Three reasons why gold is poised for a strong H2 2014

In recent months there has been renewed investor interest in gold, with the first half of 2014 seeing the gold price rise by 10%. Investors have also tempered their gold ETF selling year on year. Last year saw global gold ETF holdings decline by 33% as investors priced in tapering of QE and higher interest rates, but this year has seen a change in sentiment as year-to-date ETF holdings have only declined by 1.8%.

We believe that three primary factors are likely to generate further interest in gold from investors, and subsequently gold ETF inflows, driving the gold price higher:

1) Inflation potentially entering the system

Inflation has long been suggested as a potential consequence of unprecedented money creation by the world’s central banks over the last few years. There are signs that it may slowly be emerging in 2014. US inflation data for May 2014 showed a 0.4% month-on-month increase in consumer prices, which was twice as large as the consensus forecast of 0.2%, and it pushed the annual inflation rate up to 2.1% from 2.0% in April. Year-to-date US consumer prices have risen at a 2.6% annualised rate. Some of this can be attributed to fuel and food, but an examination of core inflation shows an acceleration to 2.3% for the first five months of the year versus 1.6% at the end of 2013.

Gold has historically proven to be an excellent hedge against inflation. Goldman Sachs recently produced research which suggests that there is a 91% correlation between US CPI and the USD gold price over the past decade[1]. The correlation remains strong at 73% when the time period is extended and run from 1970 to today. Not only has gold proven its worth as an inflation hedge, it has also proven its worth against different asset classes. Since 1970 the gold price has increased at a CAGR of +8.5%, outperforming the US CPI Index by 4.3% and the S&P 500 by 1.4% per annum.

2) Increased geopolitical risk

The second factor affecting the gold price is linked to the first. Geopolitical tension surrounding the Russia and Ukraine situation tested investors’ risk appetite in the first half of the year and continues to do so. The market has also focused on escalating violence in the Middle East, with particular attention on Iraq. The ISIS (Islamic State of Iraq and the Levant) movement’s domination of Syria, and more recently Iraq, has significant implications for the oil price. The relationship between the gold and oil price exists as oil is a significant input of the world’s activity and hence inflation baskets. If the views expressed by the Investec Energy team of a stronger-for-longer oil price is correct it would keep inflation statistics elevated. Over the long term, the gold price has traded at approximately 16x the oil price. Today that relationship is just shy of 12x and arguably represents value for gold if oil remains at these levels.

3) Gold price seasonality

The final point is that of seasonality, which has historically led to higher gold demand in the second half of the calendar year and hence better price performance. This is because the Indian monsoon/harvest season boosts incomes and the timing of the Indian wedding season, around Diwali, sees significant quantities of gold purchased as gifts.

Conclusion - What does this mean for gold equities?

Beta has also returned to the gold sector, with gold equities showing two times leverage to the gold price in 2014. Gold equities represented by the EuroMoney Gold Mines Index were up 22% at the half year stage. After years of underperforming the gold price we believe gold equities are finally showing leverage, as they are fundamentally better businesses than they have been in the past. New management teams have focused on return metrics with current and future production decisions based on whether an economic return can be earned. In a lower gold price environment this has meant marginal projects have been cancelled or deferred, freeing up capital in the business.

Shareholders have long called for better capital allocation and in turn a dividend, which helps keeps management honest. Helping deliver positive free cash flow has been a much needed focus on a bloated cost base. Excessive corporate costs and non-essential mine site costs have been slashed to the point where free cash flow yields are now positive and growing.

We expect continued interest in gold equities this year as generalist investors look to allocate after being underweight for some time and M&A returns to the sector.