Gold: The Great American Debt Machine

By: John Ing | Mon, Jan 25, 2010
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Courtesy of Hartford Courant

Everyone is taking shots at Wall Street. The President wants to impose a greed tax on banks, calling them "fat cats". The FDIC wants to reform the bankers and limit their size. The Financial Crisis Inquiry Commission is calling for scapegoats as it looks into what caused the financial system's near collapse. The attacks are well deserved and no doubt soothes the public anger at financial firms, particularly hard on the heels of paying themselves billions after receiving trillions in taxpayer bailouts. Earlier, short sellers and an over-exuberant media were blamed for the meltdown.

Paul Volcker, the widely respected and former Fed Chairman who tamed the inflation crisis in the 1970s said, "There is little evidence that innovation in financial markets have had visible effect on the productivities of the economy." In this regard, Volcker argued that the banks have more important roles as holders of deposits and providers of credit, and the same banks should push their proprietary trading operations out of their investing banks into hedge funds where they belong. He argued, "The most important financial innovation that I have seen the past 20 years is the automatic teller machine". That is pretty damning for a dysfunctional banking system that received trillions of taxpayer money and bonuses running into the billions.

Nonetheless these so called bankers made for easy scapegoats by politicians who were only too ready to deflect the blame away from Washington's role. Banks were simply the handmaiden here. Bankers are the dealers of money. The Fed is the creator of money. In his eagerness to reflate the economy, President Obama's solution was to use the same spending and borrowing policies that caused the financial collapse fuelled by too much spending and borrowing. Obama is making the same mistake again. And worse, having botched healthcare reform, next up is bank reform. Monetary growth continues to increase with much of this liquidity residing in the banking system in part because the banks have yet to deal with the toxic assets or the $1.5 trillion commercial real estate loans remaining on their balance sheets and also because they have become the new big holders of Treasury debt. Washington seems to have learned little from the financial crisis beyond the need to find scapegoats and pile up more debt.

The financial sector is still involved in highly leveraged and non-transparent transactions, many of which are off balance sheet. And rather than make money lending, the banks have expanded their proprietary trading operations like high frequency trading (aka front running). Those trading profits are financed by the trillions of cheap loans at zero interest rates from the Fed, eclipsing traditional advisory and lending activities. And after creating sub-prime mortgages and other derivatives that were supposed to have disappeared, Wall Street has created ever newer hybrid instruments like contingent convertible securities or Co Co bonds in addition to expanded CDOs and CDSs. If it looks like debt, walks like debt, it is debt. And the users of those instruments, the hedge funds and private equity funds remain outside the regulatory oversight of the investment and commercial banks. Will Wall Street never learn? Instead of more regulation, needed is less leverage, tighter capital standards and maybe even limits to executive compensation. Despite causing the disaster a year ago, the banks have gotten bigger, more profitable and become not only too big to fail, but a bigger systemic risk to the economy. The Bank for International Settlements (BIS) reports that the world's ten largest banks today account for about 70 percent of global banking assets compared with 59 percent only three years ago. Five giant Wall Street banks now dominate US finance.

Indeed Paul Volcker was right about financial innovation, but can Mr. Obama deliver?

A Fate Worse Than Debt

Instead of attacking the "fat cat" bankers, policymakers would do well to address the root causes - too much debt. America's debt load exploded during the financial crisis, with unprecedented government spending and by underwriting of private sector's debt obligations. Indeed the shift didn't make them any less toxic. And the Fed's rapid growth in credit, inflated this great American debt machine. Since Obama's inauguration one year ago, the national debt has doubled, financed of course by IOUs. While the US government averted the meltdown by printing money, it has kept its expansive monetary and spending policies in place too long creating the world's biggest debt bubble. The national debt has climbed from $33 billion in 2001 to almost $12.3 trillion. Federal debt has increased 21 percent in the latest quarter, the fifth straight increase of more than 20 percent as the government borrows, borrows and borrows more.


