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Tocqueville Gold Strategy Second Quarter 2018 Investor Letter

By John Hathaway on July 16, 2018

There has been an epic liquidation of speculative long positions in gold over the past two years.  According to the CFTC Commitments of Traders report, long positions in gold held by hedge funds and other large-scale speculators declined from 893 tonnes in July 2016 to only 13 tonnes at the end of June 2018 [As noted by Frik Els on 6/27/18].  Over that span, the gold price declined from $1330/oz. to $1250/oz., a 6% drawdown that seems modest in light of the scale of the selling.  Gold mining shares have fluctuated in a narrow band (see chart below), and for the most part seem to have held up well despite the downward pressure on metal prices.

There are many positive considerations for gold, in our opinion, that investors have chosen to ignore thus far.  We believe that they will become increasingly apparent over the remainder of 2018 and into 2019:

-The already large US fiscal deficit is accelerating due to tax cuts.  We believe the size and growth rate of federal debt will soon prove to be problematic for financial markets.  The May monthly deficit was $147 billion, the largest since 2009 in the aftermath of the global financial crisis.  Trillion-dollar annual deficits may become commonplace.  The simple math translates into annual increases in federal debt of 5% or more.  With the US debt-to-GDP ratio exceeding 100%, increases of this magnitude are banana-republic in scale.

-Inflation appears set to accelerate.  Rising inflation has never been a positive for financial-asset valuations.  The labor market is very tight.  Wage rates are rising at 2.7% per year, but that rate of gain seems likely to increase with unemployment at only 4%.  On June 6 of this year, the Wall Street Journal noted, “There are more jobs than jobless…laying the groundwork for higher wages needed to draw people from the sidelines of a historically tight labor market.”  Wages currently account for 70% of business costs.  Accelerating gains portend accelerating inflation.  Once inflation works its way into the economy, it has been successfully tamed only by painful fiscal and monetary countermeasures.  Just check the history books on this if you are a money-manager less than 60 years of age.

-Equity markets remain significantly overvalued by historical measures; they are vulnerable to significant and prolonged downside if there is an economic slowdown.  The US stock market appears to be stalling out, failing to surpass its January 26, 2018, peak.  Without seven FANG stocks (FB, NVDA, GOOG, AMZN, AAPL, MSFT and NFLX), the remainder of the S&P is negative on a year-to-date basis.  International markets seem to be leading the way lower.  From the 2018 peak, world equity indices are down 10%, with many important markets including China and Brazil down more than 20%.  The German DAX is now trading below its 200-day moving average.  We believe that faltering equity markets will renew investor interest in gold.

-The “strong” US dollar equates to monetary tightening for emerging-market economies that have borrowed heavily in US dollars.  Falling emerging-market currencies against the USD create a short squeeze for businesses and governments that must service dollar debts with falling revenues in dollar terms.  That setup seems likely to lead to credit problems and an economic slowdown that will spread across international borders.  A strong US dollar is ultimately very deflationary, even for the US, and will therefore cap any attempt by the Fed and other central banks to normalize interest rates, in our opinion.  However, for reasons stated below, dollar strength is more apparent than real, and ultimately unsustainable.

-Finally, an international trade war seems to be taking on a life of its own.  Unchecked, it will, in our opinion, accelerate inflation and decelerate economic activity.

Against this impressive array of supportive forces, the sole negative investment idea accounting for the two-year speculative liquidation of gold has been, in our opinion, the strength of the US dollar against emerging-market and competing reserve currencies.  In our view, dollar strength will prove to be short lived.  Over the longer term, dollar strength has not been a meaningful headwind.  Gold has risen four-fold against the US dollar over the past 20 years.  By definition, periods of dollar strength are a sideshow.  There is something else going on that is far more meaningful.  Powerful long-term trends transcend periodic fluctuations in the relative strength or weakness of the dollar.  These all hinge on the inexorable decay of value of any paper currency subject to political mismanagement, of which there is ample historical proof.  The US dollar is far from exempt on this score, in our opinion.

Investor interest in precious metals hovers at a 20-year low.  Gold and silver mining stocks have basically marked time over the past 24 months, and trade at very low valuations in stark and lonely contrast to highly valued capital markets.  Gold mining shares offer dynamic exposure to the possibility that the factors noted in the preceding paragraphs will awaken currently dormant investor awareness of the prospect of serious capital loss from mainstream investment strategies.

Within the precious-metal share sector, there are meaningful gradations of valuation between larger and small-cap companies.  These differences have always existed, but are particularly meaningful at the current moment because reserve lives of the largest companies are dwindling (see below chart), which will force them to consider maintaining reserves via consolidation.  We expect an upsurge in takeover activity, as we have discussed in previous letters, to materialize in the next two years.  Our investment strategy is skewed to many likely takeover targets.  We believe that our strategy should produce positive returns even in the absence of rising metal prices.

Source: Scotiabank

The prolonged correction in metal prices appears to be concluding.  It is hard to see how speculative liquidation can go much further.  We believe that there is little for speculators left to sell without becoming net short.  The reasons for the dollar’s relative strength appear to be well discounted and priced into the market.  We expect the many positive macro forces that are supportive for gold to prove increasingly difficult for investors to ignore.  Trade worries, in our opinion, are not going to fade.  Fiscal deficits will, we believe, continue to grow.  Financial assets remain expensive, with considerable downside vulnerability.  Emerging-market economic weakness should begin to undermine earnings expectations.  Inflation, we expect, will continue to plague policy-makers and undermine the notion that bonds are the safe haven they are purported to be.  Unloved, ignored, and even laughable, we expect the notion of gold exposure to return to favor.

Tocqueville Gold Monitor [pdf]

John Hathaway

Senior Portfolio Manager

© Tocqueville Asset Management L.P.

July 12, 2018

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