Description

Long GDX:

While we have historically refrained from pitching macro or thematic investments on VIC, we view the current set up for gold miners as incredibly attractive and recommend buying a basket of miners via the GDX.  We are bullish on both the price of gold and the miners.  Given the significant lag relative to gold, we feel the miners are primed for a period of out-performance.   We believe this will be driven by continued strength in gold prices and a more favorable cost environment for the miners vs. the last 2 years.  Any fund flows out of mega cap tech into other parts of the market would also be a significant tailwind given the entire market cap of the GDX is ~$320bln, vs $11.8T for MSFT/AMZN/GOOG/NVDA/AAPL. 

For target prices, we consider GDX’s prior peaks in 2020 and 2022 in the low $40’s (up 30%+) as an easily achievable base case target.  We note that GLD itself was at least 10% lower then, suggesting a “parity” target for GDX of $45 (up 42%). But history shows that miners can dramatically overshoot targets after periods of lagging.  If we are right about a) continued GLD strength, b) continued alleviation of post-covid cost pressures on miners, and c) a flow of funds out of the Mag7/FANG complex, then conditions might be right for a sizable overshoot by GDX.  

Background:

Since the beginning of 2022 the GDX has lagged gold by ~19%.  Given gold miners should have a positive beta to gold prices given their operating leverage this is a very disappointing outcome.  We believe this is driven by a combination of negative earnings revisions caused by higher than expected costs and fund flows.  As the charts below show, margins have declined in a rising gold price environment, while costs have come in above guidance. This has been compounded by investor focus on other market segments (FANG, AI ect).  For many of the miners consensus EPS expectations have been consistently revised lower over the last 2 years, while also seeing valuation multiples compress.  This is especially true among the larger bellwether companies in the sector such as NEM, GOLD and FNV. 

While the miners have been disappointing, gold has been setting new nominal highs. This is despite the Fed raising interest rate over 5% and shrinking its balance sheet over the past 2 years.  This is historically unusual as gold prices tend to be negatively correlated with real rates.  Speculators also seem to have been net sellers of gold, as the amount of gold held in ETFs has been declining.  Central banks have more than offset this, significantly increasing their purchases since the start of the Russia/Ukraine war. 

Real rates (Inverted) vs Gold:

Gold’s Outlook:

We believe gold prices should continue to grind higher driven by several factors.

1: Rates are expected to move lower.  While the market could be wrong around the timing of a rate cut this year, the direction of Fed funds rates is lower over the next year.  Historically this has resulted in both gold and the GDX rallying. 

 2: The US dollar is historically expensive relative to other currencies and likely to decline in a rate cutting environment. At the very minimum it is unlikely going to be the headwind to gold prices that it has been over the past 2 years.

3: The US fiscal outlook is increasingly dire, driven by impossible to cut entitlement programs.  This could be its own separate post entirely, but we feel the chart below shows the continued deterioration. Keep in mind the current budget deficits are in the context of a fully employed America, with healthy GDP growth.  A deficit this large with unemployment this low is historically unprecedented outside of WW2.  The deteriorating fiscal outlook is also why we think that the Fed will cut rates ahead of inflation reaching its target.  The US government simply can’t afford short rates to remain this high.  As the chart below shows, net interest outlays are significantly higher going forward. 

Why GDX should recouple with Gold. 

1: Miner cost inflation is much more favorable:

                Gold miners experienced significant cost inflation coming out of covid. This was driven by higher energy and energy related costs, combined with higher labor.  We don’t think labor costs will ease much here, but energy and energy related costs will significantly lessen.  As the chart below shows there has been a significant fall in diesel and LNG, likely driving a decline in power prices and direct operating costs.  Outside of labor, most costs for a miner are driven by energy prices with some lag.  To be clear we are not calling for outright cost deflation, we simply think the incredible cost pressures that have caused the miners to miss earnings expectations are mostly behind the sector now. 

2: Reasonable valuations:

                The GDX trades around 19X 2025 EPS, using a weighted average of consensus estimates. This compares to ~22x 2024 EPS in early 2023.  Many of the largest miners have seen their multiples compress even more dramatically as they have been hit with the brunt of the cost overruns.  For example, NEM and GOLD and are now under 15x forward, vs pre covid multiples in the mid 20s. 

3: Rate cuts have historically been a catalyst for gold miner equity out-performance:

                In both 2019 and 2007 gold miners outperformed both gold and the SPY leading into the first rate cut of the cycle.  Should we get a July cut, we are now within a few months of when historically the miners have begun to outperform in anticipation of lower interest rates.  In both cases the miners were lagging the market and gold prices YTD until a few months before the first cut.  The same situation applies today.

2007: Rates cut in September

2019: Rates cut end of July

Today:

Catalyst

The first rate cut later this year.