January Fund Performance & Market Commentary

The Delbrook Resource Opportunities Fund rose +4.9% in January vs. a +1.5% return for the SPDR Metals and Mining ETF. Performance of long positions, specifically those with primary exposure to base metals, led with returns of +3.5%. Short exposure was focused on precious metal equities and returned +0.3%, despite gold rising +3.3% during the month.  

Annualized Fund performance now sits at +20.9% since inception. Just as importantly, the Fund has a rolling 24 month Sharpe Ratio of 2.3, reflecting a careful analysis and monitoring of risk. Our investment approach stresses the importance of identifying opportunities with positive asymmetric risk profiles. We insist that our unitholders, ourselves included, be well compensated for the calculated exposure we take as we navigate an inherently volatile sector.

We continue to monitor declining inventory levels within select base metals as an indicator of short term upside in the spot market.  As previously discussed, zinc inventories are at critical levels and treatment and refining charges have declined rapidly.  A scarcity of refined zinc in the market leads us to believe that a short term spike in spot prices is imminent and forecast LME spot zinc to approach $2.00/lb in the second half of 2018. In our view, Ascendant Resources (TSX: ASND) is ideally positioned to benefit from the current zinc environment, with a compelling valuation (<2.0x P/CF) and current efforts to implement operational improvements.  

While still in the early stages, similar inventory drawdowns can be witnessed in the nickel market, where inventory declines are approximately 50% year-over-year. We expect a combination of increased demand and limited new mine supply to accelerate inventory drawdowns and support pricing going forward. Any traction with the recently announced infrastructure plan in the U.S. would exacerbate demand for base metals and potentially hasten price increases.

Macroeconomic Outlook

Fears in the U.S. equity markets that higher inflation will cause a contraction of P/E multiples seem over blown. Even if the inflation rate overshot the Federal Reserve’s 2% target by 100 basis points, we do not think it would justify a meaningful contraction of multiples. The S&P 500 P/E multiple on 2018 consensus operating income is currently 17.9x versus a 38-year average of 17.7x [Figure 1]. Given the robust economic outlook, a higher than average P/E multiple would appear justified. Collateral to fears of rising inflation is the belief that the Federal Reserve will have to raise interest rates further to slow the economy and keep it from overheating. We believe that current economic conditions warrant continued gradual rate increases, at a measured pace. Equity valuations look fair and late stage cyclicals should outperform as they have historically in previous rising rate environments. 
(Figure 1 ) Sources: Delbrook Capital Advisors, Bloomberg. Data as of Feb 2, 2018
We believe that the developed economies of the world are moving into a more mature phase of the business cycle where commodities will outperform other asset classes. Corporate earnings are strong. Unemployment is very low. With less slack in global production capacity, demand is bumping up against supply constraints. For the same reasons the Federal Reserve is raising rates, commodity producers are benefiting from higher prices. This logic supports our bullish posture toward base metals such as copper, zinc and nickel, which we have written about extensively.

Outlook for Gold

Our views on gold are more nuanced. Ostensibly, rising interest rates increase the opportunity cost of holding gold. However, we believe the focus should be on real interest rates. In other words, nominal interest rates have to rise faster than inflation and so far we are seeing only a modest increase in real rates.  
(Figure 2) Sources: Treasury Inflation-Protected Securities Delbrook Capital Advisors, Bloomberg. Data as of Feb 2, 2018
(Figure 3) Sources: Delbrook Capital Advisors, Bloomberg. Data as of Feb 8, 2018
Gold price performance during various real interest rate environments going back to 1970 also provides some context. When real rates were below zero, gold had average monthly returns of +2.1%. When real rates were between 0% and +4%, gold posted average monthly returns of +0.6%. And when real rates were greater than +4%, gold posted a +0.2% average monthly return. Currently however, global real interest rates are flat to negative depending on the country [Figure 3].
(Figure 4) Sources: Delbrook Capital Advisors, Bloomberg. Data as of Feb 8, 2018
Goldman Sachs is forecasting a 2.3% inflation rate in the U.S. during 2018. The yield on the ten-year U.S. Treasury bond was 2.83% on February 13th, up about 37 bps since start of 2018 and near its highest level since 2014. However, this only implies a real interest rate of 0.53%. Even if the 10-year Treasury bond yield were to increase by an additional 100 basis points to 3.83%, we would still only be at a real interest rate of 1.53%, which we consider relatively benign for gold prices from a historical perspective. 

It is possible that the sudden spike of volatility in the broader equity markets and rising nominal rates will cause U.S. investors to reconsider gold as a safe haven. In fact, this should be the case for investors in long duration fixed income assets. Typically, a 1 percentage-point change in interest rates implies a change in the bond’s price equal to the duration. Bonds with a duration of 10 years could decline 10% in price if nominal interest rates rise by 1 percentage point. It strikes us that rising nominal interest rates portend a bloodbath for dedicated fixed income investors on the long end of the yield curve.

The emerging market economies of the world are trailing the developed economies in the current business cycle. They generally have more exposure to commodities as a percentage of GDP and their economies are gaining momentum. For example, the Economist Intelligence Unit expects GDP growth in Chile to increase from 1.4% in 2017, to 3.0% in 2018. Similarly, Brazil’s GPD growth is expected to increase from 1.0% to 2.7% in 2018. In general, we believe economic growth in emerging markets will accelerate this year, spurred on by synchronized global growth and higher commodity prices. 

It is worth reiterating how disproportionate gold consumption is between the developed markets and emerging markets [Figure 5]. The World Gold Council reported global gold demand in 2017 of 4,072 tonnes. Jewelry accounted for 52% of that demand at 2,136 tonnes. Emerging market countries represented an astounding 80% of total jewelry demand. Gold bars and coins were reported at 1,029 tonnes or 25% of total gold demand in 2017. Again though, emerging markets represented 72% of that number. Russia, Turkey and Kazakhstan accounted for 95% of the 371 tonnes of the net central bank buying last year (9% of total demand). Meanwhile, ETF’s represented only 203 tonnes (5%) of net buying in 2017 and Germany was the bulk of that. Technology was the balance of the total gold demand at 333 tonnes (8%).
(Figure 5) Sources: Delbrook Capital Advisors, World Gold Council. Data as of Dec 31, 2017
Global gold mine production was basically flat at 3,269 tonnes in 2017, compared to 3,263 tonnes in 2016. In the 4th quarter mine production was actually down 2% year over year. Recycling made up the majority of the balance of the global gold supply at 1,160 tonnes, down 10% from 1,295 tonnes in 2016. While exploration spending responds quickly to gold price trends, it takes years for mine supply to react. We note that gold prices peaked in the fall of 2011 at just over US$1,900 per ounce and then fell to US$1,150 by the end of 2016. During that period global gold exploration spending dropped by 65% according to Newmont. Consequently, we see the potential for gradual declines in the absolute level of mined gold production over the next several years.
(Figure 6) Sources: Delbrook Capital Advisors, Thomson Reuters, World Gold Council, Metal Focus. Data as of Dec 31, 2017
In summary, we believe the low but modestly rising real interest rates, combined with prosperity growth in the emerging market countries and flat to declining mine supply should underpin the price of gold over the intermediate term. Additionally, violent market dislocations in exchange rates and equity markets could drive investors back into gold as a safe haven. Given this backdrop, the risk for the price of gold is weighted to the upside over the next 12-24 months
Matthew Zabloski
Portfolio Manager/Founder
Walter Coles
Investment Strategy