Gold Tops $2,000 and Silver Soars

August saw gold bullion breakout above $2,000 to reach a new all-time high before pulling back. Gold bullion¹ was up 29.69% YTD through August 31, 2020, and 29.43% YOY. Both silver bullion and gold mining equities reached multi-year highs in August. Gold mining equities (SGDM)² gained 44.71% YTD, and 41.87% YOY as of August 31. This compares to 9.74% YTD and 21.94% YOY returns for the S&P 500 TR Index.⁶ Silver bullion⁷ posted outsized gains in August and was up 57.64% YTD and 53.15% YOY as of August 31.

Month of August 2020

Gold Bullion Trades > $2,000/oz Before Pullback

After touching a record high of $2,075 on August 7, gold bullion closed August at $1,968, losing $8.06 or 0.4% for the month. Gold saw a small correction mid-month due to a backup in bond yields as the July U.S. unemployment figure was better than expected, a substantial U.S. Treasury issuance approached and some other minor positive economic news was reported.

Gold has had a tremendous move from its March low of $1,452 and was ripe for some profit-taking. We are not surprised by gold's softer performance in August, given the notorious low August volumes and investor caution ahead of the virtual Jackson Hole Economic Policy Symposium held on August 27-28. We continue to see gold well supported above the prior cycle high of $1,900 as it settles into a sustainable $2,000-$2,200 trading level.

Silver had a fantastic August, touching $29.86, and climbing 15.39% for the month. Silver ended the month at $28.14, just shy of our $30-$35 next level target range. Silver appears to be consolidating above the $26/$27 range before it re-tests the recent highs. The SLV ETF⁷ has dominated silver trading since July. Currently, there are 6.9 million open interest calls. The majority of the calls appear to have been rolled forward from the prior month; positioning remains very bullish. Typically, the period from September to December tends to have a pro-cyclical bias as next year's expectations are brought forward into the market. In September, "next year" tends to have an optimistic bent. Silver performs best when gold bullion is firmly supported, and a pro-cyclical view is in place.

Gold Mining Equities: Earnings are Strong and Getting Stronger

Gold mining equities had a minor pullback in August (off 2.02%)² and are consolidating well above important technical support levels (e.g., $40 on GDX³ as a reference). As the market begins to build in a higher-for-longer consensus view for gold bullion, we will continue to see very robust increases in earnings outlook and target price projections. With gold bullion near $2,000, and industry AISC (all-in sustaining costs) running at approximately $1,000 per ounce, the industry is realizing approximately 100% operating margins in one of the worst global recessions in the past century.

This is worth repeating: Gold miners are enjoying 100% operating margins in a severe recession.

Figure 1 highlights the disparity in the earnings outlook between broad equities and miners. Year to date, the best earnings per share (EPS) estimate for the S&P 500 Index has fallen 25% while the EPS for gold mining equities, as measured by NYSE Arca Gold Miners Index (GDM),⁹ has increased 20%. This is with GDM EPS calculated using consensus gold price deck estimates that are well below the realized and futures price. Typically, there is a two- to three-month lag before earnings begin to reflect realized higher prices, so we would expect earnings momentum to continue. Also, from the spring trough lows, the GDM EPS have been revised up 36% while the S&P 500 Index is up 5%.

The S&P 500 Index is at a record high, all due to higher P/E (price-to-earnings) multiples. It is also highly concentrated in a handful of mega-cap technology stocks (FAAMG: Facebook, Amazon, Apple, Microsoft, Google) that now total more than 23% of the S&P 500 Index by weight. The P/E on the S&P 500 Index has now surpassed the all-time P/E high of the 1999/2000 bubble. In comparison, gold mining equities year-to-date have a flat P/E multiple; earnings have driven all the advance. In Figure 2, the one-year target price for GDM has increased by 45% versus 7% for the S&P 500 Index year-to-date. Higher P/E projections have driven all the increase in S&P 500 Index target price from the spring lows.

Figure 1. S&P 500 Index Best EPS Estimate vs. Gold Miners (GDM) Best EPS Estimate

Source: Bloomberg. Data as of 8/31/2020.

Figure 2. Consensus Target Prices for S&P 500 Index and Gold Miners (GDM)

Source: Bloomberg. Data as of 8/31/2020.

