Gold Falls Below $1,200: What Led to the Plunge?

Gold prices have dropped below the psychological level of $1,200, owing to a stronger dollar, solid momentum in the U.S. manufacturing sector, expectations of higher interest rates in the United States and escalating global trade tensions. In fact, the yellow metal has lost about 8% so far this year, primarily weighed down by the strong US dollar against both developed and emerging market currencies, especially, weakening of the Chinese yuan and Turkish lira.

The public comment period on the U.S. proposal to impose tariffs on $200 billion or more on Chinese imports is drawing to a close on Sep 6. Once the deadline is over, the United States could impose tariffs on roughly half of the Chinese goods entering the country – making it the most impactful round of tariffs so far

The heightened concerns owing to an escalating trade conflict between the world’s two largest economies are resulting in investors dumping emerging market currencies and seeking safe haven in dollar. The dollar index, which measures the greenback against a basket of currencies, was up 0.12% to 95.56 on Sep 4.

Notably, a stronger dollar makes dollar-priced gold costlier for non-US investors. It also got an extra boost from economic data that showed manufacturing growing at its fastest pace in 14 years.

Per the Institute for Supply Management (“ISM”) latest report, manufacturing index advanced to a reading of 61.3% in August, up from July’s 58.1% and ahead of the consensus mark of 57.2% It also marked its highest level since May 2004, when it had clocked a reading of 61.4. The manufacturing index shows business conditions in the U.S. manufacturing sector and is considered a significant indicator of the overall economic condition in the United States. A reading above 50 is seen as a sign of economic growth. The August PMI indicates growth for the 112th consecutive month in the overall economy and the 24th straight month of growth in the manufacturing sector.

The New Orders Index was at 65.1% in August, up from July’s reading of 60.2%. New orders have witnessed growth for 32 consecutive months. Further, the index has been at or above 60% for the 16th straight month. Moreover, ISM’s Production Index registered 63.3% in August, up from 58.5% reported for July, indicating growth in production for the 24th consecutive month. The manufacturing sector’s labor market also observed strong momentum growth in August. The Employment Index increased to 58.5%, up from the previous reading of 56.5%.

Another factor that is working against the yellow metal is the prospect of the Fed hiking interest rates this September. A strengthening economy gives the Federal Reserve reason to raise interest rates. Higher U.S. rates dent the appeal of gold as it does not offer much interest. Consequently, an interest rate hike, which is likely at the Fed's upcoming meeting this month, is likely to weigh further on gold.

Despite these headwinds, there are other factors that might support gold’s performance in 2018.

Production Expected to Rise in 2018: A number of new mines entered production in late 2017, which is likely to support mine production till 2018.

India, China to Help Sustain Demand: Major gold markets, India and China, will continue to be growth drivers. Further, the back half of the year is seasonally strong in India due to the festive and wedding season buying. The Indian government also announced measures to bolster rural incomes, including higher minimum support prices and an increase agricultural credit. This along with normal monsoon bodes well the rural sector which is an important consumer for the gold industry. Moreover, the United States continues to be a strong market driven by economic growth, improving employment levels and growth in consumer confidence.

Lower Costs for miners: Over the past few years, gold miners have cut costs, checked capital expenditures, improved recovery efficiency within existing mines, paid down debt, eliminated non-core assets and focused on their highest ore-grade assets. These endeavors have helped lower the all-in sustaining costs for miners. Consequently, most gold mining stocks could be profitable even if spot gold prices were significantly lower.

Valuation is Inexpensive: The Zacks Mining – Gold Industry, which falls within the broader Zacks Basic Materials Sector, has underperformed both the S&P 500 and its own sector year-to-date. The industry has declined 23% while the Zacks Basic Material Sector dropped 7% and the Zacks S&P 500 Composite gained 8.8%.

However, the valuation looks really cheap now. One might get a good sense of the industry’s relative valuation by looking at its Enterprise Value to Earnings before Interest Depreciation and Amortization (EV/EBITDA). This valuation is a good measure for the industry’s given its complicated and capital-intensive nature.

The industry currently has a trailing 12-month EV/EBITDA ratio of 6.8, which looks inexpensive when compared with the market at large, as the trailing 12-month EV/EBITDA ratio for the S&P 500 is 11.9.

A comparison of the group’s EV/EBITDA ratio with that of its broader sector ensures that the group is trading at a decent discount. The Zacks Basic Material Sector’s trailing 12-month EV/EBITDA ratio of 8.03 is way above the Zacks Mining – Gold Industry’s EV/EBITDA ratio of 6.8.

We suggest investors to add stocks which are backed by a solid Zacks Rank such as Northern Dynasty Minerals, Ltd. NAK and Vista Gold Corporation VGZ. Both the stocks carry a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

The Zacks Consensus Estimate for Northern Dynasty Minerals is at a loss per share of 3 cents per share for fiscal 2018, an improvement from the prior estimate of a loss per share of 12 cents over the past 60 days. The Zacks Consensus Estimate for Vista Gold is pegged at a loss of 8 cents per share for fiscal 2018 from the prior estimate of a loss of 10 cents per share over the last 60 days.

However, we suggest steering clear of stocks such as New Gold Inc. NGD and Sandstorm Gold Ltd SAND. New Gold carries a Zacks Rank #5 (Strong Sell) and Sandstorm Gold carries a Zacks Rank #4 (Sell). Both the stocks have been witnessing negative revisions in their earnings estimates lately.

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