Everything Everywhere All At Once
John Hathaway, CFA, shares his bullish outlook on gold and gold mining stocks, in the wake of recent bank failures and the Fed’s interest rate tightrope walk. “For open-minded investors, the good news is the train has yet to leave the station, and it’s not a high-risk decision to allocate to gold.”
Ed Coyne: Welcome to Sprott Radio. I'm your host, Ed Coyne, Senior Managing Partner at Sprott. With me today is one of our returning guests, John Hathaway, Managing Partner and Senior Portfolio Manager at Sprott. Thank you for once again, John, joining us on Sprott Radio.
John Hathaway: Thanks, Ed.
Ed Coyne: John, let's dive right into it. The last couple of weeks have been very newsworthy as far as what's going on in the overall economy, what's going on in the market, what the Fed's doing and what gold is doing. I know you’ve had over 50 years of investment management experience, and I suspect you've seen just about everything from what the market has done, what the Fed's done, how gold has reacted and so forth. But, in this current environment, the Fed's bailing out banks and depositors, and at the same time, it is raising rates. Is that something you've seen in the past?
John Hathaway: This is unprecedented. I think we are in uncharted waters. This looks like the credit bust many of us in the gold patch have predicted. The movie that won the Oscars was Everything Everywhere All at Once, and that's what's happening. It's not just Silicon Valley Bank, it's not just Credit Suisse, it's not just the banking system, it is everything everywhere all at once, and that is the story.
It's a credit bust that has resulted from 10 years of manipulated interest rates going back to the global financial crisis in 2008, and the amount of leverage that was put on the books, deals done on the assumption that rates would stay low forever, which is what Fed was saying only a few years ago. You'll see many bodies floating to the surface over the next few years, and I think the banks are just the tip of the iceberg.
Ed Coyne: Thank you for that image. I think that will resonate with a lot of our listeners today. Still, it's interesting to see what's going on in the market because the S&P 500 at the time of this recording has been rising since mid-March, although it dipped a bit today (March 22) when the Fed announced another 25-basis point bump in interest rates. When we talk to our investors, they continue asking why isn't gold doing even better?
Last year gold did very well. It was flat when the market was down 19%, somewhere in that range. And year to date, gold is doing quite well, and today it did well when the Fed made its interest rate announcement. What do you say to investors when they ask why gold is not doing what we'd expect?
John: First of all, if you go back to the peak in the S&P 500, which was, I think, the beginning of last year, I think it was around 4,900, today it's down 20% from that level. Gold, taking that same starting point at the beginning of 2022, is up about 7%, maybe a little more than 7%. Gold stocks are basically flat. We are in the very early stage of recognizing the severity of the credit issues I discussed in my opening comments. It doesn't surprise me that most investors are still trying to gather their wits about the damage that's been done to their mainstream portfolios over the last year or so.
That's why the flows into the gold and gold mining stocks have been very lackluster. The good news for investors that want to be open-minded is that the train has yet to leave the station, and it is not a high-risk decision to allocate capital to this strategy because it's not as if it's on everybody's hit parade. Most people aren't even aware of gold. I think we are within striking distance of new highs for the gold price, and I believe we will see that in the days ahead, the months ahead.
Mining stocks are behind the gold price. The GDX, the proxy for gold mining stocks, is flat relative to the starting date we discussed, January 2022, and gold is up 7%. And gold mining stocks are enormously leveraged to the kind of move that I envision for the gold price.
Ed Coyne: You talk about just the last year and a half, but if you look at the previous couple of decades, many investors are shocked that gold's outperformed the S&P 500. We have more financial engineering going on in the market and more bumps in the night – whether it's COVID, the global financial crisis, or the tech bubble – that have all contributed to increased volatility. When you talk about gold over multiple decades, the last couple of decades, it's done very well. Why do you think that is?
Before we go into that, I will take a step back. You mentioned the train hasn't yet left the station. When investors want to add gold to their portfolios, how should they think about the physical gold market relative to the gold equity market? Are those two separate allocations, or how should someone think about that?
