Investment Comment: Fundamental Charms Of Gold Remain Intact After Market Drama

Joe Foster

Lombard Odier World Gold Expertise Fund

19 April 2013

Editor’s note: The following commentary about the gold market, which has seen a dramatic selloff in recent days, is from Joe Foster, who is portfolio manager of the Lombard Odier World Gold Expertise Fund. As always is the case, while this publication is pleased to share the views in such comments, it does not necessarily endorse all the views expressed. (To view a recent feature examining industry reactions to the price moves, click here.)

Gold has sold off dramatically over the last several days. Since the precious metal’s peak at around $1,900 per ounce in September 2011, aggressive central bank easing has led investors to believe that financial risks are under control. Given this perceived path to normalisation, we expected the risk that the gold market could exhibit weakness in the first half of 2013, with a positive trend emerging in the second half of 2013.

However, despite knowing the risk, this selloff is bigger than we anticipated. While sentiment has been negative for gold as markets assume the Fed is about to withdraw its liquidity measures, the selloff through $1525/ounce was technically driven, in our opinion.

The fundamentals for gold as a safe haven have not changed and we still believe that there are risks to the financial system that the market is currently ignoring, such as fiscal deficits that continue to raise debt levels, trillions in banking liquidity that could ignite an inflationary cycle, the massive US entitlement burden, a possible bond bubble, the weak banking system and a recession in Europe and Japanese monetary policies creating imbalances globally.

This kind of capitulation in the gold markets has been seen before and it will take a little while for the dust to settle. We believe that gold may consolidate for a while with the potential for another down draft before we see a positive trend develop into the fall. Further, high-cost gold companies could begin to cut capital and curtail operations at $1,400 per ounce, which could, fundamentally, also help establish a floor.

Despite the magnitude of this sell-off, we believe it does not necessarily signal the end of a longer bullish market. We tend to look at this as a mid-cycle correction, analogous to the one from around 1975 to 1977: different drivers but the same sentiment towards gold. At that time, markets thought inflation was whipped, only to have it come back with a vengeance.

Related specifically to gold shares, some companies will struggle to sustain production at some of their existing operations at the current gold price. However, we estimate the average cost of producing an ounce of gold is about $1,050 per ounce during 2013 for senior and intermediate (large and mid-cap) producers. This estimate includes mining, processing and sustaining capital costs and is based on a basket of 20 gold companies with median market cap of about $5.7 billion and annual production of at least 300,000 ounces.

Gold has worked during all previous rounds of quantitative easing and periods of balance sheet expansion. We believe that the current expansion is even more widespread and encompassing. This time, however, markets appear to believe in normalisation. Given this, we will need to wait to see how fiscal and monetary policy - and economic growth and health - unfold globally.

In summary, once gold stabilises, probably around current levels, it could represent the buying opportunity of a lifetime. The unprecedented sell off was technically driven while the fundamentals for gold as a haven have not changed.