Canadian Small-cap Model Portfolio
Gold
We are again increasing our gold exposure by raising Torex Gold Resources Inc. (TXG) to 4.0% from 2.0%.
As we have stated in our previous publications, we believe that equities are faced with several headwinds, including a slowing global economy (notably China), tightening credit conditions, U.S. debt ceiling uncertainties, and declining earnings momentum. As the market enters the traditionally weak summer period, we believe that equities could face a seasonal pullback. Defensive posturing is already taking place, with large caps leading over small caps, along with the relative strength in consumer staples and “safer” mega-cap technology in the U.S. We believe that gold also stands to benefit in this scenario.
After a pickup through the early part of the year, economic momentum has slowed of-late, both in the U.S. and China, as witnessed by the downtown in the respective Citigroup Economic Surprise Indices (Exhibit 1). Like last year, when both indices turned sharply lower (demand slowdown) and copper fell precipitously (-33%, March peak to July trough), copper is again coming under pressure this year, down 11% from the March peak. Conversely, gold has rallied 11% through copper's decline. This diverging momentum has us favouring gold equities over copper equities, and we believe that gold equities are undervalued relative to where the underlying commodities are trading (Exhibit 2). As a result, we do have high gold producer exposure with Lundin Gold Inc. (LUG, portfolio weight 5.4%), Alamos Gold Inc. (AGI, portfolio weight 4.4%), and Torex, along with a position in Major Drilling Group International Inc. (MDI, portfolio weight 6.5%).
Gold could also get a lift from the Fed. Rising bank uncertainties in the U.S. have raised the prospect that the Fed could be nearing the end of its tightening cycle, in our view. Although U.S. inflation readings last week were relatively in line (core CPI: 5.5% vs. 5.5%; core PPI: 3.2% vs. 3.3%), overall levels remain relatively high and above the Fed target levels. Given this, we do not expect the Fed to cut rates this summer, but we believe that a Fed “pause” is likely. This could initiate another rally in gold equities, in our view. In exhibits 3-6, we have captured the previous four interest-rate-easing cycles (1995-1997, 2000-2003, 2006-2009, and 2018-2020) and overlayed the S&P/TSX Gold Sub-sector. Through each of these four periods, gold equities staged significant rallies, rising on average 77%.
From a revision momentum perspective, we also favour gold among the resources. With the 11% rally in bullion from the early-March low, gold is presently trading 7% above its consensus estimate (Exhibit 7). Not only does this increase the likelihood for higher estimates within the sector, in our view (both bullion and producer cashflow estimates), but this is contrary to both copper (closest contract 8% below consensus estimate) and oil (WTI 12% below).
The increase in Torex raises our portfolio gold sector portfolio weighting in line with the S&P/TSX Small Cap Index (20.3% versus 21.6%). We believe that the potential upside in small-cap gold equities (versus large) is significant, given where bullion is presently trading (Exhibit 8).