The global economy is at risk of commodity supply shock inflation, something we have not experienced since the 1970s. Both the Bloomberg Commodities Index and the US 30-year inflation expectations are now re-testing a 12-year resistance line. A significant breakout from here would be a big shift in the macro investing landscape. Yes, the aging demographics problem and significant technological advancements are deflationary tailwinds. But in our view, the key reason why consumer prices have not gone higher is due to a long-standing period of depressed commodity prices, a trend which we think is about to change.
The Constrained Supply for Gold
When it comes to scarce commodities, at Crescat, we have an affinity first and foremost for gold and silver, the monetary metals that are among the most supply constrained resources on the planet. Coincidentally, they are facing a new surge of investor demand.
On the supply side, in the disinflationary environment since the precious metals mining industry’s prior peak in 2011, gold and silver miners have been criticized by investors as being capital destroyers. As a result, the industry’s spending discipline in the last decade has swung completely the other way. The majors have underinvested in replacing their reserves creating a supply cliff for the industry while also substantially boosting free cash flow.
Contributing to the supply shortage, the number of major new gold discoveries by year, i.e., greater than 2 million Troy ounces, has been in a declining secular trend for 30 years including the cyclical boost between 2000 and 2007. At Crescat, we have been building an activist portfolio of gold and silver mining exploration companies that we believe will kick off a new cyclical surge in discoveries over the next several years from today’s depressed levels.
Gold mining exploration expense industry wide, down sharply since 2012, has been one of the issues adding to the supply problems today. Crescat is providing capital to the industry to help reverse this trend.
Since 2012, there has also been a declining trend of capital expenditures toward developing new mines. From a macro standpoint, gold prices are likely to be supported by this lack of past investment until these trends are dramatically reversed over the next several years. Credit availability for gold and silver mining companies completely dried up over the last decade. Companies were forced to buckle up and apply strict capital controls to financially survive during that period. Investors demanded significant reductions in debt and equity issuances while miners had to effectively tighten up operational costs, cut back investment, and prioritize the quality of their balance sheet assets.
It is important to consider that the last times this industry had been acting in a similarly conservative fashion, metal prices were at historically low-price levels. This time, however, we are seeing corporate discipline with gold prices remaining near all-time highs. As a result, the major producers today have surprisingly swung into being cash flow machines. They are enjoying more free cash flow than they had in the past 25 years, an incredibly bullish setup for the entire industry, especially the smaller exploration focused players that Crescat is overweight in today. The majors are in a great position to harvest cash for the next few years. But they are also facing a supply cliff because they have not replaced their reserves. Over the next several years, they will need to make acquisitions in the exploration segment to rebuild them.
The Demand Side for Gold
On the demand side, the first key macro driver for the price of gold is central bank debt monetization, which drives increasing inflation expectations and investor demand for inflation protection for accumulated savings. Today, money printing through central bank balance sheet expansion is widely accepted and embraced. It is the only viable policy as a way out of the otherwise deflationary global debt burden, at a historic high of 365% of worldwide GDP. With deficits at World War II levels in the US, we expect money printing to be the path of least resistance among policy makers towards easing debt burdens and reconciling many of today’s economic imbalances, though it will likely come at a cost to savers who are invested in overvalued traditional financial assets.
As we show in the chart below, gold underperformed the pace of global money printing from 2011 to 2018. But since the Repo Crisis in 2019 and the coronavirus led recession that followed, global QE has been accelerating to the upside once again. Gold is being pulled up with it. Our near-term target price for gold is north of $3,000 per Troy oz. based on our macro model shown below that plots the price of gold vs. the aggregation of the top eight central bank balance sheets. This target will almost certainly be rising in the near-term with $5.8 trillion just in US Treasuries alone maturing in 2021 and much of that needing to be rolled over and funded by the lender of last resort.
The Fed, the printer of the world reserve currency, has given itself, and by extension its central bank counterparts around the world, the green light to err on the side of inflation. The US central bank has declared that it can exceed its 2% inflation target temporarily abandoning one side of its dual mandate to favor the other side of it which is full employment. So, err on the side of inflation, the Fed almost certainly will.
