AEM - GDX: Lower Downside Risk For Gold Miners And Favorable Outlook For The Price Of Gold

2024-01-15 23:44:07 ET

Summary

• The case for owning gold miners has strengthened considerably over the past year due to the lower downside risk from current levels.
• GDX does a good job at reducing certain idiosyncratic risks, but the large exposure to individual names should be taken into account.
• Macroeconomic factors, such as the risk of a recession and expanding U.S. deficits, could support the price of gold in 2024.

It has been a few months since I laid out my investment thesis for the VanEck Gold Miners ETF ( GDX ) as a follow-up to my long-term view on the price of precious metals.

It seems that the market has gotten accustomed to the $2,000 floor for the price of gold and as oil prices have cooled off the GDX has been performed largely in line with the broader equity market.

As I noted a few months back, holding gold mining stocks involves more risk than a more direct exposure to the precious metal, such as the SPDR Gold Shares ETF ( GLD ) or Sprott Physical Gold Trust ( PHYS ). This is clearly illustrated in the graph above where we see the GDX significantly higher variance of daily returns over the past few months.

Having said that, from a risk-reward point of view I still see gold miners as an attractive investment in 2024 as downside risk has been reduced over the past few years.

Lower Downside Risk

First and foremost, GDX investors should keep in mind that exposure to gold miners holds significantly larger risks associated with the equity risk premium, industry-specific events and other idiosyncratic risks.

Although the ETF reduces some of these risks through diversification, the Top 5 holdings still account for roughly 45% of the fund's total weight.

Therefore, investors should still focus on individual holdings as opposed to relying on a broader investment thesis for gold miners.

Nevertheless, over the past few years valuation multiples within the sector have cooled off significantly. For example, the sales multiples of the three largest GDX holdings - Newmont Corp. (NYSE: NEM ), Barrick Gold (NYSE: GOLD ) and Agnico Eagle Mines (NYSE: AEM ) have all nearly halved from their 2020-21 highs.

Even though gold prices have skyrocketed in recent years, the high energy costs have prevented these companies from expanding their operating margins. This dynamic has justified the aforementioned compression of multiples, but in my view has now resulted in lower downside risk.

These three companies have also expanded their capital expenditure in recent years as they were coming from record-low spending on projects in 2020-21 period. As we see from the graph below, all three of them are now spending higher amounts on Capex than their annual Depreciation & Amortization expense which is a strong signal of future expansion in production.

This dynamic weighs on operating margins over the short run as capex increases are followed by higher annual depreciation and increases in other fixed costs. At the same time, expansion projects within the industry take years to fully develop and as such result in lower operating margins during the initial expansion phase.

Macroeconomic Tailwinds

In addition to the more conservative valuations of gold miners, the price of gold is yet another reason why downside risk of GDX is now far lower than it used to be just a couple of years ago.

As expected, in recent months the spot price of gold seems to have found a floor at the $2,000 level and in my view 2024 could offer plenty of upside given the ongoing risks for the monetary regime.

To begin with, the risk of a recession in 2024 is significant as the annual change of The Conference Board Leading Economic Index ((LEI)) remains deeply in negative territory (see below).

Historically, such large drops have been associated with major economic slowdowns, but this time around the extremely loose monetary policy and the highly supportive fiscal spending have helped us avoid such a grim scenario.

The state of the yield curve is also indicating pending risk of an economic slowdown and historically has been a reliable indicator for future recessions.

A worse-than-currently-expected economic slowdown could be highly supportive of the price of gold for a number of reasons that all have to do with the perceived risk of the current monetary system.

To begin with, U.S. Budget Deficits usually expand significantly during recession as the government increases spending and tax receipts fall on the back of lower economic activity. On itself, this is hardly a cause of concern, but this time around we are likely to enter into a recession with the deficit as a share of nominal GDP at near record highs.

A notable expansion of the U.S. Deficit would most likely be accompanied by further debt increase, which in combination with the normalizing interest rates is another cause of concern given the skyrocketing government outlays on interest paid.

A further increase in interest outlays threatens not only the fiscal side of things but is also a challenge for the corporate sector where higher interest expenses and cost of capital are already proving to be a challenge for earnings.

An obvious solution for monetary authorities would be a pivot of the current stance and a return to record-low interest rates. When it comes to gold, however, such a scenario would also be a net positive as this will cement the view that the current monetary system can no longer support higher interest rates.

Conclusion

Although holding gold mining stocks is inherently riskier than more direct exposure to the precious metal, the current set-up is favourable for individual high-quality miners as well as more diversified ETFs, such as the GDX. Valuations within the gold mining industry have fallen significantly in recent years on the back of lower margins, but this is likely to change as production expands. On top of that, the price of gold seems to have found a floor at the $2,000 level and ongoing risks for the monetary system could provide significant uplift in 2024.

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