Not so precious?

Markets have softened in response to two factors; these included the bombs that caused carnage during the Boston Marathon.

This occurred an hour before the close of the market and resulted in a 100 point fall. While our thoughts go out to those impacted, we would expect the impact on markets to be short lived. The other factor was continued weakness in gold (down 9%) and to a lesser extent other commodities.

We find the weakness in gold interesting. As can be seen in the chart below, gold has been a very strong asset over the past decade during much turbulence from other asset classes. It has been seen as a defence against deflation risks and a safe haven from the GFC.

With risks declining and equities improving a sell-off has begun. We note there remains many convicted gold bulls with concerns that money printing by the Fed will cause a bout of inflation.

The issue for gold is that there is a need to find even more buyers to drive the price up and after a decade of moves this has been more difficult. Furthermore, as it starts to fall investors become more conscious of the fact it does not produce any income and this is creating selling pressure in a market searching for yield.  

We see two main consequences from the gold sell off:

1. Are safe havens safe? We have seen a near bubble in perceived safety in recent years. Gold rallied, bonds rallied, and safe stocks have rallied (eg Telstra). Does a gold sell off signal that money can begin to come out of these other trades? We remain cautious of bonds but would not expect a savage sell off given Fed buying support. However we also believe the weight of money will be looking to exit these “safer” trades over the next few years and looking for investments with a better risk / return trade off.
2. Where does the money from gold go?  We do not see it as likely that money will transfer out of gold into bonds so it is likely to find its way into equities, property or infrastructure.

We do not see gold as providing much of a road map to the performance of other commodities which should run on traditional supply / demand dynamics. We have been seeing some softness in this regard and are cautious on mining service players and small miners.

However we remain positioned in the larger miners for the following reasons:

1. They are taking steps to reduce capex and cut costs and as they free up free cash flow they will increase returns to shareholders. We note we have seen Woodside cut their proposed capex on their Browse project and we expect a significant capital return from them as a result.
2. They have world class assets, low on the cost curve which means they can ride out cycles.
3. They are already priced at a discount to valuation reflecting the market cautiousness towards commodities at present. While it is difficult to identify a catalyst at present, we could envisage a turnaround on the back of further Chinese stimulus.

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