Over recent weeks, I’ve focused more heavily on alternative assets that may allow investors strong hedges against the developing solvency risks in banks and the broader economic slowdown. Concerns regarding a more significant banking contagion have declined over the past week following the FDIC’s successful sale of SIVB and a potential expansion to the “emergency lending facility.” The government and financial system’s effort to calm fears has certainly decreased immediate liquidity risk pressures on the market. However, in light of the slowing economy, I believe this “calm” may be short-lived (weeks to months), buying investors more time to re-distribute their portfolio to reduce risk exposure.
In my view, the Federal Reserve (and most of its foreign peers) are walking a tightrope between providing sufficient liquidity stimulus to banks (and pensions, etc.) and exacerbating inflationary pressures. Without adequate liquidity stimulus, the global financial system could suffer a bank-run crisis where banks cannot sell assets to each other at sufficient prices to pay deposits. In the US, commercial banks have a total of $17.5T in deposits and just $3.4T in cash, so there is likely not enough cash in the economy to support today’s declining deposits. Of course, in 2020, the Federal Reserve over-stimulated the economy, leading to excessive inflation. Accordingly, too much stimulus may cause today’s inflation pressures to rise uncontrollably.
Ideally, the Federal Reserve will manage to pursue a “middle path,” likely supporting the bank’s immediate liquidity needs without excessive stimulus that inflation rises back toward double-digits. This path would probably mean a moderate recession occurs as some overleveraged or operationally challenged banks and companies restructure, while a depression and significant “banking meltdown” are avoided. Further, given the broader public and private insolvency issue, I believe this will require the Federal Reserve to allow inflation to remain around the 4-7% range indefinitely. To get inflation back to the “2% target”, the Federal Reserve would likely need to pursue more interest rate hikes and continue QT, potentially exacerbating liquidity and solvency pressures. Over time, a higher inflation target would also lower the real cost of today’s extreme public and private sector debt levels, mitigating the core economic issue that has built up over the past ~40 years (excessive government, household, and corporate debt to GDP).
If this view comes true, investors may find few “strong” investment options but numerous ways to hedge against it and avoid excessive real losses (losses after inflation). An economic slowdown is bearish for most stocks as valuations remain high enough that a prolonged or more considerable decline in corporate profits does not appear priced into the stock market today. Further, a prolonged rise in inflation would likely cause long-term bond prices to decline as rates adjust for a higher inflation target. Higher interest rates may also lower the fair valuation of many equities, preferred equities, and other cyclical assets. Thus, investors may find the best opportunities in a mixture of inflation-benefiting assets (such as gold), short-term bonds, and emerging market currencies (with positive trade balances). Of these, I have not yet discussed gold (my favorite of those three) in light of the recent changes to economic and monetary fundamentals.
Gold Miners are A Critical Bond Hedge Today
Gold can be tricky since physical gold is sold at excessive premiums, while gold ETFs like (GLD) are liable to counterparty risks. For any significant amount of money, I believe GLD remains suitable. Still, it could run into trouble if the deposit crisis grew so that the broader financial system caves (worse or more extensive than in 2008), which seems unlikely for now as long as the Federal Reserve avoids making severe mistakes. Still, gold miners, such as those in the VanEck Vectors Gold Miners ETF (NYSEARCA:GDX), offer indirect exposure to physical gold while benefiting as a hedge since it is essentially leveraged to gold. Since GDX usually moves around 2% for every 1% change in gold, investors can allocate a minor position toward GDX while gaining a large fiat currency risk hedge.
In my view, gold is the ideal investment today for numerous reasons. For one, over the past decade for many emerging markets and the past few years for developed markets, we’ve seen the greatest threat to fiat currencies since the end of Bretton Woods (US dollar gold-backing). The “seesaw” between inflation and solvency pressures appears to become very unstable due to excessive total debt levels, making it difficult for central banks to save both fiat currencies while maintaining economic stability. While an enormous crisis seems avoidable, a sustained increase in the inflation target appears to be the most feasible way to do so. The Federal Reserve’s willingness to expand its liquidity program while it continues to pursue interest rate hikes signals it is working to follow that “middle path,”; but some sacrifices are unavoidable.
Gold’s price in US dollars is closely inversely correlated to the real interest rate on longer-term inflation-protected Treasury bonds. These bonds pay a lower interest rate than the annual CPI rate, giving them inflation exposure, much like gold. If Treasury bonds pay higher “real rates,” then gold is effectively worth less because it does not produce any interest (and vice versa). Gold rose substantially from 2019 to late 2020 as US real interest rates collapsed on economic risk factors and QE. Interestingly, gold has remained elevated since, despite a sharp rise in real interest rates. See below:
Gold did not decline much in 2022 despite the very significant increase in real interest rates. In my view, gold has sustained its 2020 price increase since real interest rates are abnormally high due in part to falling Federal Reserve Treasury assets. In other words, as the Fed allows its bonds (purchased from 2020-2021) to expire, they’re effectively pulling cash out of the Treasury bond market, causing long-term Treasury bonds to decline in value (and rates to rise).
Relatedly, the gold market is likely also bracing for a sustained increase in the inflation rate. The Treasury market is currently pricing in a 2.19% average inflation rate over the next decade, which to me, is highly unlikely given the broader economic situation that will require a slight “dovish pivot” from the Fed. The inflation expectation rate is highly correlated to oil which I expect to rise after recessionary risks are accounted for due to growing supply constraints. An increase in the long-term inflation expectation rate would likely lower real interest rates, potentially increasing gold’s price. That said, I believe real interest rates would need to fall back below 0% for gold to rise, as gold’s price today is slightly high, given today’s significantly elevated real interest rate.
