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July 22, 2005

Gold - A Mad Tea Party
by John Ing

'Not the same thing a bit!' said the Hatter. 'You might just as well say that "I see what I eat" is the same thing as "I eat what I see"'- Quote from the Mad Hatter in "Alice In Wonderland" - Lewis Carroll.

"I know you believe you understand what you think I said, but I am not sure you realise that what you heard is not what I meant" - Alan Greenspan.

Confused? While reassuring the markets, Greenspan noted that the flat yield curve either suggested a slowing economy or instead was attributable to "new forces" such as Asian central banks, a savings glut or a labour glut. Historically, when long term yields fall as short term rates increase, it flattens a steep yield curve, indicating that the economy is heading for a serious slowdown. And it is not only a made-in US phenomenon since 10 year German bond yields are only 2 percent.

Greenspan's Conundrum
Like Alice at the Mad Tea Party, Alan Greenspan is puzzled. The interest rate "conundrum" in which 10-year Treasuries continues to fall despite an increase in short rates is confusing investors and central bankers alike. Although Alan Greenspan has moved interest rates up nine times, he hints that there are more to come. The Fed chairman worries that the economy is too strong and points to looming bubbles such as hedge funds and real estate. However, the bond market seems to be ignoring Mr. Greenspan's warnings of higher interest rates and appears to be on a path of chicken with the central bank.

Greenspan just doesn't get it. We believe that the answer to the bond market puzzle is that Greenspan and other central banks have flooded the financial markets with liquidity, resulting in too much money chasing too few goods. At the heart of this debate is that Bush has gone on the biggest spending spree since Lyndon Johnson. America has become the world's largest debtor. The Fed's requirement to finance America's burgeoning trade and budgetary deficits kept rates at ridiculously low levels in order to keep the consumer spending to avoid the very recession or slowdown that the bond market is expecting.

The recent rate increases are a reflection of the need to attract foreign monies, since Americans have outsourced the financing of these deficits. Either way, we believe that the market is vulnerable to a major reversal of sentiment since this excess liquidity could disappear quickly, particularly if investors were to be spooked from benign events such as a build-up of inventories, another shift in the US dollar or an increase in rates.

What is at issue is that America's indebtedness has left it exposed, threatening the world's financial stability. The US savings rate is near-zero, matched equally by a large increase in the savings rate of foreigners. The Americans are pumping out so many billion of dollars that it has been calculated that it needs to attract about eighty percent of all the world's savings just to maintain the dollar's value.

China Inc.
For too long, America has been living on borrowed time and borrowed funds. Those funds have been supplied by Asians who now own $1.1 trillion of US Treasuries. China with the world's biggest population and fastest growing economy is awakening economically. While we can understand China's quest for securing its energy sources, left unsaid is the huge power that China has come to wield. That power comes from its mammoth cash reserves. That the Chinese are no longer content to invest their money in US government bonds is a reflection of not only their attempt to diversify but a logical objective to seek a superior return. Also it has become cheaper to buy reserves on Wall Street than the drill bit.

As the US current account deficit climbed above six percent of gross domestic product (GDP), China accumulated over $200 billion of US Treasuries and $711 billion of foreign exchange reserves. Until recently, China was content to be a passive investor but America's profligacy caused an economic-awakened China to take a more active stance.

China is exercising its right to manage its economy, its assets and security of resources. China's currency and exchange rate are matters for the Chinese, not John W. Snow or anyone else. The Americans lost control over their currency in 1971-1973 after the Bretton Woods breakdown when currencies floated without an anchor. It's not about a more flexible renminbi, it's about the devaluation of the world's last reserve currency.

Today the world is awash with dollars. China has become the most vital creditor of the debt-laden US. China has more dollar reserves than it needs and the depreciation of the dollar lowers asset values in their own currencies. China holds the cards. But what if China revalues its currency? All those goods made in China would become more expensive. US rates would go up since Beijing would have less to spend. Inflation would ensue, coinciding with rising rates and the bursting of America's remaining bubbles. Americans should be careful what they wish for.

War of The Words
"Take more tea, " the March Hare said to Alice very earnestly. "I've had nothing yet, "Alice replied in an offended tone, "so I can't take more." "You mean you can't take less", said the Hatter, "it's very easy to take more than nothing." from Alice In Wonderland - Lewis Carroll.

