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Turnaround: Should you start allocating to ‘beaten up’ gold?

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17/02/2014
After a torrid 2013, the first few months of this year have seen a gold rally. But will it continue?

The numbers don’t lie – gold and indices heavy with gold miners had a terrible time last year. By the end of 2013, the S&P GSCI Gold Spot Price had fallen by close to 30% and the HSBC Gold Index finished down by just over 50%.

But from this low base, things have started to change. The New Year seems to have breathed a fresh breath of air into the precious metal and the companies that extract it from the earth.

The HSBC Gold Index is up about 11.4% so far this year and the S&P GSCI Gold Spot price is up just over 6%. Compare this to the MSCI AC World Index, which is down about 4%.

Add to that the fact that seven of the ten best performing funds so far this year are gold-focused, according to figures from data provider FE.

Confidence in gold

So, what’s the story behind the numbers? For Henderson fund manager in the multi-asset team James de Bunsen, this bounce is simply about investors “seeing value in a very beaten-up sector”.

“Gold shares have massively underperformed – by nearly 200% over the past five years – and this differential has simply narrowed,” he said. “Secondly, the gold price appears to have found a floor at about $1,200 per ounce and has bounced a bit from that floor.”

However, gold is most often viewed as a safe haven play – a place to put money in uncertain times. So could gold-focused stocks’ return to favour mean investors are becoming wary of the dizzying highs reached by equity markets and taking a ‘risk-off’ attitude?

“The recent pick-up in gold, and other market moves, does suggest a return among some investors to a more risk-off approach,” according to Architas senior investment manager Sheldon MacDonald.

This was triggered, he said, by concerns about emerging markets and quantitative easing (QE) tapering, followed by some worse-than-expected US economic data.

Schroders fund manager in the multi-manager team Robin McDonald said this year’s gold uptick is a “modest unwind” of an extreme consensus last year which saw managers ‘long equities and short bonds’ believing a strong Western recovery was at hand.

McDonald believes gold miners appear “very cheap” relative to the metal, and has taken a small position there.

Fidelity Multi Asset Income fund lead portfolio manager Eugene Philalithis is in general underweight to the sector, but has some indirect exposure through his equity fund holdings, and agrees with McDonald on gold miners.

“Some of the large gold miners are attractive to value-orientated managers today,” he said. “Additionally, we hold some precious metals exposures via futures in our more top-down funds. Of the funds we cover, Investec Global Gold and BlackRock Gold & General are considered excellent options.

“They both have deep, experienced teams and are well-positioned to benefit from any rebound in gold prices as well as other less mainstream precious metals.”

Dealing with risk

So opportunities for investors are out there in the gold-focused sector, but what about the risks? Even within the attractively-cheap gold mining sector these are many and varied.

“Part of what appeals to some investors about gold miners is the tremendous performance gap that began to open in late 2011,” according to Philalithis. “It’s tempting to see this as something which will eventually reverse. However, the consensus is that at least some of this is structural and perhaps permanent.”

He added: “As far as other risks go, political instability is an important factor given the location of many mines in less-developed countries, but this is well understood by investors. Often underpriced is the risk presented by rising production costs and production delays that sometimes affect large projects.”

Schroders’ McDonald acknowledges the risks are “countless” – from falling gold price to rising extraction costs – but he believes these issues are very well known and are, to an extent, “in the price”.

Certainly the favour investors have been showing the gold-focused sector so far this year would suggest these are risks they are willing to take. So after its strong start, is the gold-focused sector one to watch in 2014?

Most of the multi-managers we spoke to said ‘no’.

“My view is that it may be too early to start allocating heavily to gold, and therefore gold miners,” said Philalithis. “However, if the view on gold prices changed then I think mining stocks would deserve a look.”

Philalithis added gold spot price is hovering near the average of production costs, and producers in aggregate are now hedging less of their production forward than in recent years.

“This allows operational gearing – or gearing to the price of gold – to shine through more clearly. The recent bounce could last a while longer, but our sense is gold has further to fall,” he concluded.

Emperor’s new clothes
“The argument for buyers is that gold will be a store of value in inflationary times, and empirical studies provide some support for this. However, our view is that this is only true as long as everyone believes it to be true – just like The Emperor’s New Clothes.”
Architas senior investment manager Sheldon MacDonald

Natural resources fund manager view
James Sutton, client portfolio manager, JPM Natural Resources Fund, cautions investors not to get too excited about the bounce in gold, but likes large cap miners.

“Gold might have bounced back as a safe haven trade in the emerging markets sell-off, but we remain cautious. Gold miners are still under a lot of pricing pressure.

“Investors should be careful assuming the recent bounce in gold prices changes the fundamental outlook. Gold can be a valid hedge against extreme tail risks, but unlike classic commodities, it doesn’t have an intrinsic value. It doesn’t come with a cash flow, it has little economic use and it is not tied to global consumption.

“Historically holding gold has been a good way to hedge against depreciation of the US dollar. However, with US Federal Reserve tapering, US interest rates and the US dollar are going to be volatile. That leaves gold vulnerable. By itself without proper diversification, it’s an expensive insurance policy that only provides limited coverage.”

Gold focused stocks’ performance in 2014 

gold-chart

 

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