Miners: Approaching a Golden Moment?

This week, MWM completed its latest quarterly client call. Thanks go out to those on the call and all clients we have the privilege to serve. 

In this letter, HAI will train an eye on the precious metals sector.

Since gold prices began to break down with conviction in late April, it’s been a brutal stretch throughout the precious metals complex. Gold’s breakdown coincided with an aggressive leg lower in major market stock indexes that triggered widespread deleveraging across the financial universe. In such market-wide liquidity crunches, gold is historically sold off by institutions and leveraged speculators to free up liquidity, unwind leveraged portfolios, and cover margin calls. This phenomenon is natural in today’s markets, but it’s crucial to understand.

This past spring was a case in point. As the stock market plunged to lower lows, it triggered widespread recognition that a temperamental bear was out of hibernation, looking to make trouble, and intent upon roiling financial markets for the foreseeable future. Accordingly, deleveraging and the attendant heavy selling pressure in markets begat heavy selling pressure in gold. Gold’s problems were then quickly compounded as the declining price broke through significant technical support in the form of an uptrend line that had defined the rally off the August 2021 lows. Once gold’s trend line support was taken out, the technical trapdoor was open for a free-fall and a trip to potentially test multi-year lows in the $1,670s.

Just as market liquidity factors and a technical breakdown were generating significant downside price momentum in gold, additional factors were also rudely conspiring to add further pressure on the yellow metal. Treasury yields were reaching multi-year highs. The U.S. Dollar index was breaking out above 100, was at multi-year highs, and was outright ripping in one of its strongest moves in decades. Higher yields and a rising dollar put pressure on gold. In this instance, both were absolutely surging.

Lastly, and perhaps most significantly, the global outbreak of 40-year high levels of non-transitory consumer price inflation finally caused the U.S. Federal Reserve, albeit acting more than a day late and more than a dollar short, to aggressively lean in and commit to its most aggressive rate-hike cycle in recent memory. The Fed’s hawkish policy pivot is materially relevant to gold. Since the last remnants of the gold standard ended in 1971, the financial system has been governed, instead, by what can be called the Fed standard. In the market’s new arrangement, gold has assumed the unofficial role of insurance against Fed standard monetary policy malpractice. In fact, the gold bull market of recent decades is, to a significant degree, a reflection of gold acting as insurance of just this nature. What formerly only gold buyers and a few others could see is now on display to the world. The Federal Reserve’s extreme monetary mismanagement has birthed history’s greatest credit bubble.

Since this past spring, however, the Fed has increasingly dug in its hawkish policy heels, invoked the name of Paul Volker, and gotten responsible. The Fed has since made it known through repeated unambiguous communiqués, multiple jumbo interest rate hikes, and an aggressive quantitative tightening schedule, that it will fight inflation “unconditionally” until consumer prices have fallen back to its 2% target. In the context of gold as insurance against a reckless Fed, this sudden bout of seemingly convincing central bank responsibility is applying significant further downside pressure to gold. 

With all of that said, remember that the Fed’s newfound penchant for policy responsibility is almost certainly a necessarily temporary posture. That point is absolutely crucial to understanding the current set-up in the metals (near-term downside risk, followed closely by a potentially aggressive bull move higher). Still, until the market sniffs out an imminent, newly stimulative policy pivot, the price of gold as insurance will remain vulnerable.

These negative gold price dynamics that have temporarily taken hold of the sector are obviously of great consequence for the precious metals mining sector. In the face of intensifying inflationary cost pressures, the mining stocks held up very well and continued to rally right up until the gold price broke down last spring. With gold prices at high levels and rising, mining stocks can still rally, even with cost pressure headwinds, but they can’t rally in the margin-squeeze, no-go zone of rising costs simultaneously paired with faltering gold prices. These are, however, the exact dynamics that have engulfed the sector since late April.

Adding to the mining stock malaise, hedge funds overweight the most attractive, highest quality stocks in the sector. When hedge funds face acute liquidity constraints and margin calls, these large holders turn into price-insensitive forced sellers, and inflict outsized price damage in a hurry. Forced liquidations have certainly been a factor exacerbating declines in the miners dramatically.