And that is like the Americans who are reluctant to wean themselves from the easy money policies that piled on debt on a horrific scale. The foreign appetite for US debt is waning. Americans should listen to the message and fix their own balance sheet, fix their own currency and fix their own businesses. While China-bashing is quickly becoming the rage - it is a red herring.

China National Oil Corp's (CNOOC) bid for Unocal Corp set off a geo-political debate as Congress and others in a xenophobic knee jerk reaction wrapped themselves in the flag of nationalism. This comes following Chinese computer firm, Lenovo's acquisition of IBM's personal computer division and now Haier, China's largest appliance maker, bid for US appliance giant Maytag Corp. The bids are an important shift in China's investment activity. At the end of April, China held $230 billion in US treasury securities and by diversifying, China is using its cash hoard to acquire expertise from developed companies.

Rather than buy golf courses and Hollywood film studios, the Chinese are simply acquiring under-achieving industrial assets with global brands. Yet the Chinese are actually proceeding cautiously with their investments. For example, the National Development and Reform Commission acts as gatekeeper and studies oversea investments and their approval is needed before final consent is granted by China's cabinet.

Though 70 percent of CNOOC is indirectly state-owned and thus not directly funded by the government, politicians were quick to raise concerns about national security and its parenthood. Missing is that Americans are non-plussed in dealing with Aramco owned by the government of Saudi Arabia. Missing is that China and the United States have become deeply interdependent. China has become America's third-largest trading partner (Canada is number one). China needs a market for its exports and the Americans need funding for its growing trade and budgetary deficits. In addition, the US consumer keeps buying cheap Chinese goods and US manufacturers depend on China for the production of those goods. Indeed about half of China's exports are by companies that are wholly or partly owned by foreigners.

Despite the rhetoric, America with its mountain of debt is not in a position to stop future purchases. The use of China's economic muscle provides an early warning sign for the Americans. The debate over the yuan, pegged to the US dollar is simply a proxy over China's emergence as an economic superpower. Threats to impose tariffs or telling the Chinese to change their internal monetary policy will not only fall on deaf ears but make them no friends.

Enter the Dragon
The implications of China's emergence as a superpower is going to have bullish implications for commodities. According to Zhang Jian, president of the China Non-Ferrous Metal Mining Company, China may have to import 57 percent of its iron ore, 70 percent of copper concentrates, and 80 percent of alumina by the end of the decade. The statistics are mind numbing. By now we know China is the world's largest consumer of steel, iron ore, copper and aluminium. Then there are the agricultural commodities where China has already displaced Japan in consumption.

In the past, the foreign policies of Britain and the United States were governed by their need for commodities and now so will China's need force those countries to develop new strategies for foreign policy and security of resources. Oil shaped much of America's foreign policy in the last forty years as did the Boer War for Britain. The U.S. went to war with Iraq twice because of concern over the control of two of the world's largest oil reserves. In our view, China's emergence is at the very inflection point to have a major influence on global geo-political environment. The centre of influence in global and monetary policies has tilted from a US-centric world to the Middle Kingdom.

China has already developed a foreign policy and military strategy to protect its access to raw materials. In August, China and Russia have scheduled the largest military exercise ever with 8,000 troops. From Sudan to the Caribbean, the Chinese have become masters of influence by negotiating agreements filling the vacuum left by the Americans. China has independently developed trade ties with those not friendly to the United States. China is in Kazakhstan building pipelines and acquiring reserves to protect its supply. Chinese state-owned companies are making direct foreign investments in Venezuela, Africa, Indonesia and Australia. And recently the Chinese has started knocking on the doors in Canada for access to our resources.

This growth and new role for our commodities has occurred so quickly that policymakers have not yet looked at the implications. Canada is well placed to benefit. Canada exports 80 percent of the minerals produced or refined here and is well poised to benefit from China's voracious appetite. At the current rate of growth, China will be a bigger influence than America and thus Canada is in a position to be an influential player in the early decades of the 21st Century. Indeed, we believe that Canada's role as a provider of resources will eventually be overshadowed as a provider of capital.

Fiat Money
The euro took another pounding in the wake of the French and Dutch rejection leading to fears of economic paralysis as the Community sorts out what to do without a constitution. As Canada discovered, a constitution does not make country, since it took more than a hundred years to repatriate our constitution. The European Community was created to promote trade, provide stability and establish a common currency. Although the euro had a near-death birth, it enjoyed a huge rally to record levels but has now collapsed following the rejection by the French and Dutch. Notwithstanding this "up and down" performance, underlying the value of a currency is the economic fundamentals.

Here the Europeans have been woefully undisciplined. Germany, Italy. Portugal and France could not rein in their budgetary deficits and all have exceeded the three percent of GDP cap. Spending was not kept in check and there has been a common lack of discipline. Thus the euro has become like any other currency, not worth the paper its printed on.

After Buying Companies, They Will Buy Gold
With Asian central banks awash with billions of reserves, what else could they do with their billions. Not only are they buying real assets, they're diversifying by buying Canadian dollars and other currencies than the US dollar. The Chinese have become the fourth largest gold buyer in the world. Gold is going to play a much bigger role. China's central bank has less than two percent of its reserves in gold. Japan too is light. This will change. In our view, the lack of faith in currencies will result in a move to gold, the ultimate currency.

Gold in US dollars has seen a near 80 percent rally from $255 an ounce to an almost seventeen year high of $455 an ounce last December as gold marched in lockstep to the US dollar collapse. Gold was a classic hedge for investors and a beneficiary of the greenback's three-year plunge through the end of 2004. Early this year, the greenback rallied and gold sank to $410 an ounce. But the dollar has strengthened in the past month and gold has risen $25 an ounce decoupling from the dollar. The pattern is changing.

With the euro sinking to a fourteen month low, gold priced in euros has broken out from a four-year range. Gold has also broken out against the Japanese yen. Like the seventies when gold broke out in Swiss franc terms, gold provides a hedge not only for Europeans but against all currencies. Historically, when people lack confidence in currencies, gold has been an alternative and now with both the dollar and euros appearing less credit-worthy, gold is expected to retest its seventeen year high with an interim target at $510 an ounce. Gold is an effective hedge against fiat currencies. We believe that gold's hedge qualities will underpin the second major upleg.

Recommendations
We continue to recommend an overweighted position in gold equities, particularly since the group has been outperforming bullion. Gold miners did not make much money in the first quarter due in part to rising costs and a higher looney. Few miners bought back hedges. Earnings in the second quarter are expected to change little. The dilemma for all is to replace reserves and thus we expect further consolidations. Our top picks continue to be Newmont and in the mid-cap category we favour Kinross Gold, Agnico-Eagle, and Meridian. Among the developing junior producers we continue to favour Crystallex, Bema Gold, and Yamana. And among the junior exploration category we rate as buys both White Knight Resources for the promising Cortez Hill play and Virginia Gold Mines for the exciting Eleonore discovery in northern Quebec.

Agnico-Eagle Mines
Agnico-Eagle will unveil the Goldex project in Quebec and a production decision is expected this year. Meanwhile the company is progressing at the Lapa project with underground development and test mining. Lapa is expected to be Agnico-Eagle's next mine with a resource of almost 2 million ounces. Agnico-Eagle's main LaRonde mine in northwestern Quebec continues to exceed expectations and the company is benefiting from higher silver, zinc, and copper prices (by-product credits). Agnico-Eagle has ventured further afield and will develop the Finnish asset with 2.2 million ounces resource. Agnico-Eagle has bid $150 million for Riddarhyttan which will mean that Agnico-Eagle shares will stall over the near term. While we continue to recommend the shares, it will take at least another four or five months for the additional shares to be absorbed by the market.

Barrick Gold
Barrick had a weak quarter due in part to lower output from Eskay Creek which was offset in part by a contribution from newly opened Tulawaka. Barrick should produce 5.5 million ounces this year at a cash cost of $127 an ounce. Production is expected to pick up with the commencement of Veladero in Argentina and the early start up of Lagunas Norte in Peru which is expected to come into production later this year. Next year the Cowal Mine in Australia will be brought into production. Barrick did not reduce their gold hedges in the quarter which is still their Achilles heel. We expect Barrick to reduce these hedges which will help the stock price.

Bema Gold Corp.
Bema's gold future hinges on Kupol which is a rich gold/silver deposit in northern Siberia. Capital costs have increased but with a mine life in excess of ten years, this deposit is a company builder. Bema has already begun site construction and we expect the company to make a positive production decision this year. Kupol is expected to be in production by the middle of 2008, producing more than half a million ounces and almost 6 million ounces of silver annually. The Street is concerned about an avalanche of paper, but we think the company can build Kupol without creating a lot of dilution. We continue to recommend the shares here.

Crystallex International Corporation
Crystallex is all dressed up and ready to go to the party but her date has not yet arrived. Although the company has already built a road and ordered over $100 million worth of equipment, it is still waiting for the issuance of the final environmental permit which was submitted in April of 2004. This permit would allow the construction of Las Cristinas. Las Cristinas is one of the few undeveloped major world class deposits in the world. Crystallex has modelled a 20,000 tonnes per day operation but plans to expand the operation to 40,000 tonnes per day, which would produce over half a million ounces annually. The company has modelled the extraction of Las Cristinas at $350 an ounce and with a pit depth of 390 metres and metallurgical recoveries of 89 percent. The deposit is open at depth and other mineralised zones have not yet been drilled. We continue to recommend the shares, expecting an eventual takeout since the company is well placed to benefit from rising gold prices.

Eldorado Gold Corp.
Eldorado will produce 80,000 ounces from the Sao Bento mine where it is deepening the shaft. The company is continuing to develop the Kisladag open pit gold mine in Turkey which should startup by the first quarter next year. The Kisladag mine will be the biggest gold mine in Turkey and has a resource of over 5 million ounces suitable for a fourteen year mine life. Kisladag is a company builder and the Efemcukuru deposit in western Turkey is Eldorado's second potential gold mine. Eldorado has also made a bid for Afcan Mining which owns the Tanjianshan project in Qinghai Province in western China. We recommend Eldorado shares here.

Kinross Gold Corp.
Kinross is still stuck in the regulatory maze of getting SEC approval for the Buckhorn transaction. There appears to be some progress and should the company get approval they will be able to file their financials. Nonetheless, the stock recently has recently outperformed other gold companies due in part to expectations of SEC approval and rumours that the company will expand internationally through a reverse merger with Polyus, the gold arm of the Russian giant Norilsk. Such a move would create one of the worlds major gold players upon a solid base of assets including the all-important Gold Fields block. Meanwhile Kinross' balance sheet has improved and the expansion at Paracuatu is on target. Kinross is currently well leveraged to the gold price with huge upside in Round Mountain and 50 percent owned Refugio in Chile which reopens this year.

Meridian Gold Corp.
Meridian Gold shares have acted better than its peers due in part to its low cost production and the continuing expansion at El Penon in Chile. Underground development in the Dorada vein is continuing with production expected in 2006. In the past, Meridian has successfully replaced reserves at El Penon due to an active exploration program that continues to find additional zones. Meridian has an excellent balance sheet and while developments at the Esquel gold project in southern Argentina has been put on hold due to local opposition, the project is a hidden asset. We continue to recommend this low cost producer here.

Yamana Gold Inc.
Yamana was added our list due to the successful completion of Fazenda Brasileiro and Nova mines in Brazil which will allow the company to produce 130,000 ounces. Next year the Sao Francisco and Chapada mines should come on stream and Yamana is expected to produce over 300,000 ounces. Yamana shares are undervalued and the company is on the threshold of becoming an intermediate gold producer with a solid base in Brazil. We recommend purchase.

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John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040

Disclosures:
Rating Structure
Analysts at Maison use two main rating structures: a performance rating and a number rating system.
Performance Rating: Out perform: The target price is more than 25% over the most recent closing price. Market Perform: The target price is more than 15% but less than 25% of the most recent closing price. Under Perform: The target price is less than 15% over the most recent closing price.
Number Rating: Our number rating system is a range from 1 to 5. (1=Strong Sell; 2=Sell; 3=Hold; 4=Buy; 5=Strong Buy) With 5 considered among the best performers among its peers and 1 is the worst performing stock lagging its peer group. A 3 would be market perform in line with the TSX market. NR is no rating given that the company is either in registration or we do not have an opinion.
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