John Hathaway: Gold, the physical metal, is safe haven. And it's becoming increasingly clear that this is the case because bonds, which were traditionally considered safe havens, have been rocky, particularly longer-duration Treasuries. Fixed income has also been rocky. There are not many safe haven investments around. If you go back to the dawn of radical monetary policy, which was 2000, gold has performed as well or probably better than other broad categories of investment assets, including equities and bonds, the two main ones. Gold mining stocks are more volatile, but they have their moments, and I think that moment is upon us where they're likely to outperform.
Physical gold is for investors who are seeking safety. For investors looking for the alpha, the added return that can come from having the correct macroeconomic view and understanding of the dire straits that the world is facing in financial markets, gold mining stocks are the appropriate allocation. Again, they don't come without risk. They are two different investment approaches, but they are linked at the hip.
Ed Coyne: Let's stick with the miners for a moment. Like the S&P 500 and the Russell 2000 indices, you've got the large-cap senior miners that are much more established and typically have multiple mine sites. Then you have the smaller-cap junior miners. Talk about the difference between those two and what risks impact large-cap seniors relative to small-cap juniors. From an opportunity standpoint, where are you looking right now? I'm not asking for specific names, but from a market-cap and size standpoint, where do you think the greatest opportunities are among the gold miners?
John Hathaway: In terms of potential upside, probably from the mid- and smaller-cap gold mining names. But the entire spectrum of gold mining stocks is poised to do very well if the gold price accelerates from here, which is what I think. Obviously, there is much debate about that. The big-cap mining companies should be just fine. They pay pretty decent dividends, so they're justifiable holdings in mainstream-type portfolios.
For people who are more interested in maximizing returns – and this is not something I would try at home alone without some guidance from an investment manager such as Sprott – the potentially biggest returns lie with the mid- and smaller-cap gold miners, the five baggers, the 10 baggers that you can get from this entire investment strategy having been out in the cold for many, many years. The compression of value is enormous. I think all it would take is another $150 in the gold price, which is 5%-7% higher from here. That could be life-changing for all gold stocks, particularly for the single asset mid-cap to smaller gold mining stocks we specialize in.
Ed Coyne: John, I guess this was happening more last year when there was some doubt about gold equities because the cost of labor was going up, access to labor was tight, materials were going up, fuel prices were going up, and that hits the bottom line. That seems to have waned a bit. You mentioned this earlier about the quality of the balance sheets. Talk a little bit more about that, because I think something that most of our listeners might be surprised by is that these are some very high-quality companies from a cash standpoint, from a lack of leverage standpoint.
I think our listeners would enjoy hearing what that space entails from a quality or value standpoint. Is there value there? What do these companies look like on an absolute basis but also relative to stocks in the S&P 500?
John Hathaway: Many of the things you mentioned are yesterday's news. The margin squeeze that was troublesome a year ago or six months ago is not as problematic today. Another issue is the cost of building a new mine, which involves big risks. Many of these smaller companies have bet the ranch and put their balance sheet at some risk to take on large projects. But we've identified a handful of very good smaller gold mining companies where they've crossed the finish line, and the build is behind them, and the risk to the balance sheet, to the share count, all of that kind of thing, again, is yesterday's news. I would say that's the opportunity set that we see.
When we're talking about the big-cap gold mining companies, they’re quality. They have strong balance sheets, low debt, highly liquid capital structure. Let's talk about margins for a second. Again, we've been through a year when the cost of producing an ounce of gold has increased by about 10%. It's gone from $1,100 to maybe $1,250 or $1,300 an ounce. That's a global take on the cost curve.
Should that flatten out, and I think it may still go up a little bit, but not as much as last year, and in the meantime, the gold price is around $1,800. We're knocking on the door of $2,000, so call that 15% on top of the $1,800 we're looking at with rearview mirrors. Margins are exploding higher, and costs are beginning to stabilize. While corporate America and Silicon Valley will be licking their wounds with debt issues and lousy business conditions, the gold mining sector is the only one that I can think of, and I might be missing one or two things, that will enjoy good business conditions in a recessionary environment.
