Investment commentators have spilled a lot of digital ink exploring the investment implications of the tariff war and the shift to a new international order instigated by US President Donald Trump. Nobody knows exactly what the new order will look like but we do know the shift to multipolar will not be cheap and likely mean a rising inflationary trend.
If so, gold will benefit and gold mining companies, already the next best thing, could have a long period of outperformance. This will be a challenge since few investors have experience with mining companies.
We are not in the business of providing investment advice, and certainly claim no mastery of the intricacies of gold mining. However, we do know a lot about accounting quality and thought it might be useful to see which of the miners have quality accounts according to the Transparently Risk Engine.
Before all that, let’s set the scene on the broader implications of these tariffs and inflation.
The new order, inflation and gold
Tariffs will mean a big one-off adjustment in prices but this is just the start of a bigger story. Shifting to a multi-polar world means replacing heavily subsidized Chinese excess industrial capacity with brand spanking new and hence more expensive capacity, much of it in locations requiring new infrastructure to support industrialization.
Capacity constraints, a term that almost fell out of usage thanks to limitless Chinese supply until Covid-19, will be a feature of the new international order. At the same time that businesses will need to invest more, governments will be spending big on defence and the infrastructure needed to support industrialization or, for some, re-industrialization.
Big government deficit spending plus big private investment spending plus capacity constraints equals an excellent chance that the trend in inflation will rise in the coming years.
Figure I illustrates the relationship between real asset returns and the trend in inflation since 1972.
Our analysis begins in 1972 because the gold price was fixed until 1971. We assess the trend in inflation by determining whether the eight-year average inflation rate is rising or falling. We use an eight-year average since this is the approximate length of the business cycle and thus helps to smooth cyclical influences.
Stocks and bonds do not like a rising trend in inflation. The S&P 500 Index’s return falls to 0.9% when the trend is increasing versus 13.9% when falling. The reasons are complex but basically corporate margins get squeezed in prolonged periods of rising inflation. The real bond return (represented by US 10-year Treasuries) falls to 0.5% from 4.2%.
Gold loves a rising inflation trend.The real return rises to 11.2% versus just 1.1% in a declining inflation environment.
So,the main investment implication of the shift to a new order is that investors are likely to substantially increase gold exposure in the coming years.
Figure I: Real asset returns under a falling versus rising inflation trend
Source: Transparently.AI
Does the level of inflation matter?
Yes, the level of inflation also matters, but less than a lot of people think. This is because the business of investing is about reacting to change rather than levels. The key point to note is that inflation is not considered bothersome when it is below around 3%. When inflation is below around 3%, most investors ignore gold and stocks typically perform well regardless of the inflation trend.
Generally, the higher the inflation rate above 3%, the less stocks and bonds like it. Figure II illustrates relative asset returns under rising inflation with price increases of different magnitude since 1972. Gold performs best in periods when inflation is between 3% and 5% but also performs well at even higher rates.
Figure II: Real asset returns at different inflation levels with a rising inflation trend
Source: Transparently.AI
How to add gold exposure?
The bottom line from an investment perspective is that if investors perceive a meaningful risk that inflation will trend higher as a consequence of current geopolitical trends, they will expect a more challenging future investment environment.
Corporate failure rates will worsen as margins become compressed and interest rates rise. Investors will increasingly focus on security rather than growth. The need for due diligence, and the importance of accounting quality, will be magnified in such an environment. Products such as that offered by Transparently will be in high demand.
But of course, the biggest demand will be inflation hedges such as gold.
Most investors will add gold exchange-traded products (ETPs) but the problem with many paper gold investments is that most are not actually backed by physical gold in a vault, they are backed by commitments to deliver physical gold. There is counterparty risk. Since there is considerable leverage in the gold market, considerable shorting due to hedging and a lack of liquidity in the spot market due to gold leasing, some perceive a risk that paper gold investments may not perform like gold in periods of extreme stress.
The most recent examples of structural market weakness have related to gold held by central banks.