Inflation is a toothpaste that sovereign Treasuries and their central banks throughout history have struggled putting back in the tube once they have let it out. In practice, inflation is driven in large part by the expectations and actions of consumers and investors which are hard to predict and occur with lags and unknown multiplier effects in relation to monetary policies. When consumer and investor psychology shifts toward recognizing and acting upon rising inflation, it becomes highly reflexive, i.e., circular and self-reinforcing.
The second key macro driver for upward trending gold prices on the demand side today is declining real interest rates, which are a combined reflection of central bank interest rate suppression tactics and investors’ rising inflation expectations. The recent plunge lower in real yields (shown inverted in the chart below) has diverged from the price of gold signaling a strong impending move upward again in the metal.
The outlook for gold all ties back to the bigger macro imbalances we see in the US economy today. The Federal Reserve is crippled in its ability to prevent inflation and instead has become the funding mechanism through its massive purchases of US Treasuries that enables the US government to run a large fiscal deficit. The Fed essentially has no independence in the matter. It must fund the government’s fiscal stimulus programs as the lender of last resort. And as the repo crisis showed, the liquidity is also necessary in the short run to prevent the equity and corporate bond markets from collapsing, but this is very shortsighted because rising commodity prices and real-world inflation, that is the byproduct of the newly printed money, is the killer of record overvalued financial assets.
The Opportunity for Gold Exploration
As we showed above, the underinvestment in most of the last decade in the gold mining industry will soon send the majors scrambling to invest their near term soaring free cash flow in the most prospective new gold and silver deposits being explored today. These properties are in the hands of the extremely undervalued and ultra-depressed small cap segment of the mining industry, the junior explorers, a group that has been through a brutal, capital starved bear market that effectively lasted ten years. The whole industry completed a double-bottom retest by successfully holding above its 2015 lows and rebounding sharply to lead all industries in stock price performance coming off the March 2020 correction. We think there is much more performance ahead for this industry as it is still in the early stages of a new secular bull market.
We are confident that within the precious metals mining industry, the most value for shareholders will be created from the small cap exploration segment over the next several years. We think Crescat’s Precious Metals Fund and SMA strategies have already started to demonstrate that potential in 2020.
By working with world-renowned exploration geologist, Quinton Hennigh as Crescat’s geologic and technical advisor, Crescat has already created an activist portfolio of over 50 companies where we are among the largest shareholders of a targeted 200 million ounces new high-grade gold equivalent discoveries. We plan to continue to grow these targeted ounces while getting the needed investment capital to our companies to prove out these economic deposits through drilling and discovery.
Crescat’s activist fund is a large and significant capital deployment opportunity. We are currently seeking a select group of right-minded institutional partners who can understand and appreciate the focus, scale, and timeliness of what we have set out to accomplish in this fund.
Our activist portfolio is positioned ahead of a likely major new wave of M&A by the large and mid-tier producers which are still to come as they necessarily must replace their reserves through acquisition. We also have a handful of holdings that we call keepers, the cream of the crop companies that control the unquestionably new world class, high grade gold and silver deposits that will catapult them into the next great mid and large cap gold producers in the industry over the course of the new secular bull market.
To be frank, buying gold or silver is not a contrarian investment position today. There are enough people in agreement with the idea that all government backed fiat currencies are doomed to some level of devaluation through inflation due to the level of fiscal and monetary imprudence and unsustainable debt imbalances in the financial system. Naturally, with a constructive view on precious metals, the next step for most investors is to start dipping their toes into well-known and established mining companies. Despite their past reputation of being capital destroyers, investors today are warming up to the idea of buying the “Newmonts and Barricks” of the world or even ETFs such as GDX and GDXJ. What we see as contrarian, however, is a much bigger opportunity to unlock value through a well-targeted strategy in the exploration segment of the industry. No doubt, many are skeptical of the gold exploration business, given its poor performance during the last downturn in the industry at large, but the biggest gains today in the industry are likely to come from what are the smaller cap names.
source: http://www.crescat.net
