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Metals & Mining

Gold feels underpinned for the medium term Recent comments from the FED about average inflation targeting mean we believe the current gold price strength is likely to extend well into 2023E, ushering in a period of truly spectacular cash flow generation by the gold sector. This will give management teams the resources to delever, fund development projects and return cash to investors, enabling investors to select stocks based on their preferred characteristics.

Gold cash flows look set to impress

The three-to-four year period of expected strong gold prices will translate into some very impressive cash generation for the gold sector. In the first instance we believe the rising tide of sustained record gold prices will float all boats, but in the medium term it will be the management teams who combine debt reduction, production growth and capital returns most efficiently, and with least cost inflation, that will generate the biggest rewards for investors.

Updated gold forecasts – over US$1,800/oz until late 2023E

We increase our gold price forecasts, reflecting the FED’s recent pronouncement in terms of the timing and scale of potential rate rises over the coming years. We also adjust our forecasts to take into account the recent strength – driven almost entirely (we believe) by the recovery in long-term inflation expectations from a low of ~0.95% in March to 1.7% now.

Gold price looks underpinned

We see a three-to-four year period of strong gold prices (by any historic measure) underpinned by what appears to be a Federal Reserve Bank determined to ensure that it does not get in the way of a recovery from the Covid-19 pandemic and associated economic fallout. Even in a low inflation environment, gold is likely to hold at over US$1,800/oz. If inflation expectations start to accelerate, gold prices could rise to over US$2,100/oz given the FED’s shift to average inflation targeting. We would buy gold equities if the gold prices fades towards or below US$1,900/oz and take profits (potentially to reinvest on a pull back) if it spikes up towards and over US$2,100.

Gold price moving on rising inflation expectations

The gold price is up 27% through 2020, driven firstly by a fall in longer-term bond yields (January to March), then once bond yields stabilised at a low level in April, through a steady rise in long-term inflation expectations. Interestingly, those long-term inflation expectations are roughly back to where they were on
1 January, but the longer-term (10-year) US T-bill yield is at 0.7% vs 1.8% on
1 January. It is this emerging gap that has driven gold to all-time highs.

Three scenarios mapping out a range of inflation levels

We see the question “where from here” for gold prices splits into a two-part question, namely: “what happens to longer-term inflation expectations?” and “how does the FED react to changes in both near- and long- term inflation?" – ie what happens to long-term bond yields? To put some boundaries around this, we depict three scenarios setting long-term inflation estimates at 1.5%, 2% and 2.5% (unimaginatively named low, base and high).

Gold to average high $1,900s for 24+months

The strong gold price has been driven by increasingly negative real interest rates so far this year.

Short-term buy signal – gold drifting close to or below US$1,900/oz

Our low inflation scenario (long-term inflation estimates fade to 1.5%) suggests that we could see a gold price low of around US$1,850 over the next 12-24 months, assuming that the long bond yields did not also weaken in sympathy.

Short-term sell signal – gold approaches/breaks US$2,100

Our high inflation scenario assumes that at least to start with, the FED would remain quiescent – after all, we think it’s strange for it to announce “average inflation targeting” and immediately react if longer-term inflation expectations drift up – particularly as the said expectations have been below 2% since late 2018, ie rising two years.

Our revised quarterly forecasts

As mentioned above, our previous expectations of a gently rising gold price has been rather overtaken by events. We now see a relatively stable gold price that we expect to trade in a narrow band of between US$1,950 and US$2,000/oz into 2023E.

Average 32% increase to our target prices

Unsurprisingly, the increase to gold prices for an extended period means we see substantial increases in our target prices for our gold coverage group.

Hochschild (HOC) upgraded to Buy (from Add)

We have upgraded our rating on Hochschild from Add to Buy. We have adjusted our HOC forecasts to account for the weaker 2020 guidance recently issued, which results in a 17% decrease in our forecast 2020 output to 342k oz AuEq. However, with higher gold and silver (~40% of HOC EBITDA) prices looking set to remain for some time, cash flow generation should be much higher than we originally anticipated. We now forecast 2021 and 2022 EBITDA 14% and 18% higher, respectively. With significant upgrades to our cash flow profile over the coming two-to-three years, we also believe the chance of significantly greater shareholder returns will be an option available to management from 2021. We have increased our target price by 49% to 325p. Upgrade to Buy.

Pan African resources# (PAF) maintained as a Buy

Although we have not changed our rating, it is worth noting that we have incorporated the recently reported strong FY20 results. The only major change for FY21 is that we lowered our production forecast by 3% to 190k oz (from 197k oz previously), in line with management’s guidance.

Pure Gold# (PUR) downgraded to Add (from Buy) on very strong performance since launch

We make one recommendation change – downgrading Pure Gold Mining from Buy to Add – simply reflecting the very strong run it has been on (up 252% so far this year). The shares are up 366% since we launched coverage on 7 June 2019.

Centamin (CEY) downgraded to Add (from Buy)

We have been consistently positive on Centamin since March when the stock dropped down to the 88p level. We have adjusted our model to account for slightly lower production in 2020, down 1% to 518k oz from 524k oz. However, over 2021 and 2022, we now forecast EBITDA some 27% and 20% higher, respectively. With net cash expected to rise above the US$400m level by 2021, we would also expect to see greater shareholder returns out of this already strongly cash-generative business. We increase our target price to 243p, up 31% from 185p. With just over 10% upside to our target, we reduce to an Add rating, but still continue to see at least a 5% dividend yield to come from this business for some time to come.

Petropavlovsk (POG) retained as a Hold

Despite the higher gold price, we retain our Hold recommendation for Petropavlovsk. We see the shares as relatively higher risk due to the recent contested management and board changes. We see the expected operating performance over the next 6-12 months as being under threat given the removal of Dr Maslovskiy who has been instrumental in ensuring that the individual operation sites kept to budgets and plans. As such, we are nervous of a period of drift following his departure. Given this comes at a critical point in the development of the Pioneer flotation lines, we see higher than usual risk to production and cost levels. Certainly the rapid delevering under our forecast gold price environment would suggest a strong leverage to the share price. At present we think much of this is priced in, while operations could slip relative to expectations.

Estimate changes

Unsurprisingly, given the increases to our gold price forecasts from H2 2020E onwards, EBITDA and EPS estimates for our coverage group all increase. We see 17% EBITDA increases for 2021E and 22% for 2022E.