The world is still struggling to cope with the spread of COVID-19 and, despite the easing of lock-downs and the resumption of economic activity, it is proving hard to recover from such a deep recession. Governments and central banks around the world are injecting stunning amounts of money into retaining as much productive capacity as possible until we gain control of the pandemic. During the housing crisis of 2007-2009, the then-comprehensive bailout programmes were developed and released over a period of about 1.5 years; this time, programmes of magnitude some ten times larger than that were deployed in about two weeks. Clearly there were some extensive emergency plans ready before the pandemic struck unexpectedly.
The first signs that the global credit bubble was at risk appeared in September 2019 when the overnight secured lending rate rose to a 7% premium over the Fed Funds rate. Perhaps it was the result of the Fed reducing its balance sheet in 2019, thus draining reserves from the banking system. Realising the danger, the Fed quickly launched its “liquidity expansion” and injected funds directly into the system. By late February, before the virus started taking hold in major economies, the overall size of the Fed balance sheet had increased by 12% to USD 4.2 trillion in just four months. Upon confirmation of the pandemic and the dramatic measures taken to control its spread, there was little hesitation to flood the market with cash, pushing the Fed’s balance sheet to over USD 6.1 trillion — 62% larger than in early September 2019. What’s worse, the dramatic effect of the current recession is estimated by Goldman Sachs to result in a USD 3.6 trillion budget deficit in the United States. Deficits of such magnitude can cause monetary debasement and currency crises as more money printing will be required to finance them. Unsurprisingly, the US Dollar has been losing its value against a basket of foreign currencies. Yet, as similar conditions prevail in other major economies such as Japan, the UK and the EU, most leading currencies will likely follow suit.
“The rapid rise in gold prices has taken most people by surprise and it’s only a matter of time before a tsunami of deal making arrives”
In such unprecedented conditions, investors have rushed towards assets with perceived value. Stock prices of industries seen to be resilient, such as internet technology giants, have led the gains. Defensive investment strategies have also looked at the traditional safe havens, such as gold, and pushed its price to new highs, above the level reached in the aftermath of the housing crisis in 2011. Silver initially suffered in the liquidity crunch during March as some believed industrial demand for the metal would collapse. As gold continued to rise, silver has caught up in the last five months, moving towards its longer-term correlation with gold. The unfortunate effects of the pandemic striking at a time of global economic weakness cannot be overstated. It’s becoming clear that the economic consequences will be severe and there are few places and assets that can offer safety. As interest rates are set to stay at zero or negative for a long time, and inflation is set to rise as industries try to rebuild, there could hardly be more supportive conditions for precious metals. As supply of gold and silver bullion is limited, their prices may be set to rise further, and even the most ambitious-sounding forecasts could be exceeded.
The shares of precious metals mining companies have performed well since the middle of 2019 as investors recognised the increase in profitability as the gold price rose. Nevertheless, an analysis of a select universe of company data sourced from Factset by Scotiabank indicates that mining equities still trade at a substantial discount to the gold price.
The explanation might be that for several years of a protracted bear-market, mining companies concentrated their efforts on managing operations cost-effectively and strengthening their balance sheets. They were forced to use high-grade resources, abandon marginal projects, and reduce exploration expenditure. Even though producing companies now enjoy increasing free cashflow generation, they are starved for growth. Most seem to experience declining average production grades and shortening mine lives as they produce more than they can replace. Senior managements of these companies are naturally concerned and frantically allocating more capital to project development. Previously moth-balled deposits hidden deep in archives are getting dusted-off and re-evaluated in light of higher gold prices. The argument of marginality versus deep value has been raised to the top of Board agendas, and corporate activity might just be the only option remaining. This is where smaller companies controlling projects with substantial resources start to shine. Most of these suffered severe capital starvation during the bear market and many went bankrupt or were sold to new owners for a fraction of historical cash spent in discovering and delineating projects. In the past six to nine months, the most promising of these have been recapitalised and have refreshed old resource statements and economic and feasibility studies, enabling them to present themselves as beautiful trophies ready for engagement.
Specialist investors that sensed this coming over a year ago are again making multiple returns as share prices get re-rated.
The party is only getting started though as gold continues to rise. Growth in production cannot come quickly from exploration as it is now estimated that a new discovery might take ten to fifteen years to pour new gold or silver. Acquiring an old, previously considered marginal project presents a much quicker path, and it seems that prices are still cheap. Some impressive deals have already been concluded in the sector by the most entrepreneurial teams, but there are certainly more to come. The rapid rise in gold prices has taken most people by surprise and it’s only a matter of time before a tsunami of deal making arrives. Wise investors should prepare by assembling a carefully selected portfolio of development opportunities. Key criteria should be: (i) location in a safe, stable political jurisdiction with a long mining history; (ii) an experienced management team in geology and deal making; (iii) a large and growing resource base preferably with a developed economic or feasibility study and; (iv) proximity to large producing mines to which they might present strategic importance. Endowed with such embedded wealth and store of value, one hopes they can weather economic and political crises as well as the debasement of leading currencies.
