The gold mining industry has experienced a harsh downturn over recent years; cost bases have been significantly reduced, maintenance capital spending has been pared right back and exploration activities have become almost non-existent. The excitement of the Colorado gold rush that kick-started the industry in the 1860’s is long gone, but precious metals may still represent a rich vein of opportunity for the modern investor.
Mine supply is likely to remain under considerable pressure over the coming years, serving as a supportive fundamental for the gold price. The gold price is, however, more than just the relationship between supply and demand and influenced by macroeconomic drivers such as inflation, interest rates and credit conditions. The asset also provides a hedge against extreme outcomes, in both economics and politics. Evidence of this latter point from this year alone is compelling. Adverse events such as the Bank of Japan's move to negative rates or Brexit show that gold is clearly an insurance policy for the prudent portfolio.
However, the behaviour of the gold price this year suggests something more than just a random confluence of these two improbable events. Gold is often one or two moves ahead of the rest of us, which gives rise to the question as to whether it could be signalling something more substantive. Could it be indicating that inflation is finally going to be the result of central banks excessive money printing? When the average market participant, and possibly even the Federal Reserve itself, finally come to terms with secular stagnation, what if it was to become secular stagflation instead? Is that the next stage in the struggle between inflation and deflation? It is the job of the contrarian investor to ask these difficult questions.
There is a strong precedent for this, and one that falls outside of the experience of almost all market participants. The potential growth rate of the US economy is very low, while debt levels in the government and corporate sectors remain uncomfortably high and still rising. This is not a good combination. Unsurprisingly, if there is very little real growth, then nominal growth is the only alternative, and that means inflation. As increasingly outlandish alternatives of both the monetary and (increasingly) the fiscal variety are put forward as the means to achieve this, the gold price seems to have latched onto the ramifications quicker than most. Fiscal policy, especially if supported by monetary policy, is more obviously inflationary than quantitative easing.
There is also the gold to silver price ratio. Estimates vary widely, but the US Geological Survey and others suggest that the abundance of silver deposits is roughly twenty times greater than that of gold in the earth's crust. Silver has also outperformed gold this year, reversing many years of the opposite trend which had led to a historically stretched ratio where 1 ounce of gold could buy as many as 80 ounces of silver. In prior cycles, peaks in this ratio have only been reached after periods of economic distress or downturn, as was the case in 1992, 2002 and 2009. Because the more significant industrial uses of silver make it more sensitive to economic activity, it typically takes the lead during reflationary upcycles in which both prices are rising. It now strongly appears that this key ratio has formed a new trend, confirming a more inflationary outlook.