Inflation Shock!

Gold rises as US CPI inflation spikes further

Gold rose 1.2% this week to US$1,797/oz as US inflation again beat expectations in November 2021, rising 6.88% yoy, its highest level in nearly forty years, offsetting downward pressure that could be arising from the start of the Fed's taper.

Market sees gold stock upside, but equity markets under pressure

While the market still sees substantial upside to the target prices of most gold stocks, and many have seen upgrades to targets since 2021, they may face a challenge in getting to these levels given the growing downward pressure on equity markets.

Producers and juniors rise as gold picks up

The producing and junior miners gained as gold rose, even as global equity markets were relatively weak, with the GDX up 1.7% and the GDXJ rising 0.5%, while the price performances of the Canadian junior miners were mixed.

Inflation Shock!

Gold rose 1.2% to US$1,797/oz, as US inflation once again shocked the market, up 6.88% yoy in November 2021. Inflation has also been picking up globally, with European inflation up 3.36% as of the most recently reported September 2021 data, considerably above the average of the last five years (Figure 4). While Japan has been in deflation since October 2020, apart from a slight 0.20% gain June 2021, it is again nearing inflation, with the CPI down just -0.09% yoy in September 2021. The current levels of US inflation are already near forty-year highs, although they are still off historical highs of 12.10% in January 1975 and 14.27% in June 1980 (Figure 5). The move from the current levels around 7.0% to the 1975 peak took about 15 months, and to the 1980 peak took twenty-three months, which suggests that even if inflation were to reach well over 10%, it could take another year to get there.

Inflation shock could be more than just transitory

The Fed and some analysts believe that this inflation is transitory, based on; 1) a major increase off the very low base from the global health crisis in 2020 and 2) continuing disruptions to global supply chains that are leading to temporary price rises for many items. While we acknowledge that these factors are affecting inflation, we believe that the main underlying factor is the massive increase in the US money supply over the past two years. Growth in the US M3 money supply has subsided considerably from its peak from early February 2020 to January 2021, when it reached 27.1% yoy (Figure 6). However, it is still high versus its long-term history, growing 12.8% yoy as of the most recently reported September 2021 data (Figure 6). While the Fed's taper should bring growth in money supply down further, it could be many months before the growth is 'normalized' near the average of 5.4% from 2015 to 2019.

Given that there tends to be a considerable lag between an expansion in the money supply and the resulting CPI inflation, of up to a year or more, we may currently only be seeing the early effects from the tsunami of money unleashed especially from February 2020 to January 2021. Therefore, inflation could remain very high well into 2022, even if the effects from the low base and the supply disruptions were to subside. Some analysts are also expecting that even as inflation continues to spike, that there are signs that global economic growth, which has been very strong for over a year, may be easing, as much of this has been because of the low base effect in 2020. While we usually would expect strong inflation to be correlated with high growth, there have been historical periods, notably during the 1970s, where there was very high inflation, but low growth, also known as stagflation. If inflation remains high in 2022 but economic growth slows, we could see a rerun of this difficult situation.

Such a scenario could be a mixed one for the producing gold stocks. High inflation would be likely to support the gold price overall, and even drive it higher, depending on how severe it gets. However, this would also drive up mining costs, which could reduce gold producers' margins, with the net effect really depending on which rises more, cost inflation, or the gold price. Another issue would be the Fed's reaction to inflation. We have assumed that their taper and rate raising cycle will be subdued, for fear of crashing the economy and stock market. However, if inflation heads well above 10%, we could see the Fed forced into unexpectedly aggressive rate hikes. If this were to occur, equity markets and the economy would very likely take a substantial hit, and the stocks of gold producers could come under some pressure, even with the gold price remaining elevated.

For the junior miners, the situation could prove even more difficult, with a period of stagflation likely seeing gold producers start to pull back on the strong investment and acquisition activity of the past year, as well as private investors, that are often a crucial source of capital for junior miners. As above, in a worst case where inflation spirals out of control, the Fed hikes rates aggressively and equity markets are hit, the juniors, given their higher risk levels compared the producers, could face much larger stock price declines than the producers, as we have seen in previous declines.

A 'bullish' high inflation, low growth scenario for gold in 2022

We have outlined some negative scenarios here, which we believe investors should at least consider, to maintain appropriate caution given what we see as rising risk in equity markets. However, there is also the potential for a 2022 that is okay for both the gold producers and juniors. This would involve inflation remaining relatively high and supporting gold, but starting to flatten out, and not triggering aggressive Fed action, which is possible, as the rate of money supply expansion has started to ease. This would also lead to only a moderate increase in costs for producing gold miners, and with a gold price averaging US$1,800/oz or more, would still support strong margins for the sector.

