Financial markets have been anticipating a US recession for some time. One clear signal is the inverted US yield curve, meaning that long-term interest rates are below short-term ones. That is typically a signal that recession is coming sooner or later. The very weak US ISM services data released a couple of weeks ago suggest a recession could be coming pretty soon.
Investors will therefore be considering their allocations to different asset classes. While the past is not always a reliable guide to the future, we thought it would be useful to take a look at how both gold and gold equities have performed during previous periods of US recession.
We also consider the operational prospects for the sector, and how investors are positioned currently in terms of allocations to gold.
How have gold and gold equities performed in previous US recessions?
The table below shows returns of gold and gold equities over the last seven US recessions going back to 1973. The recessionary periods have been defined using the National Bureau of Economic Research (NBER) recession index.
While cause and effect can always be debated, the overall conclusions are pretty clear. Gold tends to do well in absolute and relative terms during US recessions; gold equities have done even better.
Looking at the returns from six months prior to the start of the recession to six months after the end of the recession, we can see that gold has returned 28% on average and outperformed the S&P 500 by 37%. Gold equities have beaten this and generated returns of 61% on average, outperforming the S&P 500 by 69%. (Given the variation in the length of the recessions studied, six months before and after was chosen as the most optimal timeframe).
Every cycle is different and clearly the US economic cycle is far from the only factor influencing the gold market. One observation we would make is that when the policy responses to US have been particularly loose / accommodative, the gold price performance has been most explosive. This was the case in 1973 (when Arthur Burns was Federal Reserve governor) and was also the case in 2008 and 2020.
We think policy responses to future US recessions will also be highly accommodative and involve a return to combined fiscal / monetary support. This is because extremely high aggregate debt levels and large deficits mean the risk of a recession morphing into something much worse will remain far too high for policymakers to risk.
What about the poor returns in 1981 and 1990?
1981: This was the “Volcker recession” ushered in by huge interest rate rises specifically aimed at crushing inflation regardless of economic impact (arguably the 1980 and 1981 recessions should be combined as Volcker was in position from 1979).
The “easy-money” high inflation period of the late 1960s/70s had seen gold prices move from US$35/oz in 1972 to over US$800/oz in very early 1980. This occurred as dollar credibility tanked following President Nixon’s decision to suspend the direct international convertibility of the US dollar to gold, bringing an end to exchange rate stability (this was known as “closing the gold window”).
What this meant going into the 1980s was that the base for both gold bullion and gold equities was incredibly high. The epoch-changing nature of Fed Chairman Paul Volcker’s aggressive use of monetary policy was the start of a protracted bear market for gold.
Again, one of the reasons we are structurally positive on gold is that, given extremely high sovereign debt levels and large deficits, we believe any repeat of a Volcker-style intervention would quite likely lead to systemic financial collapse.
1990: This was a mild recession that followed Iraq’s invasion of Kuwait. What is striking to us from a gold market perspective is that this was the beginning of a period of aggressive central bank gold sales which lasted throughout the 1990s/early 2000s. Again, the contrast to today is very striking, with central bank gold demand running at record levels and set to remain strong.
Two more reasons to be positive on gold equities
Aside from the typically strong performance during recessions, we would also highlight two other reasons for taking a positive view on gold and gold equities.
Firstly, the overall operating environment for gold equities looks to be improving into 2023. Certainly, it is unlikely to be as difficult as in 2022.
Last year, gold producer profit margins were squeezed between rising costs (oil, steel, labour) and falling gold prices. This led to gold producer equities underperforming bullion (at least in US dollar terms).
We could see margins re-expand this year with stronger gold prices. On the cost side, some areas are seeing outright falls already. In “stickier” areas like labour we expect some slowdown in cost rises after what have been strong increases since the pandemic, particularly in North America and Australia.
Secondly, gold producer equities remain at cheap levels on a long-term view and investors are still extremely under-positioned.
Two recent charts from Scotia, a Canadian broker, make that point very clearly. The first chart below shows investors currently carry a close to zero weight in gold equities (see the red dot). Meanwhile, the weight of gold equities in the S&P/TSX Composite Index (Canada’s benchmark equity index) remains low relative to history. Resource-rich Canada has a number of listed gold producers, which is why their weight in this index provides a useful guide to investor appetite for gold equities.
And the second chart, below, shows how overall sector valuations remain around one-third below the levels reached in the 2009-2012 period. The chart uses EV/EBITDA multiples, comparing the total value of the companies’ operations (EV) to a measure of profitability (EBITDA, or earnings before interest, tax, depreciation and amortisation).
This chart demonstrates how there is nothing currently built in to equity valuations for a higher for longer gold price environment.