That said, in the context of an extremely difficult operating environment, complete with higher costs and lower gold, most quality senior producers remain strategically disciplined and fundamentally healthy. With huge price declines already booked and the resulting basement-level valuation multiples tacked onto fundamentally strong companies, discount shopping season appears to have arrived in the sector.

Price to net-asset-value (P/NAV) multiples are presently at the lowest levels since the 2015 all-time sector valuation lows. Meanwhile, strategically and fundamentally improved top-quality miners are in far better shape than in any recent comparable gold cycle. They demand a premium, not a discount multiple relative to the past. With valuations decidedly attractive, the fate of the sector now hinges upon cost pressure improvements and a floor being put in on the gold price.

On the cost side, the two dominant input factors for miner costs are labor and diesel prices. Labor costs likely won’t improve for some time. Labor productivity will improve, the rate of change on labor cost escalation will likely slow, but labor costs in absolute terms likely won’t drop for core mining company employees. The exception would be if gold prices dropped below $1,550 for an extended time and marginal projects among the industry’s weaker players were shuttered. 

Nevertheless, some miners are far more negatively affected by the present high cost for labor than others. As such, going forward, labor cost issues will be company specific and regional in nature. Junior mining companies with a single project operating on a short mine life won’t offer the sort of job security provided by senior producers with many projects always cycling into production. Especially in crowded mining jurisdictions with already tight labor markets, these disadvantaged juniors and smaller mid-tiers are forced to overpay significantly to bid for employees and specialized contractors. Larger senior producers that dominate mineral extraction in a region, on the other hand, will be relatively unaffected.

Turning to fuel prices, miners are already set-up for significant cost relief. Since the late May peak, gas prices have since declined by more than 46%. As a result, at least for the remainder of the year, gas prices are set to contribute positive cost surprises rather than the first-half 2022 cost headwinds now already fully priced into mining stock valuations.

So, with historic valuation discounts and an industry that may now be past peak cost pressures, higher gold price cooperation remains the last key variable needed to catalyze a substantial rally in quality miners. As for that last key variable, there’s good reason for optimism on gold prices as well.

Certainly, the Fed’s newly initiated inflation fight has weighed on gold, and prices have shed $300 since Fed policy doves abruptly turned hawks. Economist Ludwig von Mises correctly observes, however, that, “The most important thing to remember is that inflation is not an act of God… Inflation is not…a disease that comes like the plague. Inflation is policy.”

The real problem for the Fed, however, is that the current outbreak of 40-year high levels of consumer price inflation is a consequence inextricably linked to a Fed policy that has intentionally facilitated a multi-decade credit expansion-fueled boom.

Again, further illustrating the problem, von Mises reminds us that, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

The problematic paradox remains that the suddenly responsible inflation fighting Fed is trying to implement “a voluntary abandonment of further credit expansion” in its efforts to wage the war—presumably just long enough to knock inflation lower without popping history’s greatest credit bubble. It’s a perilous maneuver to say the least, one that’s of the highest possible degree of difficulty.

As the powerful but lagging impacts of the voluntary abandonment of further credit expansion increasingly court the crisis Mises warned of, the Fed is fast approaching a new policy choice. If, in the face of crisis dynamics, the Fed reverts, as expected, to inflation as policy, the attempt to stimulate and reflate the faltering credit bubble will release the coiled spring that is gold, and prices will catapult higher. With incredibly supportive valuations and an improving cost outlook, quality miners with the strongest fundamentals and disciplined strategies are exceptionally well positioned to capitalize and offer significant upside leverage to what may be a rapidly approaching gold bull move to remember.

Weekly performance: The S&P 500 gained 3.65%. Gold was positive by 0.35%, silver added 4.98%, platinum gained 7.16%, and palladium was strong, up 7.48%. The HUI gold miners index outperformed, up 6.15%. The IFRA iShares US Infrastructure ETF gained 3.70%. Energy commodities were volatile and lower this week. WTI crude oil was almost flat, down 0.09%, while natural gas was off by 8.99%. The CRB Commodity Index was lower by 0.26%, while copper was up by 4.69%. The Dow Jones US Specialty Real Estate Investment Trust Index was higher by 3.57% on the week, while the Vanguard Utilities ETF (VPU) was up 3.47%. The dollar softened by 0.47% to close the week at 109 even. The yield on the 10-yr Treasury gained 13 bps to end the week at 3.33%

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC