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Morningstar | Yamana Shares Rally After a Strong 2Q, but Shares Look Fairly Valued

Yamana turned in a strong second quarter. With the opening of Cerro Moro and higher production at Chapada, Canadian Malartic, and Jacobina, total production from Yamana mines rose 8% to 224,083 gold ounces. Improved by-product production also helped drive lower all-in sustaining costs ,or AISC, which declined 15% to $682 per ounce.

Following a strong second quarter, the company now expects to exceed previous gold production guidance of 900,000 ounces and AISC to be within guidance of $725-$745 per ounce. We had already anticipated this outcome in our existing forecast, so we largely maintain our forecast. As a result, we maintain our fair value estimates of $3 per share and CAD 3.90 per share, respectively. Our no-moat rating also remains unchanged.

Shares rallied more than 10% after Yamana's second quarter earnings announcement. As a result, we see shares as roughly fairly valued at this time.

In June, the U.S. Federal Reserve once again raised the federal-funds rate by 25 basis points to 1.75%-2%. This was the second rate hike of the year. Most officials at the central bank expect two additional rate hikes in 2018. The market appears to be largely in line with this view, as current interest rate options prices imply a more than 66% chance that there will be at least two hikes, if not more, for the full year.

All else equal, the prospect of higher inflation adds to gold's investment appeal, which is one reason ETF gold holdings rose through most of 2018 and spot prices remained above $1,300. However, as we had anticipated, higher inflation has emboldened the Fed to pursue rate hikes at a quicker pace, which lifts the real interest rate and, in doing so, increases the opportunity cost of holding gold.

Historically, we've observed a strong inverse relationship between the real interest rate and the price of gold: when the former rises, the latter tends to fall. We thought it was only a matter of time before gold investment adjusts to the higher opportunity cost, not only leading to slowing investment demand, but also outflow of gold from ETFs back into the gold market. Our prediction has begun to take hold as ETFs saw outflows in all regions in June.

On the back of weak investment demand, gold prices have fallen to slightly above $1,200 per ounce. Nevertheless, we still believe gold has a promising future, and we forecast a nominal gold price of $1,300 per ounce by 2020. We expect that, in the long term, Chinese and Indian jewelry demand will fill the gap left by waning investor demand.

For more on why rate hikes present a significant risk to near-term gold prices, please see our August 2017 report "Gold is Standing on One Leg."