For Gold, Real Bond Yields are Telling the Real Story

In the first week of August, gold had a sharp move to its all-time high of $2,075. This move was driven by real yields falling dramatically but more so in the short end, signaling a steep deterioration in the growth outlook. The inflation expectation (growth) outlook was falling well below the U.S. Federal Reserve's (Fed) 2% target. The short end of the real yield curve should have been pinned down by Fed policy, while the long end of the real yield curve should have pulled higher by a better growth outlook. Instead, the entire real yield curve parallel shifted sharply lower, resulting in gold prices spiking. In addition to the real yield curve view of a deteriorating economic outlook, the other possible interpretation would be that the Fed policy is losing its influence and potency, especially in the longer end.

The downshift in real yields and the real yield curve has also affected the U.S. dollar (USD). We reviewed the many causes of a weak USD in our July commentary. The USD is highly influenced by real yields, especially at the shorter end, which is breaking to seven-year lows. The U.S. 10-YR Treasury real yield closed the month at an all-time low. These two factors alone remain highly supportive of higher gold prices, but another consideration is the migration of assets from the bond market to gold. By early August, the U.S. 10-YR Treasury yield had fallen to 0.50%, and the 30-YR Treasury yield had dropped to below 1.20%. With Fed policy at the zero bound, there is not much more upside potential, but there is considerable risk to the downside. Buying a 30-YR Treasury bond with a paltry 1.20% yield with a terminal payoff in a currency the Fed is actively depreciating is questionable. Since the August peak, the 30-YR Treasury yield has backed up to 1.47%, or a 4.80% price drop; there is plenty of convexity risk. The only viable portfolio argument is that bonds offer diversification. At the current pricing levels and ZIRP (zero interest rate policy), the historical negative correlation of bonds to equities continuing is highly doubtful; rather, it will likely be a more non-correlated type of relationship (diversification).

We have long advocated that gold offers a far more compelling investment argument than bonds, from a risk-reward, diversification and a store of value point of view. Since 2016, gold has outperformed the U.S. Treasury Index by more than 50% on a relative basis. Considering we are at the zero bound for bonds for the foreseeable future and with much more stimulus inevitable, we believe that gold is set to outperform bonds for many more years to come.

Figure 3. Gold Bullion vs. U.S. Treasury Index.
Gold has been outperforming bonds since 2016.

Source: Bloomberg. Data as of 8/31/2020.

Gold Priced in Various Currencies, and Various Currencies Priced in Gold

Gold's performance, as measured in major currencies, has excelled and reached new relative highs. Gold has been held as a store of value for multiple millenniums and as a portfolio asset for several decades or more. Perhaps more than any other asset class, gold seems to bear the burden of excessive amounts of subjective views. In Figure 4, we took several of the largest currencies and indexed to a base of 100 over the past 20 years. Gold has outperformed every currency by a considerable margin (4x to 8x). If we take this calculation back to 1973 when the Bretton Woods Accord's currency-gold exchange pegs finally fell apart, the normalized numbers in Figure 4 will show an 8x to 54x outperformance by gold.

In a fiat currency world, gold makes sense; the only consideration is perhaps timing. When central banks are actively depreciation currencies, gold makes sense, period. When central banks are actively depreciating currencies to this extreme and with more to come, it is hard not to consider gold as a mandatory portfolio holding. The numbers speak for themselves; they are objectively eye-popping.

Figure 4. Gold in Various Currencies Indexed: 20 Years (2000-2020) 

Over the past 20 years, gold has increased in value relative to these five major currencies — U.S. Dollar, Euro, Yen, British Pound Sterling and Swiss Franc.

Source: Bloomberg. Data as of 8/31/2020.

In Figure 5, we highlight several major currencies priced in gold, the inverse of what is commonly seen. On average, the major currencies have lost about 90% of their buying power in gold. There is not a single currency anywhere that has not lost the vast majority of its purchasing power versus gold over the past 20 years. There is not a single developed economy with an issuing currency that is not actively depreciating its currency. Every advanced economy is, in one way or another, to a varying degree, is moving towards an MMT (modern monetary theory) type of monetary policy brought on by the COVID-19 pandemic. The old phrase, "a race to the bottom," has never been more apt or more evident.

