In recent months I have been reducing my moderately defensive position relative to both benchmarks believing sentiment continues to trail fundamentals. July saw this theme continue, with an emphasis on gold mining companies which now look oversold and cheap relative to the commodity itself.
The case for gold miners
The recession in the west is unusual in that it is built on debt. Being a deleveraging rather than a destocking recession, the answer is not more debt as some eurozone leaders believe.
True, some governments are attempting to reduce debt through austerity packages. But this is proving unpopular, at times counter-productive, and marginal in its effect. The UK government may have reduced the deficit by 25 per cent, but this simply means it has slowed by a quarter the rate at which we add to our existing debt.
Economic growth is the answer, but the dead weight of debt makes this difficult. There is little money to give away to encourage spending, little scope to cut interest rates further, and little political courage to introduce the supply side reforms needed to improve competitiveness.
In the absence of growth, and assuming governments chose not to default, inflation becomes more attractive as a policy option to erode debt levels. To this end, as I have long pointed out, interest rates are being kept at artificially low levels at both the short and long end of the curve - as part of the 'financial repression' package. History shows we have been here before. Further rounds of quantitative easing to keep economies going will also be part of the mix
This general scenario bodes well for gold bullion. The fear of periphery defaults, the lack of growth and the prospect of inflation are all supportive. Gold offers a safe haven. It remains one of the best ways to protect yourself against western governments determined to devalue their currencies as they print more money to repay their debts.
The supply/demand equation of the commodity itself is also supportive. World gold production is still below its 2001 levels. Six of the eight largest gold-producing countries in the world have declining production. Furthermore, gold continues to get more difficult to mine. The average grade of gold mined keeps going down and is now around 1.5 grams per ton of ore.
Yet the central banks keep buying and have been net buyers since 2009. Furthermore, Asian demand is forecast to continue to increase over the long term with India and China already accounting for over half of all global investment demand. Meanwhile, evidence suggests institutional investors may now be thinking of gold bullion as an asset class in its own right.
But if the outlook for gold is good, then the outlook for gold miners is even better. By any number of measures, gold mining shares look cheap relative to the commodity itself. For example, the ratio between the Philadelphia Gold and Silver Index and the gold price itself has dipped to below 0.1 - a level only seen once before in 2008 since the index was formed during the early 1990s.
Mining shares have not escaped the general sell-off in equities despite gold's run. But, as gold moves steadily higher, I believe sentiment toward the miners will improve. And given the extent of underperformance to date, there is a lot of catching up to do.
Portfolio changes
In the Growth portfolio I have switched out of the Leveraged Gold ETF (LBUL) and into Golden Prospect Precious Metals Trust (GPM). GPM comes from the well respected New City Investment Managers stable. The portfolio is split 70 per cent gold mining companies and 30 per cent silver. This mix is positive given the recent underperformance of silver relative to gold.
Producers account for around three-quarters of assets. This is wise, for institutional investors will tend to avoid high-risk explorers when sentiment changes. Meanwhile, explorers with the potential for low-cost production are favoured given funding may become more difficult if the debt crisis unfolds.
Furthermore, I have increased both portfolios' exposure to City Natural Resources High Yield Trust (CYN), having top-sliced holdings at higher levels a little while ago. CYN aims to provide capital and income growth from a wide range of commodities, both hard and soft, but gold mining companies presently account for over a quarter of assets. CYN presently stands on a 15 per cent discount.
In my next column, I will explain why I have replaced Herald investment trust (HRI) with Dunedin Smaller companies trust (DNDL) in the Income portfolio.
