QE and the Gold Price
Wednesday, 8/21/2013 21:15
Crashing into the emergency room, gold mining stocks need a thorough post-QE exam...
CHRIS MANCINI, CFA is a research analyst at the
Gabelli Gold Fund Inc., specializing in precious-metals mining companies.
With over 13 years of investment management experience, including research analyst positions at hedge funds Satellite Asset Management and R6 Capital Management, Chris Mancini now recommends performing triage on gold stocks, looking for companies with cash and cash flow which will survive the crisis, as he explains in this interview with
The Gold Report...
The Gold Report: Were you surprised by the collapse of the prices of gold and silver?
Chris Mancini: Yes, I was very surprised. I thought that the macro backdrop for gold and silver was very positive at the beginning of the year. The Federal Reserve had just begun its process of Quantitative Easing 3 (QE3): printing $85 billion a month. Japan announced it would undertake its own QE program, which would be a much bigger percentage of its GDP than the US plan.
TGR: And Mario Draghi said he'd do "whatever it takes"?
Chris Mancini: Yes. The president of the European Central Bank said he'd do whatever it takes to ensure that there was a recovery in Europe, implying a willingness to buy bonds with printed money. It seemed that all this liquidity splashing around should have been positive for gold.
TGR: What, if any, is the relationship between QE and the price of gold?
Chris Mancini: I think what drives the gold price is the view that gold is the ultimate savings instrument. It can't be tampered with, is not replicable and is nobody else's liability. With QE1 and QE2, that money found its way to the highest-growth economies: China, India, Thailand, Vietnam and other countries in Asia. These countries experienced high rates of inflation because this money was chasing scarce resources. And so the average guy on the street was getting 3-4% interest rates on his savings in a the equivalent of a six-month certificate of deposit versus price increases of goods of more than 10%. In other words, negative real interest rates. Holding cash in the bank is a money-losing proposition. This led to an increased demand for gold.
With QE3, we have continued to see a lot of demand from China, India and other countries in Asia, especially as the gold price has come down. But we also heard this steady drumbeat of talk that QE was going to end because the economy was doing really well. And because the economy was doing well, people should be in income-producing investments, like stocks or even bonds. So they started getting into them.
This became a self-fulfilling cycle: stocks went up, which meant that the economy was supposedly getting better, which meant that QE was ending, so you shouldn't have any gold. Then we had the crash in April.
TGR: Don't some people believe that QE is the only thing keeping us from economic disaster?
Chris Mancini: Over the past three quarters, we've had enormous and unprecedented amounts of fiscal and monetary stimulus, while the US economy has grown on average by less than 1%. What I don't understand is why people expect the economy to grow at 3-4% without any monetary or fiscal stimulus.
Interest rates were pushed way down by QE, and so people needed to find yield. They weren't finding any in bonds. So they went into dividend-paying stocks. So you had this enormous rise in the stock market so far this year, which I think has been mostly due to QE and forcing investors out of other assets, bonds specifically.
TGR: That's what they say about inflation – the money has to go somewhere, right?
Chris Mancini: What the stock market is showing us is the effect of the creation of $85bn every month.
TGR: Let's assume there will be a tapering of QE. What effect will this have on the price of gold?
Chris Mancini: I don't think a relatively small tapering of QE would have a meaningful effect because it has already been priced in to a large degree. If QE ends completely, I think the S&P 500, Dow and NASDAQ will correct meaningfully. And then you'll hear a tremendous clamor from the markets for more QE. If that happens, there will be a realization that we're in this for good, and I think that this would be good for gold.
TGR: You have probably come across these stories of skullduggery in paper gold. One story heard often these days is that the Comex in London has no physical gold. Another is of tremendous amounts of paper gold being leased in order to drive down the price. Do you put any credence in these stories?
Chris Mancini: I don't know the intricacies of it, so I can't really say. However, the severe drop in gold on those two days in April made very little sense from a pure supply and demand perspective. It just didn't smell right.
TGR: Even before the gold price collapse, gold stocks were in the doldrums. So with gold in the $1300s, what is the case for gold equities?
Chris Mancini: The gold stocks are highly leveraged to the gold price. So if the price of gold goes back up to where it was at the beginning of the year, $1500-1600 per ounce, the profitability for gold miners is going to be highly leveraged on the upside. The other case to be made is that given that the average all-in cost of production is around $1100 and there are plenty of mines that produce at $1350 or above, there will be mines that will come offline. So that supply coming offline should support the gold price.
The companies are cutting costs right now, and the cost base should be relatively fixed. With gold at, say, $1600 the companies will be very profitable given the cost cuts taking place now. I believe they'll then pay down debt, and then they'll hopefully start returning cash to shareholders in the form of dividends. I think there is a very good argument to be made that if you own the miners now and you want exposure to upside movement in the gold price, the miners are a very good way to do it.
TGR: You've divided gold companies into three categories "relative to their ability to be able to weather the current storm." These categories are the "Good," the "Not-So-Bad" and the "Maybe Ugly". Which criteria determine the good gold stocks?
Chris Mancini: Access to cash, access to cash flow and the ability to take advantage of the current distress in the market. The best example now is a royalty or streaming company.
TGR: What characterizes the Not-So-Bad companies?
Chris Mancini: Access to enough cash that they won't need to finance anytime soon or access to capital through cash flow.
TGR: How do you rate companies that have financed, but will need to go to the markets again?
Chris Mancini: I would rate them between Maybe Ugly and Not-So-Bad. The true Maybe Ugly companies don't have a defined resource and don't have economics surrounding the resource. They're just exploring and need cash.
TGR: If trillions of Dollars keep being created to forestall deflation, what does this mean for gold in the long term?
Chris Mancini: I don't think anyone really knows the answer to that. To the degree that we had economic growth over the past 10 years, it's been predicated on increased leverage. After the leverage bubble popped, consumers couldn't borrow any more. The way we avoided deflation was through increased government borrowing and money printing. Eventually, it comes down to people questioning the value of the Dollars in their pockets, and when people begin to doubt paper money, gold should be a very valuable alternative and do extremely well.
TGR: Chris, thanks so much.
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