This would in turn encourage continued acquisition activity and investment in the sector by the gold producers, and the situation would not be so dire as to spook private investors from continuing to provide capital to the sector. Meanwhile, we could see growth could chug along at relatively low levels, but not decline enough to cause major concerns. While such a low growth rate might not be so supportive of base metals, or even silver, which has both monetary and industrial drivers, it would not necessarily affect gold much, given that it is mainly a monetary metal.

Market still seeing strong upside for most gold stocks

In the context of the above scenarios we have outlined, this week we look at the consensus target prices of the gold producers and juniors, and the changes in target prices since July 2021. The market is still seeing upside to the targets of all the major producers, including 50% or more for seven of them, with NovaGold, Equinox and B2Gold seeing the strongest expected gains (Figure 7). This is likely driven by a combination of; 1) the gold companies trading at reasonably low valuation multiples relative to their history, and 2) potential upside from a rise in the gold price.

However, we take these upside targets with a degree of caution. First, we believe that even though the equity valuations are reasonably low in historical terms, that with overall US equity valuations extremely high, and potentially poised for a decline, that at best these gold stocks valuations might be maintained, and that the next year may not see a major multiple expansion. Second, while we believe that the gold price will be supported at least at its current levels, and may see moderate upside, the Fed's taper will nonetheless maintain some pressure on the gold price, possibly preventing it from seeing outstanding gains. This of course all assumes that inflation remains below 10% next year; if it starts to head well above this level, we could see a considerable surge in the gold price, more than offsetting the potential pressure from a broader weakness in overall equity markets.

Most gold stocks have seen upgrades to target prices since July 2021

In addition to the absolute upside to target prices, we also want to consider how much these target prices have changed over the year to see if analysts are becoming more or less bullish on the sector. Comparing the current target prices to the July 2021 estimates, we see that analysts overall are continuing to upgrade their numbers, with eleven of the fifteen gold producers seeing higher targets. However, these upgrades have been reasonably moderate, with only four seeing what we could call bullish upgrades by over 20% over more. Also key is that the two largest stocks in the sector, which account for a major proportion of market cap and production, have seen their targets cut, with Newmont reduced -15% and Barrick down -8%.

For the juniors, the percentages of the upgrades range much more widely, as could be expected, because there is much more room for upside surprises, with new highgrade finds leading to sudden jumps in share prices, and in turn higher targets from analysts. In contrast, there is generally less room for major surprises for the producers, as they tend to be much larger, and a given strong result at an exploration project tends to have less weight in affecting the overall share price of the company. We can see examples of such large target price changes for juniors this year in Osisko Development, up 374%, Prime Mining, at 240%, Arizona Metals, rising 159% and New Found Gold, boosted 135%, on their outstanding drill results over the past year. Target price changes for the rest of the juniors have been comparably moderate.

How institutional imperatives can skew equity target prices to the upside

Another issue to consider with the market consensus target prices is a broader one that affects most equity sectors, where the recommendations usually skew towards the upside. This is because most of these targets come from investment banks with an interest in assuming that next year is better than the current year. They may have corporate relationships with companies that they cover, which may incentivize them towards a relatively upbeat outlook such companies, even though officially research is expected to remain very independent from other activities at investment banks.

Another issue is that analysts themselves have often been covering the stocks over long periods of time and know company management, which may tend to lead them to not be too 'hard' on companies in order to maintain these long-standing relationships. All these factors can lead to target prices being skewed toward the upside, so investors may want to take the upside suggested by the target prices and pull it back by some degree for a more conservative value estimate. However, even if we are to use this relatively conservative method for the expected upside for producing and junior gold miners, we would still likely see a quite strong outlook for the sector moving into next year.

Producers nearly all rise as gold gain offsets equity market pressure

The producing gold miners were nearly all up as gold's rise this week offset continued pressure on equity markets (Figure 9). B2Gold reached an agreement with the State of Mali for a new exploration permit covering the same perimeter as the Menankoto Permit and withdrew its arbitration proceedings against the country. Yamana reported its Greenhouse Gas Abatement targets, Eldorado reported on operational progress at Lamaque and Kisladag, and Alamos exercised common share purchase warrants to increase its stake in Red Pine Exploration to 19.5%. SSR Mining reported drill results from the Marigold mine in Nevada and the Amisk property in Saskatchewan, and Lundin announced its 2022 guidance of 405k-445k oz Au, and its three-year guidance of an average over 400k oz Au per year (Figure 14).

Canadian juniors mixed as stock markets relatively weak

The Canadian juniors were mixed, even as the gold price increased, as stock markets remained relatively weak (Figure 10). For the Canadian juniors operating mainly domestically, Artemis reported that it had been included in the GDXJ junior miner ETF and that Wheaton had entered into a gold and silver stream agreement with Artemis after New Gold exercised its right of first refusal (Figure 12). For the Canadian juniors operating mainly internationally, Novo reported that its mining review outlined an optimized five-year plan for Beaton's Creek gold project through to 2026, with three phases, which was already driving newer higher processing grades in November 2021 (Figure 13).