Commodities

Gold investors globally have been cheering in recent months as the USD gold price hit prices not seen since 2013. But for Australian producers and investors, the story is even better. When gold was last at this level, the Aussie dollar was buying around 90 US cents, but today, with the AUD below 68 cents, the Aussie gold price is scaling new heights, briefly touching A$2240 earlier this week.

With many Australian gold producers having costs around the A$1100 per ounce mark, operating an Australian gold mine is akin to a license to print money at current prices. For Australian equity investors with exposure to gold, the recent volatility in markets has been well hedged, with most gold equities rallying strongly on the market’s down days.

One Australian fund manager who’s been well positioned to benefit is John Deniz, founder and Chief Investment Officer of Paragon Funds Management, whose fund returned 26.9% so far this year on the back of strong performance from Aussie gold producers.

What caused the rally?

Gold prices are driven by a variety of forces, but the current rally appears to be the result of monetary policy, and the financial market volatility that ensued.

“Gold particularly benefits from accommodative monetary policy (namely low and falling cash rates), quantitative easing, falling bond rates (namely negative or approaching negative real rates) and global market volatility. All four arose in the last month,” Deniz said.

For those who might’ve missed it, the US Federal Reserve cut its cash rate by 25bps in July. It also halted it’s ‘quantitative tightening' program, meaning it’s no longer attempting to reduce the size of its balance sheet. Unsurprisingly, this was accompanied by falling bond yields and increased volatility in equity markets.

Adding fuel to the fire, Donald Trump Tweeted on Friday that China would be on the receiving end of additional tariffs.

Finally, overnight, gold prices again pushed higher after three central banks (New Zealand, India, and the Philippines) slashed rates more than expected, and Trump added pressure to the US Federal Reserve to ease monetary policy.

Is there still money to be made?

After any big rally in an asset, the natural reaction of many investors is to assume that ‘the easy money has been made’ and that further rallies are unlikely. However, that may not be the case here.

“We believe the move in gold, and moves in our gold longs specifically, are still in their infancy. The global market cap of the gold sector is ~US$225b, around half what it was at its previous peak in 2011,” Deniz told Livewire.

Chart 1. Global market cap of the gold sector ($US billions)

Source: RBC, Paragon Funds Management

“As we have stated previously, we consider gold a strong hedge to global market volatility as this is when gold tends to do well. Volatility will be an ongoing feature in global markets due to the mix of macro risk factors including US-China trade wars, growth slowing globally and US recession fears.

“Gold particularly benefits from US rate cutting cycles (see Chart 2 below). Following the Fed’s dovish pivot in January and the end of their recent tightening cycle, in June they signalled the start of their rate cutting cycle which officially commenced in July,” he said. Futures markets are currently pricing in a further 75bps of cash rate cuts by the Fed by June 2020.”

Chart 2. US$ gold bull markets – top 4 moves during US rate cut cycles

Source: Canaccord Genuity, Paragon Funds Management

Where are all the opportunities?

As the old saying goes, ‘a rising tide lifts all boats.’ But that might not be so true here. Several gold producers and developers have seen large falls in their share prices, despite the rising gold price.

“Gold equities however are not for the faint hearted, as evidenced by recent major downgrades across well-owned large and small caps such as St Barbara, Dacian, Gascoyne, Millennium and Aurelia – all production-related downgrades - pleasingly avoided by us,” Deniz said.

Production issues aside, he believes the opportunity for high quality gold stocks is still ripe.

“It is worth noting that the global market cap of the gold sector at ~US$225b, if it were a company would rank outside the top 30 stocks in the S&P500. As such, the gold sector has ample scope to re-rate. Generalist funds are under-weight the sector – as they were in 2009 ahead of a very big move in gold, and they will initially chase the large cap names, as they do every cycle."

So, what should investors be looking for in the current environment?

“We believe (and have already demonstrated) the best returns will be made in identifying key stocks that meet particular criteria:

  1. Emerging economic project developments ;
  2. High-cost operating-and/or-leveraged small and mid-cap producers; and
  3. Growing large-cap producers.”

The best by a long mile

A prolonged rate cutting cycle could see a bull market in gold that lasts two years or more. Assuming the story above plays out as expected and the gold price stays ‘stronger for longer’, John says there’s “no question” that the small-cap stocks in the 'discovery and delineation' phase will be the best performers. However, these types of assets can be very high risk and few investors are properly equipped to analyse the opportunities.

However, high-cost operating-and/or-leveraged mid-cap gold producers offer significant upside, without the high levels of exploration risk carried by earlier stage assets.

On this basis, he believes Alacer Gold (AQG) is “the best by a long mile.” Alacer’s main producing asset is world class and the company carries both financial and operating leverage, with around US$190m of net debt.

“They’re rapidly de-gearing their balance sheet. They’ll do what St Barbara did back in the day; it came out of the gold crash with too much debt, the gold price rallied, production surprised to the upside, and it became a cash machine. It started generating vast amounts of free cash and rapidly took the balance sheet from very highly levered, to a strong net cash position. I expect you’ll see that in Alacer, which could be in a net-cash position in ~12 months.”

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Michael Whelan

Gross Debt USD315m, Net Debt USD190m. Operating in Turkey which has a number of challenges apart from a belligerent President. You’d think AQG will have its work cut out for it ?