Q&A: How will the US debt crisis impact gold?

Bradley George, co-portfolio manager of the Investec Global Gold fund, discusses the impact of the US crisis on gold as the deadline for increasing the debt ceiling approaches.

• What is the relationship between the US dollar and gold prices?

As the world's supreme hard asset for centuries, logically, gold is inversely correlated with the world's supreme paper asset, the US dollar (the world’s reserve currency).

This relationship, however, is not perfect and there have been times when investors have turned to both gold and the US dollar simultaneously in their search for safe haven assets.

In the long run, however, we expect the USD/gold inverse relationship to hold; this should be the case for as long as the USD is the world's principal reserve currency.

The USD on a trade-weighted basis is still close to new lows. On a multi-year basis, the USD has been depreciating for decades and in the long run a decline of the USD would continue to help gold prices.

• Will the decision made by the US on its debt ceiling impact gold?

In our view, concern around the long-term ability of the US to repay its debt is one of the factors behind the long-term rally in gold. These concerns are now coming to a head as politicians struggle to negotiate deficit reduction measures in exchange for an increase in the debt ceiling by the 2 August 2011 deadline.

Yet if the gold rally is at least partly predicated on long-term credit concerns, then we believe the long-term view still looks positive for gold as foreign creditors holding US assets will have to cope with very low yields on US treasuries while at the same time facing a generally depreciating currency.

When looked at from this perspective, we believe gold is still attractive as an alternative asset to diversify USD exposure in the longer term. It would seem this has been the rationale behind central banks change of attitude since 2008, becoming net buyers of gold to diversify some of their USD exposure.

• What is your outlook for gold?

We remain constructive towards the gold price and in particular towards gold equities. Gold demand remains robust and we believe the current environment is positive for a safe haven asset such as gold, with European sovereign debt concerns spreading to larger economies such as Italy and Spain, and the US struggling to negotiate an increase in the debt ceiling by 2 August 2011.

Looking ahead, we believe it will continue to be well supported in a world of negative real interest rates, given inflation in both developed and developing markets, central bank buying (from developing economies in particular) US dollar depreciation and continuing sovereign debt issues.

• Where else do you see value for investors?

While there has been a dislocation in 2011 between gold equities and the gold price, we believe valuations remain supportive of gold equities, and across our universe we see in excess of 15% upside in most of sectors (North American majors, intermediate producers and emerging producers).

The latest bout of underperformance following the release of results for the last two quarters have reflected cost inflation creeping into businesses on the back of higher fuel (predominantly diesel) and reagent prices.

Cost inflation will remain stubbornly high, with oil prices at elevated levels, affecting gold miners who are some of the most susceptible mining companies to fuel price increases with approximately 40% of their costs being energy-related.

Brent crude oil has outperformed the gold price up until May, resulting in the ratio touching 13x[1]. However the recent strong move upwards in gold has stemmed oil price outperformance. We believe Brent crude oil prices will remain elevated, but trade down to $105/bl over the remainder of the year.

We have already experienced a significant $15/bl decrease (12% decline) in the oil price in the first week of May 2011, a correction that resulted from prices pushing ahead of fundamentals in prior weeks, and again in mid June when Brent crude oil prices corrected 12% to $105/bl after the IEA released 60 million barrels of crude oil onto the market.

On the other hand, we expect gold to average $1,550/oz for 2011. The recent rise in the gold price has subsequently returned the oil price-gold ratio to the mean of 15x[2]. Our belief that oil price will retreat resulting in gold outpacing oil from mid-year onwards could also improve the outlook for gold equities.

Under these assumptions, we expect gold miners’ margins to start expanding and this is something not reflected in gold companies’ share prices. Notwithstanding the reduction in free cashflow from cost increases, we have relatively high dividend yields of approximately 1% for many of the equities.

We remain positive on gold equities, where production is growing and by-product credits are high with respect to copper ($9,700/tonne) and silver ($39.50/oz). Also, those companies that have hedged diesel prices or have low price inflation clauses for the electricity consumption are attractive. These factors will help mitigate unit cost increases.

In addition, companies with significant exploration potential are seen as attractive investments as they can add ounces to resources and reserves.