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The Case for Gold (Part 2)

June 04, 2020

The conditions for gold to rise in value were great last June. They were so good, in fact, that I did something I had never done in my career as a newsletter editor—I bought gold.

And the case for gold has only gotten better since then. Even if you missed the run so far, there’s still time to get in on this trade.

Let me tell you why…

First, physical gold supplies have been under stress.

The demand for physical gold for both allocated and unallocated gold positions as well as for bullion coins has driven spreads between spot gold and physical gold way higher than normal.

Gold inventories have been spiking for required settlements for futures contracts as well as for deliveries for customers taking physical gold.

Comex Gold Inventory—Source: CME & Bloomberg Finance, L.P.

This spike in inventories came with a surge in shipments flown into New York amounting to an additional 17+ million ounces in just the past four weeks.

And in the rollover in current month contracts from May to June, this week was messy. The discount didn’t close as it should because the surge in inventories hit a brief glut.

CME Gold May (White), June (Purple) & Spread (Red)—Source: CME & Bloomberg Finance, L.P.

This is provides a buying opportunity right now as the settlements and the inventory match-up are getting resolved. More normalized pricing means gold should head higher based on the fundamentals noted above.

The forward curve for CME (New York) gold contracts is in “contango.”

That means the longer-term futures contracts are higher in price than spot gold, reflecting a normal market, which reflects storage costs and interest rate carry/opportunity costs.

CME Forward Curve for Gold Contracts—Source: CME & Bloomberg Finance, L.P.

With the US Treasury Yield curve very flat out five years—meaning interest rates are low and don’t rise much for each year out—I see the move up the forward curve for gold futures in spot prices supporting higher gold over the coming months. Storage normalization in the physical market is aiding this.

Meanwhile, in London, the other major market for gold and gold futures, the London Metals Exchange (LME) has a forward price curve for contracts that’s in “backwardization.” That means longer-term contracts are at discounts to shorter-term contracts.

LME Gold Futures Contracts Forward Curve—Source: LME & Bloomberg Finance, L.P.

I see this condition in London reflecting the surge in physical supplies that were shifted in haste to New York. The move left London in shorter supplies for near-term contracts. This too will aid demand for gold in the near term.

And the discount of London (LME) to New York (CME) should close over the coming weeks as the markets catch up on physical supplies and deliveries.

Now, let’s look at the premium of bullion coins to gold spot prices. The premium to bullion coins over spot gold tends to be modest, with the average for all of 2018 through 2019 running at $4.06 per ounce.

But during the quest for cash in March, it plunged to a discount of $112.78 in early April. It then spiked into the $50 range due to shortages that emerged, just like what happened in the physical gold market.

Average Gold Coin/Spot Premium—Source: Bloomberg Finance, L.P.

The spread has begun to stabilize again. And dealers that I know confirm this. They have customers that were waiting for delivery and also to buy more. That pent-up demand is going to flow through to higher prices for gold bullion coins, also supporting a higher price.

Then we come to another source of gold supply imbalance. Gold ETF inflows in the US have hit a year-to-date record of over $18.5 billion, with the leading SPDR Gold Shares ETF (GLD) pulling in over $12 billion.

This continued participation by individuals and institutional investors should continue to drive gold market prices higher on higher demand.

Now, I’m not a fan of GLD. Instead, my favorite pick is Franco-Nevada (FNV).

FNV is not a mining company. Rather, it owns interests in gold and other mineral production. It yields 0.72% against GLD’s 0.00% yield, and it also avoids GLD’s 0.40% cost of carry.

Most importantly, FNV’s return significantly outpaces both gold and GLD. It has returned over 60% since my initial recommendation last year compared to GLD’s meager 20%.

FNV (White) & GLD (Orange) Total Returns—Source: Bloomberg Finance, L.P.

And there is one more reason not to buy GLD.

Like with other gold ETFs, they are considered grantor trusts under IRS rules and are subject to 28% tax rates even on longer-term holdings, not long-term capital gains rates that are much, much lower.

Bottom line: Gold should fare well on fundamentals of lower interest rates and a compliant US dollar.

And the recent gyrations in the futures and physical markets for gold are providing a continued buying opportunity right now.

With Franco-Nevada (FNV), you get the appreciation and you also get the dividend yield.

All My Best,

Neil George
Editor, Income Investor’s Digest & Profitable Investing
Author, Income for Life

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