Courtesy of DollarDaze.org

The increase in the Fed's balance sheet from $817 billion in 2001 to over $2.2 trillion is a broad gauge of its lending to the financial system. The US has sold more than $2.1 trillion of Treasury notes and bonds in fiscal 2009 more than the previous combined two years. Treasury International Capital (TIC) data shows that three groups purchased Treasury securities, the Fed itself purchased almost $300 billion while Foreign and Internal Buyers purchased another $370 billion or so. The Chinese actually voiced concerns about buying more debt and the diminishing value of the dollar. So who bought the balance? Those missing billions were financed by "Other Investors" aka Bernanke's quantitative easing programme - i.e. the printing press to the tune of $1.1 trillion of dollars or more than 50 times before the meltdown.

Today, the hole in America's public finances vies with some of the lesser developed Eastern European nations. US government spending grew 13 percent in the latest quarter, fuelled by higher unemployment, debt interest payments and the penchant to bailout the weaker sections of the economy. Meanwhile tax revenues have fallen 14 percent. And the household sector remains as heavily indebted as ever with debt as a percentage of disposable income at a whopping 165 percent. Householders are over-borrowed and over-leveraged. The debt load is unsustainable. Public debt is now over 60 percent of the economy and that is before entitlement spending which is set to surge.


Courtesy of NDR.com

Also unchanged is the role of the big three credit rating agencies whose inflated grades for Wall Street's risky securities played a critical role in the market meltdown. And today those same banks and issuers are paying for these same stellar ratings, leaving unchanged the potential conflicts of interest embedded in the ratings model. The rating agencies are the keystone of the shadow banking system in that they and they alone give the seal approval for the creditworthiness of the debt issued by companies and public entities alike. This model is deeply flawed. Those agencies are also supposed to provide a regulatory role but when they are paid by the issuer, their ratings are not only suspect but we are left to wonder whether they are part of the problem. And notwithstanding the enormous cost of fighting the financial meltdown, those oligopolistic rating agencies avoided liability despite their close relationships and conflicted "issuer pay" model. Today, those same rating agencies have reduced Greece's credit rating, because of soaring debt levels. Debt-stricken Greece is not alone because Ireland's and Spain's unprecedented spending puts their sovereign ratings at risk. No longer are countries too big to fail. Greece's crime? Greece's ballooning deficit will hit 12.7 percent of GDP and the debt to GDP ratio totals 115 percent of GDP. But today, the United States' deficit is 13 percent of GDP. Where are the rating agencies now?

The Dark Side of Debt

We believe the US sovereign debt bubble has become a growing concern for financial investors, particularly since it is built on an unhealthy reliance on foreign borrowing. Freed from the need to defend the dollar, and the constraints of a gold standard, the United States has become the world's largest borrower, monetizing its debt by printing dollars without limitation. The US financial system has seen explosive growth with policymakers encouraging excessive lending and debt levels to virtually every sector of the economy. However, investors rightly worry that America's debt fuelled profligacy is much like a Ponzi scheme that has become so large, that it has simply run out of buyers to pay for its day-to-day economic existence, leaving overseas investors and future generations to pick up the bill. But governments can always borrow endless amounts because of their capacity to tax. And governments do not default? Wrong, Russia defaulted in 1997 and Iceland is threatening to renege on a $5 billion payment. In addition, the potential default of $22 billion of Dubai World debt has spread growing concerns about the "implicit guarantees" given by governments. Dubai's near collapse also symbolized wider uncertainties about commercial real estate loans.

Dubai's problems are an early warning that if America cannot get its finances under control, markets can quickly lose confidence. Not surprisingly investors overlook that money losing mortgage giants Fannie Mae and Freddie Mac are government sponsored enterprises that share a similiar implicit government guarantee and still require huge amounts of taxpaper money to keep these mortgage entities afloat. Like Lehman Brothers, Dubai made the same mistake of piling on too much debt, borrowing short to acquire long term assets. All believed that they were too big to fail, and all exploited financial engineering which is too common today but oh so lethal.

The central issue today is that the debt burden on all governments have soared. Giant-sized government debt levels are approaching hyperinflation levels. For example in Germany, government debt outstanding is expected to increase to 70 percent of GDP next year, up from 6 percent in 2002. In the United Kingdom, government debt to GDP will be at 80 percent. Public debt in Ireland will increase to 83 percent next year up from 25 percent in 2007. In the United States, debt to GDP is fast approaching the 100 percent mark, and because of the rapid escalation of debt, a large part or more than 44 percent of this debt matures within one year. And Washington is to raise the debt ceiling yet again.