Figure 5. Purchasing Power of Main Currencies in Gold

Over the past 20 years, these five major currencies — U.S. Dollar, Euro, Yen, British Pound Sterling and Swiss Franc — have all lost purchasing power value when compared to gold bullion.

Source: Bloomberg. Data as of 8/31/2020.

Another Fed Pivot, Average Inflation Targeting (AIT)

At this year's Jackson Hole Economic Policy Symposium, Fed Chairman Powell officially announced a change in the Fed's inflation framework to an average inflation targeting of 2% over time. There was no specified formula to define how the average would be calculated, but Powell did emphasize that it would be "flexible." The obvious takeaway is that the Fed Funds rate will stay at 0% for a very long time (ZIRP Infinity). Inflation can run hot for a while, and the U.S. unemployment rate can go to very low levels before the Fed raises rates. Under this framework, for example, the rate hikes and balance sheet reduction of 2015 to 2018 to head off inflation and tack back to normalization would not have occurred (Punch Bowl Infinity).

Furthermore, the Fed believes a "robust job market can be sustained without causing an outbreak of inflation," essentially acknowledging the Phillips Curve is broken. This is a critical pivot that MMT supporters have been emphasizing. There also does not seem to be a requirement to run inflation below 2% after running above for a period of time. But the Fed also said it would not hesitate to act if inflation were to become "excessive." Sensible asymmetric inflation targeting.

The Fed, however, did not state how it would achieve its higher sustainable inflation rate, aside from saying it will use the full range of tools (i.e., forward guidance and QE [quantitative easing]). Forward guidance and QE during the past decade were effective at keeping interest rates low but were unable to generate inflation. In the post-COVID world, the Fed's ability to generate inflation seems very doubtful without continuing massive fiscal stimulus programs and other new policy initiatives. The Fed's response to the COVID-19 pandemic and future responses continue to align with a multi-year gold bull market.

It has not, and it will not likely be inflation that powers the secular gold bull market higher. It will be the policies and actions that are undertaken to generate inflation that will drive gold ever higher. To get a sense of what will be necessary, Figure 6 shows the Fed's preferred measure of inflation: the U.S. Personal Consumption Expenditure Core Price Index (or PCE). Since the GFC (global financial crisis), despite all the stimulus and better economic times, the Fed's 2% inflation target was achieved in only two periods lasting a total of 13 months before the Fed tapped the brakes. Since the beginning of 2009, the average inflation reading on PCE has been 1.56%.

To achieve a 2% average inflation from a pandemic-induced recession will be far more challenging. To start, the unprecedented collapse in the global economy was a simultaneous supply and demand shock akin to a deflationary supernova from which the world is still recovering from unevenly. Long term, there are possible embers for inflation, such as reshoring of supply chains, protectionism and the slingshot effect of a safe and effective vaccine coupled with massive stimulus on pent-up consumer demand, but they are undetermined at this point.

Figure 6. U.S. Personal Consumption Expenditure Core Price Index (PCE Index)

Source: Bloomberg. Data as of 9/1/2020.

The path to economic reflation, growth and normalization will require even larger doses of demand-side driven pro-growth fiscal stimulus. From the Fed commentaries on the social-economic impact of COVID, future programs will need to have a redistributive focus to be more inclusive to reduce the gaping levels of inequality, and we can expect big government spending programs as well. From the lessons of the GFC and the new emerging realities of the post-COVID world, the central bankers' view is growing that undershooting the amount of monetary and fiscal stimulus is a far riskier proposition than overshooting the amount of stimulus. In round numbers, in the U.S., the pandemic created a loss of 22 million jobs at the low. So far, 9 million jobs have been recovered. There is a growing concern about how much of the 13 million lost jobs will become permanent. A significant worry is that structural higher unemployment and the lingering presence of the COVID-19 virus will create a state of economic precarity that will blunt stimulus efforts, hence the bigger hammer.

AIT is likely only the first significant change in Fed policy. The September FOMC (Federal Open Market Committee) meeting may provide more important news and further clarity on AIT, YCC (yield curve control) and other possible Fed initiatives. There is still much uncertainty as to what the Fed's policy framework review will entail, but the one near certainty is that long term, it will be bullish for gold as all the paths are converging to a single endpoint.