Market Update – January 31
Excerpt from our 2023 Annual Shareholder Letter, which can be read in full by clicking here.
There appears to be growing understanding in the market that higher interest rates are not sustainable. As Goldman Sachs released in a research note to clients on October 3, 2023, “A sharp rise in long-term interest rates combined with widening deficits and heightened fiscal discord in Congress have renewed questions about the sustainability of rising government interest costs.” Renowned investor, Stanley Druckenmiller at JP Morgan’s Robin Hood Conference stated, “When the debt rolls over, by 2033, interest expense is going to be 4.5% of Gross Domestic Product (“GDP”), if rates are where they are now,” said Druckenmiller. “By 2043, sounds like a longtime, but it’s really not; 20 years, interest expense as a percent of GDP will be 7%. That is 144% of all current discretionary spending.”
The Federal Reserve (the “Fed”) is clearly aware of its circumstances publishing a paper discussing fiscal dominance on its website – “Fiscal dominance refers to the possibility that the accumulation of government debt and continuing deficits can produce increases in inflation that “dominate central bank intentions to keep inflation low. ”Meaning, Fed policy to fight inflation is getting boxed in due to the size of total federal debt outstanding and the cost to service that debt, in our opinion. The Fed has signaled it plans to pivot and cut rates in 2024. Whether it is motivated by election year politics is open for debate. What we do know is past peaks in Fed Funds have corresponded with rising gold prices and peaks in the S&P 500 over the last three interest cycles with precious metals equities indices delivering between 200% to 400% gains.
Our view is when the gold price breaks through new highs, it will reinforce a narrative that past fiscal and monetary policy failures have boxed the Fed into a policy that promotes inflation and monetization of U.S. debt by the Fed to meet fiscal obligations, or face a deflationary credit collapse with a follow-on banking or credit crisis.
While gold prices have held firm since the height of the regional banking crisis in the spring of 2023, holdings of gold in exchange traded funds (“ETFs”) have nosedived as investors pull money from gold assets to participate in the Big Tech Artificial Intelligence (“AI”) rally and purchase treasuries. Countering negative Western sentiment toward gold has been large purchases of gold by foreign central banks. China, Russia, Czech Republic, Uzbekistan, Philippines, Singapore, and Qatar were buyers gold in 2023. China’s holdings of U.S. Treasuries are trending down, while its gold holdings are increasing, up 204 tons through November2023. It added 23 tons in October. The National Bank of Poland (“NBP”) has stated its “dream” is to get to 20% gold holding in its central bank reserves. It added 58 tons in Q3 to the 48 tons purchased in Q2. For context, Poland currently holds 334 tons of gold or 11% of its reserves. Central banks may have different agendas in purchasing gold. For countries such as China, Russia, India and other BRICS countries, they may besetting the stage for an alternative settlement system to the U.S. dollar. For others, it may simply be the stated goal of protecting against purchasing power debasement of main fiat currencies, USD, yen and euro. Central bank buying affirms gold as a monetary asset. For the Chinese and Russians, they may be trying to follow the “Golden Rule – He who has the gold makes the rules”.
Despite the gold price performing well over the past year, investor indifference toward value and “real” assets is punctuated by the concentration of capital into the Magnificent Seven4 stocks (“Mag 7”) representing a record 29% of the entire S&P 500 as of November 30, 2023. For context, the sum of the market cap of 15 of the largest gold producing companies is glaringly only 2% of the sum of the market cap of the Mag 7. We believe this speaks to the opportunity for investors who can connect the macro dots. If just 0.5% of the market cap from the Mag 7 were to flow toward the selected basket of precious metal miners, it would represent a 16% increase in market cap for the gold miner basket.
Shares of Gold Mining Companies
The divergence between the gold price and precious metals equities over this past fiscal year was and is understandably disappointing for investors. We believe capital flows into Big Tech chasing the wave of excitement tied to AI, plus investors finding 5% treasury yields enticing after a prolonged period of near zero yields, along with investors who invested in gold assets during COVID no longer feel the need for a defensive asset. It is worth noting that capital investment into the precious metals sector has historically been inversely correlated to the technology sector. When tech is booming, precious metals equities tend to be out of favor as investors chase growth versus safe haven assets. Whatever the reason, precious metals equities have been sold down to levels that represent 50% of book value on existing capacity.
