Deflation, inflation and reinflation all play into scenarios for the gold price and precious metals equity markets, as outlined by Paolo Lostritto, director of mining equity research at National Bank Financial. How to play good defense in this unusual market? Companies with free cash flow top his list, but high-leverage, midtier producers with great management teams can satisfy investors with more appetite for risk, says Lostritto in this interview with The Gold Report.
The Gold Report: Paolo, what three words would you choose to give our readers a sense of what to expect in the precious metals equity space in 2014?
Paolo Lostritto: Defense, defense and more defense.
TGR: The Vince Lombardi approach.
PL: Even though deflation risk is priced into most of the equities, it’s difficult to predict when inflation expectations will start to gain traction. While quantitative easing tapering efforts are being introduced with some signs of economic improvement in the U.S., we believe tapering could reignite deflation fears. The market was reassured after Janet Yellen’s nomination as Federal Reserve chair, but the bond yield-to-maturity suggests that deflation risk is still alive and well. There is more work to be done before inflation becomes a bigger concern, and as such, we believe the gold market will remain challenging. The challenge is centered on balance sheet risk in a market where margins are negative, thus resulting in many value traps that are out there right now.
TGR: Earlier this week, I spoke with a U.S.-based analyst who believes that rising wage pressure, higher rent and food prices in the U.S. will lead to a slow climb in inflation in 2014 and beyond. Yet, you are talking about the risk of deflation. Other than bond yield rates, what else tells you that deflation is the bigger risk?
PL: Across the board, commodity prices have been under pressure, suggesting that the risk of deflation is still real. Another data point is the inflation expectations data set compiled by the Cleveland Federal Reserve. Right now, it shows that inflation expectations are muted at best.
We believe we are in a similar environment to the 1974–1976 midcycle correction in gold before the onset of inflation. During that period, gold fell from ~US$200/ounce (~US$200/oz) to ~US$100/oz before higher money velocity generated inflation in the Western world that drove gold to more than US$700/oz. While gold has nearly decreased by a similar percentage since the highs set in 2011, we have yet to see definitive evidence of higher money velocity. This, combined with positive real rates, results in our cautious stance. It is worth noting that if higher inflation were to materialize, it is likely to be driven by emerging markets, which would then begin to export said inflation.
I believe gold could go much higher in the long term, but in the meantime, we’ve got to take a position that a lower price is quite possible and that balance sheet risk remains high.
TGR: An October 2013 research report from National Bank Financial (NBF) suggests that there is inflation risk when the money multiplier increases beyond a 1:1 ratio. What will keep that ratio below 1:1?
PL: The money multiplier is a crude measure of money velocity. While it demonstrates that both the monetary base and M1 are growing, there has been enough to translate into higher inflation expectations. The government is giving mixed signals. The Fed’s policies are reinflationary. Government policies, in contrast, have been emphasizing austerity.
We need to see that the liquidity being provided is actually getting traction and is producing real economic growth. While there are early signs that this is starting to happen, I would like to see how the bond market reprices inflation expectations. We still believe the deflation risk remains high—you need to be defensive.
There are signs that the U.S. economy is turning around. But, our NBF economists don’t see inflation in the system, and that’s bad for gold. That will change only when the velocity of money starts to improve, leading to better capacity utilization, which translates to higher inflation expectations. It will take time for those signals to align.
TGR: In the event of another collapse, what weapons does the Fed have left?
PL: More money is all we’ve got left. The Fed can purchase more bonds, which effectively introduces more liquidity, but we would probably see monetary policies that would coincide with fiscal policy to allow for some infrastructure projects. We would want the new liquidity to show up in the real economy, as opposed to the coffers of Tier 1 banks.
TGR: Physical holdings in exchange-traded funds (ETFs) have fallen in lockstep with the gold price. Are Chinese and Indian gold imports enough to sustain the gold price, or push it higher?
“I believe gold could go much higher in the long term, but in the meantime, we’ve got to take a position that a lower price is quite possible and that balance sheet risk remains high.”
PL: About 800 tonnes have sold out of the ETFs, and there have been a similar amount of purchases through Hong Kong into mainland China. Demand in India remains robust, despite elevated import taxes. There also are signs of more smuggling into India. However, we’re still dealing with a potential 1,800 tonnes of ETF supply.