Central banks hold gold for a variety of reasons, and are among the biggest holders of bullion. In the low inflation era, central banks leased large quantities of gold because it provided income at a time when soft gold prices were weakening their balance sheets. During the period of the lease, central banks have no claim on their leased gold reserves. In a rising inflation period, gold leasing will abate because central banks will prefer to benefit from a rising gold price.
Reduced leasing will lower the amount of gold available to the spot market. In a genuine squeeze, there is a danger that those who have leased gold will be unable to buy it back and subsequently fail. Central bank gold will disappear in the process. If Elon Musk is correct about gold missing at Fort Knox, this is the most likely explanation.
The short of it is that some investors prefer to hold physical gold, gold mining stocks or gold mining royalty companies in preference to ETPs. These will be unaffected if a credit/liquidity problem in the physical gold market impacts confidence in ETPs.
Some will question the strength of the link between gold miners and the gold price. This is not the forum for a detailed discussion but we highlight four issues:
- We calculate that the short-term link between gold stocks and the gold price, the beta, ranges from around 1.4x to around 1.6x. Thus, if the gold price rises 10% in six months, gold stocks will typically rise about 16%;
- The extent of gold hedging is a major complication when comparing gold companies;
- The inflation environment affects the valuation of gold stocks. In extended periods of low and falling inflation, gold miners will underperform physical gold because the price-to-book ratio tends to fall. In the low inflation environment between 1993 and 2015, for example, we calculate that the price-to-book ratio of the four biggest US miners fell from more than 4x to around 1x. The emergence of gold ETPs and of ESG investing exaggerated this trend. In a prolonged upswing in inflation, one should expect the price-to-book ratio of gold miners to increase over time, outperforming gold. If gold ETPs experience a loss of confidence, gold miners will benefit.
- Operating leverage is profoundly important. It refers to the link between a change in revenue, due to a change in the gold price, and the change in profit. The higher the operating margin of a gold miner, the lower the operating leverage. If the gold price rises 10 percent, the profit of a low-cost miner with a 40% gross profit will rise by 25%. However, the gross profit of a high-cost miner with an operating margin of just 5% will rise 200%.
Ordinarily, investors prefer companies with wide margins, lots of free cash flow and low financial leverage. In a sustained gold bull market, however, the weaker gold miners, especially those that swing from making losses to making profits, will outperform strong miners. Thus, the real skill in gold investing is finding high cost miners with good governance, something for which the Transparently system is uniquely suited.
For the purpose of this exercise, however, we have compared the 30 or so largest gold producers in the US, Canada, the UK and Australia. Those that topped the list for accounting transparency and manipulation risk are shown in Figure III. We included some mining royalty companies in the comparison. This list was not exhaustive and we may have missed some.
We considered looking for gold miners with weakest financials (best operating leverage) and good accounting quality but the list was very long and beyond the scope of this note.
The companies included in Figure III have ratings of B- or better. Hedging ratios among these companies vary. Newmont and Evolution have zero hedging. The mining royalty companies also have no hedging.
Figure III: Gold mining companies with ratings of B- or higher
Source: Transparently.AI
The Transparently Risk Engine assigns a 0-100% risk score to each company on the system, which is an assessment of its accounting quality. The score underpins the A+ to F rating that the engine gives a company’s accounts. Companies rated A or B, such as those in Figure III, can generally be regarded to have solid accounting standards.
We should point out that it is difficult for a mining company to get a B rating on our system. This is because mining companies have a highly volatile selling price and often have complex leasing offtake agreements.
The volatility of the gold price frequently raises red flags for business manipulation and margin signals on the Transparently system. Most companies do not have the revenue volatility of miners and the system sees unusual volatility as a signal to be investigated. In this case, we are aware of what is causing the red flag.
The complexity of lease offtake agreements reduces the transparency of the accounts of many gold miners. It is a genuine source of manipulation risk but is not a major concern in the majority of cases. As with hedging activities, investors in mining companies should make efforts to understand offtake agreements, which vary from company to company.
From the perspective of the Transparently system, all of the miners and royalty companies listed above appear to have reasonably sound accounting practices. This is useful information to be taken into consideration when screening for gold investments.
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