When sentiment towards a sector is negative, the market will look for reasons to not buy as short sellers dominate the narrative that moves price. Margin compression has been the theme or excuse given for generalist investors holding back from looking at precious metal equities, which historically provides leverage to sustained higher gold prices. Though many gold miners did suffer through historical inflation during the Covid-19 supply squeeze, mostly with higher diesel costs, the margins have been sustained and surpassed over the past 5 years. For example, the average change in the all-in sustaining costs of the largest gold miners has increased by roughly 39%. It is important to compare the rise in costs to margin increase, which has increased by over 68%. Mining company managements have signaled inflationary pressures have stabilized, with miners set to deliver higher margins with a sustained $2,000 plus gold price. We believe the precious metals mining sector is on the cusp of attracting significant capital flows once confidence in central banking wanes along with sentiment in the broad market rolling over.
Since the precious metals sector is a depleting resource business, gold reserves and resources must be replaced through exploration or acquisition. Two of the most successful companies replacing and adding reserves through exploration in our portfolio have been Alamos Gold, Inc. and Endeavour Mining PLC. On the Merger and Acquisitions (“M&A”) front, Newmont Corp. (“Newmont”) moved to reacquire a legacy spin off in Australian major producer Newcrest Mining Ltd., which was announced on February 5, 2023. The $16.81B deal, one of the world’s largest of the year, was finalized in late October. Under the deal, it is widely expected for Newmont to sell several of the mines with annual production under 500,000 ounces in its combined portfolio. Thus, several intermediate and junior gold producers have been circling looking to add to their production profiles. As with many industries, one way to attract capital flows is through accretive M&A activity. We see the Newmont reorganization as a possible catalyst for capital moving toward the sector.
What helps separate the OCM Gold Fund from other precious metals funds is our ability to create sizeable allocations, respectively, to high quality assets that are still under invested, which can be seen in our 5 and 10 – year performance compared to our peers (1st in sector). The pockets of relative strength in the sector over the past few years have been in a select group of junior gold producers in Canada and Australia. The lack of discovery success finding deposits with 3 million ounces or more over the past decade, signals to us that the market will gravitate more toward intermediate/mid-tier gold producers and junior gold producers going forward with projects and production in North America and Australia commanding premium valuations. Additionally, we believe those companies that hold equity dear, maintain capital discipline on new projects and understand shareholders need to participate in cash flows will outperform their peers. Your Fund is being positioned accordingly.
We believe the investment case for owning gold assets remains as compelling as ever for investors looking to hedge against fiscal and monetary policy failure in an increasingly volatile geopolitical environment. In our opinion, the fallout from years of extraordinary monetary policy measures going back 20 years remains uncertain, especially in light of fiscal policy backing the Fed into a corner. With total federal debt outstanding having risen from $10 trillion to $34 trillion over the past 15 years, the sustainability of the Fed fighting inflation with higher rates is becoming problematic for the fiscal position of the U.S. The increase in gold purchases by central banks over the past two years can in part be attributed to foreign central banks losing confidence in the USD as a store of value going forward. The other factor leading to increase gold purchases by central banks and selling of treasuries is the world moving away from a uni-polar world headed by U.S. led Western influence to a multi-polar world spearheaded by China and Russia with the group of BRICS nations. The BRICS countries are looking for trade settlement away from the USD in addition to holding a neutral reserve asset immune from Western sanctions.
While the gold price has moved above $2,000 on the back of central bank purchases and strong Asian demand, Western sentiment toward gold assets is suffering a similar fate to the dotcom era, only this time it is Big Tech AI that is sucking up all the folks and capital with fear of missing out (“FOMO”). Gold assets are being liquidated from bullion ETFs to shares of gold mining companies in the West as investor exuberance on Big Tech and confidence the Fed can engineer a soft-landing shades investors’ ability to connect the macro dots. As famed Oaktree Capital founder Howard Marks said, “In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical”. The period following the bursting of the dotcom bubble in 2001 ushered in a tremendous bull market in gold assets. If Western investors join Asian and central bank buying from current levels over $2,000, the prospect for outsized profits for gold mining companies and in turn appreciation of precious metals equities is high, in our opinion. For us, we believe the time to position to make the best returns in a sector is investing when capital is scarce in that sector. Capital is certainly scarce in the precious metals sector at present.
We appreciate your shareholding and confidence in the OCM Gold Fund, and we look forward to meeting the investment objective of preserving your purchasing power. Should you have any questions regarding the Fund or gold, please contact your financial adviser or you may contact us directly at 1-800-779-4681. For questions regarding your account, please contact Shareholder Service at 1-800-628-9403