The market cap of this space is so small, just a couple of hundred billion, that when investors see the opportunity and start migrating into it, we’re likely to see good returns over the next couple of years.
Ed Coyne: Is it fair to say for a newer investor looking at the gold space, start with physical first as a risk mitigator to help hedge their portfolio, and then, as they get comfortable with that allocation, begin considering a basket of gold mining stocks through an ETF or a mutual fund? Is that what you're saying to the investors listening to this podcast?
John Hathaway: It's much easier to get your arms around the safety aspect of owning physical gold, but I would imagine that we have a lot of listeners that are a little more greedy than that and might like to see a little bit of return to offset the challenges they may be facing in their mainstream investment strategy. Gold may help, but gold mining stocks have the potential to offset a couple of years of bad returns in standard variety S&P 500-type stocks.
Ed Coyne: These are some great comments about gold mining equities because you could be thinking about both right now. You can be risk-off with physical gold and more opportunistic with gold mining equities all in the same allocation, which is exciting right now for our space.
Let's talk about what's going on with the announcements of the shotgun marriage over the weekend of Credit Suisse and UBS following the collapses of Signature Bank and Silicon Valley Bank. All these things have happened. In your mind, is the tide finally going out, or is there more to come potentially?
John Hathaway: There's never just one cockroach. These are early versions of the other cockroaches we'll soon see. Don't forget that the banking system, which is supposedly safe because of all the Dodd-Frank regulations that came after the global financial crisis, is no longer the major engine of credit creation. The major engine of credit creation is the non-banking financial sector, which the numbers off the top of my head are 20% to 30% larger than the banking system. That would include everything from hedge funds to pension funds.
The pension funds are loaded with bad stuff that will roll over. The numbers I've seen regarding the potential shortfall, particularly in defined benefit plans, will be in the trillions of dollars. If the government bailed out the fat cats in 2008, I have a hard time believing it won't be bailing out the pension funds, which are the workers, the middle-income and lower-income sectors of the population.
The kinds of bailouts that are on the way that are going to break an already broken fiscal situation are almost too large to imagine. Those are the kinds of things that will, I think, explode the potential valuation of gold against paper assets. I believe we are just around the corner from that recognition.
Ed Coyne: Where is that money coming from? The problem now is that we issue more debt, and we're paying higher rates. So are we effectively issuing more debt to cover the interest rate payments? It just seems like it's a vicious cycle.
John Hathaway: We are now borrowing to pay interest on the national debt. Interest on the national debt could be as much as a trillion dollars this year. Thank you, Jay Powell, for that. Thank you to all the administrations of the last 20 years for that because we have an ongoing budget deficit of a couple of trillion dollars, and that's without a recession. With a recession, it'll go up even more.
As I remember reading my early-stage economics lessons, when a country starts borrowing to pay interest, it deserves the designation of a banana republic. We are officially entering into banana republic territory. The credibility of our currency, the U.S. dollar, is in dire question. I would expect to see that reflected in a lower exchange rate relative to the Euro and other major currencies, but most importantly, relative to gold. We're in the rapids before Niagara Falls. I can hear the rumbling in the distance, and I think it's good for gold. I think everybody else ought to start paying attention.
Ed Coyne: I think you're spot on with the paying attention part. The easy money is all going into the S&P 500. I think those days are far behind us, and being a little more thoughtful about how you allocate is certainly something we all need to be focused on. Something as simple as an allocation to physical gold can be a good start in helping you diversify your portfolio in a low-cost liquid way. John, I always appreciate you making time for our listeners and me on Sprott Radio.
For those listeners that want to learn more about Sprott and our metals and mining suite of solutions, we always encourage you to visit us at sprott.com. John Hathaway has published commentary and you can read more about his thoughts by visiting sprott.com/insights. Once again, I'm your host Ed Coyne, and you're listening to Sprott Radio.
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