with Ramadan, then goes through the season of lights, the Diwali season and then we have Christmas and Chinese New Year. And there’s no doubt that there’s a higher probability of gold rising, but we can get these cycles where the fear trade becomes important.
Gold becomes of importance as sound money whenever we have negative real interest rates. Whenever there have been positive real interest rates, gold has been at low levels.
Right now you have a negative real rate of return – in other words what will the government pay you with treasury bills relative to the CPI number – and that’s usually bullish for gold. The other fear trade factor is money supply and monetization of the debt, and we’re still seeing that. So from the fear trade side, nothing substantial has changed. The amount of negative real rate return has decreased because there has been a rise in five-year and 10-year government notes, so that does have an impact.
The threat people are worried about is that rates are going to go positive here over the next two years, and we don’t think that. At US Global we just don’t see the rationale for that.
There hasn’t been a big shift in the employment numbers except for the definitions of employment that capture a smaller universe. And if we go back to 1994, to the Clinton era definition of unemployment and you took that exact model, the unemployment rate today would be double the official rate.
The positive parts for gold is that demand still is strong from central banks. And China continues to consume record amounts of gold. With the trading that takes place in New York, something like 98% of all trades just trade and only 2% are for delivery. And when you look at China, on Shanghai’s gold exchange, it’s 98% delivery. The trading is much less than New York, but the gold seems to be leaving the West and going to the East.
The fact is that gold has already been sold down and there’s a couple firms, Credit Suisse and Goldman Sachs who are big proponents that gold is going to trade lower. But some other things have happened this week. On Monday, there was a flash of these high-frequency traders flashing 43,000 contracts – you’re talking about $12 billion worth of gold being flashed to be sold. Only 3,000 contracts were sold and the remaining 40,000 was cancelled. So that really spooked the market and gold sold down dramatically. The same thing happened Oct. 1st. Oct. 1st is a holiday in China, so no gold markets are open there and someone quickly sold 10,400 contracts – that’s over $1 billion in gold – in five minutes. And that just triggered a cascade down in the price. (CNBC describes the latest incident Friday here.)
I was doing a television interview and I reminded the audience that Apple (NASDAQ-AAPL) for the past year is down more than gold and investors lost more money in Apple than all the gold in the GLDs around the world. So there’s a misrepresentation of gold being a boogeyman and to me it’s just important and the math shows that having a 10% weighting – 5% in bullion, 5% in gold stocks, and then rebalancing each year – has shown to be prudent. And when we look at our models of comparing to the S&P 500 and we rebalance, we’re still ahead with lower volatility and we’re going to stick with that – over three years, over five years, over 10 years.
MM: We have seen huge outflows from gold ETFs. Do you see that money coming back at some point?
FH: Possibly, I don’t know what the catalyst is people are looking for it to take place.
MM: So you don’t see a catalyst there?
FH: I think it’s a lot momentum, it’s predominantly fear – there’s a fear trade to protect against the dollar, and clearly the stronger dollar over the past year has had an impact on gold.
MM: This political drama in the U.S. with the debt ceiling and the shutdown is sowing a lot of uncertainty. Do you see this being resolved with minimal damage to the economy or do you this drawing out?
FH: I think it will resolve itself. What’s sort of positive about is that America’s all about competition and innovation, and this is a classic sporting event. When you sit back and look at it, it’s two teams battling it out, like two hockey teams, and that’s the American model – that’s the free market system at its best. There appears to be in the general media a support for ideologues that are environmentalists – that that’s okay, but it’s not okay to have the Tea Party who are asking for accountability for tax dollars being spent in government. We’re just seeing that the Tea Party became much more organized, just like a lot of the anti-development groups, so with that the average person has to sit back and recognize that minorities such as the Tea Party or environmentalist groups etc. if they become very well organized, that they are all of a sudden be able to dictate a lot of the ch
ange that takes place in government.
MM: US Global had a team of people at the Denver Gold Forum last month. You wrote a blog post about it saying that part of the takeaway there was there’s a possibility of M&A coming in the gold space, but these companies don’t have the money to spend on acquisitions. So it doesn’t sound very positive.
FH: I think you will see some M&A work on some of the juniors, but I don’t think it’s going to stop companies like Agnico Eagle Mines (TSX: AEM; NYSE: AEM) buying 5% of companies looking for that first-mover advantage tying up these properties.
And I think you’re going to see some of the majors do mergers focusing on economies of scale to lower their basic G&A. There’ll be mergers of equals to drive down costs. All these companies should be reporting their G&A per ounce of gold – what’s it costing? Some of these companies are getting up there to a little over US$200 of G&A per oz. for every ounce of gold, which is basically for fancy offices. So I think that some companies will say, “If you put us together, we can save tremendously by economies of scale.” We’ve seen it before when gold was quite low in the ‘90s. If you look at the price of gold and the total cost for producing an ounce of gold, whenever that gets extremely tight, as we’re seeing today, then we see acquisitions
When we look at the energy patch, the first half was slow for M&A, but now it’s picking up again because these are the cheapest reserves, they’re the easiest ones that you can analyze and right now many of these companies have massive reserves relative to the cost today of going to drill those reserves. I think that’s going to be an ongoing important factor that will draw M&A work – why spend money exploring when I can turn around and buy company A?
MM: Gold bullion and gold stocks have both been beaten down. What’s the better buy?
FH: I think that gold stocks are cheaper, at an all-time record low relative to multiples of cash flow compared to the S&P 500. And dividends – they’ve recognized that they have to stop growing for the sake of growing and sharing some of that growth income with investors. We’re now seeing the average mid-cap gold dividend is greater than a five-year government note. So why would you buy U.S. government bonds when you can turn around and buy stocks which are giving you a higher yield? Gold stocks are more attractive.
MM: Gold has been in decline for the last two years – is the gold bull run over or is it on pause? Where are we in that cycle?
FH: I wrote a piece a while ago on the magnitude of these corrections in June and going back to the ’70s, we had huge corrections and this correction still is not as great as what took place in the ’70s – and gold went on to $850 an ounce in 1980. So it’s just a very painful process that we’re going through for gold investors, but the backdrop hasn’t changed – the backdrop that drives gold as being attractive hasn’t changed. I think what will change is the supply. National Bank came out with an article commenting that a lot of the gold that was supposed to come on-stream is not going to come on-stream – there’s no funding for it, there’s been so many delays and disappointments everywhere that it’s not coming on stream and there’s no capital you can raise to do it.
MM: It may not be economic at these prices as well.
FH: Correct. So we’re going to see the supply of gold start to shrink from the mines and I think that will positive down the road – I’m talking about 18 months out.
This interview has been edited and condensed.
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