The main point here is that the opportunity cost of holding a non-yielding commodity such as gold is markedly reduced when the alternative is to deposit cash in a bank account or government bond offering no interest and on which there is in effect a holding tax. For instance, investors holding 10-year German Bunds are paying 17 basis points a year to the government for the privilege of holding their paper, in Japan the negative yield is 28 basis points a year, and in Switzerland it’s an eye-watering 64 basis points a year. In fact, research from bond strategists at investment bank Citi reveals that yields on 35 per cent of its global government bond index, which has a total value of $21.1 trillion (£16.4 trillion) are now in negative territory. Yields on all Swiss bonds, worth in total US$40bn, have turned negative and some of those mature in 50 years time.
Moreover, a large chunk of government debt is likely to enter negative territory in the near future as 10-year yields on sovereign debt of Denmark and the Netherlands are a whisker a way from falling below zero. When the alternative is earning nothing on your cash, or actually paying a government to lend to it, it’s quite understandable why some investors are buying the yellow metal. Moreover, it’s rational for UK investors to seek a safe haven in a US dollar denominated asset given that some currency strategists believe that the exchange rate could fall to as low as £1:US$1.20 from the current level of £1:US$1.29 to take the decline to 20 per cent since the EU Referendum closed on Thursday, 23 June.
The devaluation could be even greater because there are real prospects of the Bank of England cutting bank base rate to zero at its August meeting, and ramping up the digital printing presses once again by reinstating its quantitative easing programmes, given the perceived shock to the economy from the Brexit vote. If this happens it would remove all yield support from the currency and I wouldn’t be surprised if sterling falls well below £1:US$1.20 against the greenback. The backdrop of the UK’s huge current account deficit, and potential damage to business and consumer sentiment caused by Brexit, are two very good reasons why it could. There are eerie similarities now with the sterling crisis in the final quarter of 2008.
A boon for sterling investors
For sterling investors, the surge in the gold price is proving a real boon. The sterling gold price is up 49 per cent since December. Moreover, although the US dollar gold price is still 29.5 per cent off its all-time high of US$1921 per oz hit in September 2011, in sterling terms the price is only down 14 per cent, the 18.5 per cent depreciation of sterling against the greenback in the past five years being the reason why.
There are other reasons to explain the gold price surge apart from safe haven buying and investors speculating on the strength of the greenback. The obvious one being the improving balance between supply and demand as central banks turned hefty buyers of gold in the second half of last year. This was one reason why aggregate gold demand, despite being around its five-year average of 1,110 tonnes in the final quarter of 2015, exceeded supply of 1,037 tonnes by quite some margin.
Moreover, in the first quarter of 2016 there has been a surge in investment demand driven by latent demand amongst investors who were waiting to re-enter the gold market. Indeed, investment demand more than doubled to US$23.4bn, up from US$10.9bn in the same three month period of 2015, and well ahead of the five-year average of US$13.9bn. Inflows into Exchange Traded Funds (ETFs) hit a seven-year high and propelled gold demand to almost 1,290 tonnes, a record for the first quarter. As a result total global gold demand of US$49bn exceeded supply of US$43.1bn in the first quarter of 2016, a trend that’s likely to continue so as long as investment demand stays firm as seems likely for the immediate future.
Interestingly, in its latest report, The World Gold Council notes that “although institutional investors were reportedly the driving force behind this flood of inflows, retail investors were also a considerable contributor, looking to gold for diversification”.
Playing the gold price rally
The positive gold price action, and the industry supply demand backdrop, is of more than a passing interest to me because I included shares in pawnbroker H&T (HAT:262p) as one of the constituents of my 2015 Bargain shares portfolio. The holding is doing rather well as the share price has risen 49 per cent from 174p to 260p on an offer-to-bid basis in the past 17 months, and the company has also paid out 10.7p of dividends, so it has produced a total return of 55 per cent. This compares favourably with a flat performance from the FTSE Aim index. I reiterated my buy advice on the shares at 195p in early March when I highlighted a smart way of riding on the coat tails of the surging gold price (‘A golden opportunity’, 8 March 2016).
At the time I thought that analysts were being too conservative forecasting that H&T's revenues would only edge up to £89m this year. Last year, the company managed to grow its pre-tax profits from £5.5m to £6.8m in 2015 on a modest rise in revenues to £87.5m even though the average gold price fell from £825 per oz in January 2015 to a low of £712 per oz in December last year. It’s now back to £1,058 per oz, and rising. That’s worth noting for a number of reasons.
Firstly, a rising gold price significantly reduces the possibility of pawnbrokers losing money on a pledge given the underlying asset is increasing in value.
Secondly, in a favourable gold price environment, customers are more likely to be enticed to sell or pledge their gold assets which in turn drives up the company's £39m pledge book and boosts the pawn service charge. And because the company degeared its balance sheet when the gold price was weak, it now has ample funds to boost pawnbroking lending volumes in the upturn. Net borrowings of £2m at the start of this year equate to 2 per cent of shareholders funds of £94m, leaving a £50m four-year credit facility largely untapped.
Thirdly a rising gold price not only has the effect of boosting the gold margin H&T earns on selling scrap if pledges made on gold assets are not redeemed by customers, but it enhances the value of stock, primarily pawnbroking jewellery, held for sale in its retail shops. This creates a windfall gain on inventory on the books as the break-even gold price on defaulted pledges is below the rising market price. There is also a boost to profits earned from gold purchasing activities.
The good news story doesn’t end there either. That’s because H&T has been expanding its new business lines including a personal loans product that earns an average yield of 68 per cent on advances made. The loan book here was around £4.2m at the start of this year, or 11 per cent of the company’s pledge book, but it's growing quickly. Indeed, in a first half trading update this morning, the company announced that the loan book has risen by 48 per cent to £6.2m in the past six months and now accounts for 13.7 per cent of all lending. Furthermore, if credit conditions become tighter in the event of a UK economic downturn, demand for this type of high interest lending is only going one way and that's up.
Bearing this in mind, it’s worth pointing out that H&T is well positioned to capture more of the profitable upside given that one third of all the outlets operated by the major groups in the alternative credit market have closed in the past 30 months, in part due to more stringent FCA standards on high short-term credit lending which have forced many businesses to exit the market.
Upside risk to forecasts
It’s my considered view that if the gold price holds firm, and sterling continues its descent as seems a reasonable prediction in light of a likely cut in Bank of England base rate next month, then the risk to H&T’s earnings is heavily skewed to the upside. The company alluded to as much in this morning's first half trading update, ahead of results scheduled to be released on 16 August.
When full-year results were released in early March, analyst Andrew Watson at brokerage N+1 Singer predicted H&T would drive up pre-tax profit from £6.8m to £8.2m this year to deliver EPS of 17.4p, up from 14.9p in 2015. So based on what increasingly look like conservative estimates the shares are rated on a reasonable 15 times earnings, falling to 13.8 times EPS forecasts of 18.9p for 2017.
There is substantial yield support too as H&T’s board increased the full-year dividend by two thirds to 8p a share, far higher than analysts had anticipated. Based on a likely payout of 8.6p a share this year and one covered twice over by forward earnings, the prospective yield is attractive at 3.3 per cent. The shares are trading on a price-to-book value of one, so are heavily asset backed too.
For good measure, H&T’s share price has just taken out the April and May highs around 249p, suggesting that the next up leg has started. From a technical perspective the next target is around the 300p level. So, ahead of interim results in mid-August, and likely earnings upgrades, I continue to rate the shares a buy on a bid-offer spread of 260p to 262p.