Gold is Superior to Foreign Currencies
Due to their excessively higher real interest rates, certain emerging market foreign currencies, such as the Brazilian Real, are decent hedges against financial risk factors. That said, most “developed” fiat currencies are faring weaker than the US dollar due to their central bank’s unwillingness to increase interest rates. The Japanese Yen is the most notable example, given it continues to pay a near-zero interest rate despite a sharp increase in inflationary pressures. This factor has led to the significant outperformance of the US dollar, causing some negative stress on gold. However, gold has performed exceptionally well in Japanese Yen and European currencies. See below:
The US dollar is backing off its all-time high made last year, benefiting the price of gold. Gold is starting to trade near its all-time high today while it made successive new peaks in other global currencies the previous year. The fact is that international currencies still trade in relationship to gold, with countries with meager real interest rates (like Japan) or unstable inflation (like the UK) seeing gold rise the most. The US dollar’s gold price has been weakest due to the Federal Reserve’s more hawkish position compared to its foreign peers; however, that era appears to be ending as US dollar rate increases spur trouble in both the US banking system and Europe’s – as seen in extreme increases in international repo credit facility usage and Japan’s direct currency intervention.
Put simply, the global economy cannot afford for the US dollar to rise any higher than it has. The dollar’s strength relative to other significant currencies has caused real costs to grow much faster in Europe and Japan due to the dollar’s position as the prime international trade currency and global US dollar external debt levels. Many countries, such as China and Japan, have accelerated US Treasury bond sales due to the dollar’s strength. Since US banks are also selling Treasuries, the bond market has too many sellers and not enough buyers. Once the debt ceiling is increased, the Treasury will need to accelerate Treasury auctions significantly to recoup lost cash, further exacerbating pressure on the T-Bond market. A decline in the US dollar would likely decrease currency pressures on foreign markets, discouraging T-Bond sales and mitigating this risk. Thus, I suspect gold will soon rise much higher in the US as the US dollar returns to its normal price range.
Does GDX Offer a Value Opportunity?
In most instances, I believe gold miners are a preferable way to invest in gold since they generate the physical metal. For those looking to hedge against fiat currency risk factors, the miner ETF GDX is preferable due to its elevated exposure to gold – allowing investors the same hedge potential with less capital. Of course, if gold falls too low, GDX can lose substantial capital as miners dilute equity to make up for losses, as seen in the early 2010s. Rising labor and energy costs could also weigh on GDX if gold does not grow as fast as production costs, hampering miner profit margins.
GDX also fluctuates with changes in the valuation of its holdings. If the market is too bullish, gold miners may become overvalued compared to their expected profits. Of course, with gold weak since 2020, many miners may be undervalued today, given the most recent increase in gold’s price. For example, gold is essentially at its all-time high, while GDX is still 27% below its August 2020 and April 2022 peak price range.
GDX is currently trading at a weighted average “P/E” of 22.4X or higher due to its recent price increase. Adjusting its February 28th “P/E” from GDX’s factsheet for GDX’s 15% rally since then, its “P/E” today is likely closer to 25-26X. However, the forward EPS of most of GDX’s constituents is likely much higher than its TTM EPS. Assuming gold miners have an average AISC of $1,173/oz and the $1801/oz average 2022 gold price, gold miners’ typical marginal profit in 2022 was likely around $628/oz. Looking forward, that figure is expected to rise to ~$800/oz based on today’s $1975/oz gold price. Accordingly, forward EPS levels are likely around 28% above TTM EPS levels. Thus, I believe GDX’s forward “P/E” valuation is likely closer to 19.5X based on the current price of gold.
A forward valuation of 19.5X is not necessarily low, but it is also not too high that GDX is at risk of becoming overvalued. Further, if gold rises to $2300/oz, then gold miner profit margins would likely rise to ~$1125/oz or ~80% above estimated TTM levels. That change would bring GDX’s forward “P/E” down to ~14X, indicating GDX may be undervalued given a continued rise in the price of gold.
Obviously, these estimates assume constant output levels, interest and tax costs, production prices, and more. Since GDX is a global fund, fluctuations in international currencies alter its exposure to the US dollar gold price. However, while GDX does not appear undervalued to gold today, it would only take a relatively small increase in gold’s price to make it very cheap.
The Bottom Line
I believe ETFs like GDX will not make any investors abnormally wealthy due to a substantial speculative rise in gold. That said, as a hedge, I believe GDX has highly advantageous exposure to the likely price impact of shifting Federal Reserve policies on gold. As the Federal Reserve becomes more dovish in response to economic and financial challenges, gold appears expected to rise to a new all-time high due to a decline in real interest rates and/or a fall in the US dollar. Investors may be wise to park 20-40% of assets in inflation-benefiting alternatives such as GDX and/or EM stock funds like (EWZ) while leaving 60-80% of their portfolio in ultra-low risk short-term bonds like (BIL). This strategy would pay a decent yield due to high discount interest rates while mitigating recession and banking exposures while providing ample protection from an increase to the inflation target rate.
GDX could lose value if stocks decline sufficiently as investors race away from all equity assets; however, I believe that would be short-lived as any recession would promote a dovish policy shift that benefits gold. GDX could also depreciate if inflation causes mining costs to rise too fast (particularly an increase in oil and gas); however, I suspect gold should keep up or outperform wage inflation. While investors should account for those risk factors, I believe GDX is among the best all-around hedges in today’s shifting financial market.