Courtesy of DollarDaze.org

Any debt must be funded either through borrowing from overseas investors, borrowing from domestic markets, or creating new money, or some combination of the three. In the past, America's deficits were financed largely by overseas investors, but their enthusiasm waned with the lower dollar, so the Treasury instead filled the vacuum by creating money as well as borrowing large amounts. Crucially, however American taxpayers too are paying for this. To finance the deficits there has been an explosion in the money supply aggregates in a blatant printing of money exercise. And in creating new money, the Fed has kept interest rates low, inflating bigger and bigger bubbles including a foreign exchange bubble with an economy dependant on the drug of government support. America's debasement of their currency is no longer acceptable to its lenders, both domestic and foreign. China for example lent huge sums to America, recycling its trade surpluses by buying Treasuries but their enthusiasm too is waning. China's foreign exchange reserves are at a whopping $2.4 trillion with the majority denominated in US dollars. The 14 percent drop in Treasuries and depreciation of the dollar has already caused huge losses. In a move that should worry the US, China has partially hedged against a depreciating dollar by setting up entities to buy strategic commodities, companies and gold using its massive dollar reserves.

Gold Is An Alternative To The Dollar

Already international central bankers are taking anti-dollar defences. India has purchased 200 tonnes of gold from the International Monetary Fund (IMF) and Brazil has slapped a two percent tax on capital inflows (i.e. stopping an influx of paper dollars). Demand for alternatives to the dollar has increased so much that gold is expected to go up as fewer lenders buy all that American debt. Dollar alternatives like gold is a good thing to have.

Deflation was yesterday's crisis, unemployment is today's. Tomorrow? Inflation. We believe that gold's rise above $1,000 an ounce was due to investor concern that the US dollar is being debased and that the same policy prescription that caused the meltdown over a year ago is being used again to refloat the economy. Central banks cannot create more gold. Gold is no one else's liability. The economic consequence of the worst economic crisis since the Great Depression has yet to emerge. In a very short period of time, gold's bandwagon filled, so much that the wheels looked ready to fall off. Too many now view gold as a speculative bubble forgetting that gold's move is due more to its role as the ultimate store of value. Gold is portable and has been used as money for thousands of year.

Gold prices recently spiked at $1,226 gaining over 40 percent in the year before pulling back $100. Gold has actually quadrupled from its lows. Yet, gold is universally disliked from the media to just about every economist and even now Roubini. All overlook that it is not the price of gold we should be watching, it is gold's role as an overlooked benchmark that shows the greenbacks' rapid loss of purchasing power. Gold is a barometer of investor anxiety and today there is too much anxiety. Much of gold's price move is not due to price speculation but to limited supplies. Roubini's bearishness is based upon the expectations that when the Fed raises interest rates as part of its exit strategy, the move will firm the dollar. However Roubini overlooks that higher rates would also crush the nascent economic recovery which is already far too dependent on cheap money, exposing a vulnerable banking sector as well as raise the US interest bill sending even more people into gold.

When gold took off in the seventies, it too was considered in a bubble. It was not. The US dollar had collapsed, money supply grew at double digit levels and the CRB future index, which is a predictor of future inflation, soared. In the seventies the average income was $17,000 and consumer debt was at $10 billion. The savings rate then at a comfortable 12 percent. Today the US dollar too has collapsed, money supply continues to grow at double digit levels and commodities are up some 29 percent. Today, the average income of the American family is $28,000, but consumer debt stands at a whopping $13.8 trillion and the savings rate is a modest 4 percent. Gold? Gold went up in the seventies from $35 an ounce to $850 an ounce amid rising interesting rates. Also any change in interest rates will cause gold to move up as speculators reverse the huge carry trade and dump their so called borrowed cheap dollars en masse. Finally, unlike the seventies, the US balance sheet is in for worse shape with the tide of red ink surpassing that created after World War II.

Déjà Vu

The US dollar was once stockpiled by central banks and used to settle trade but has declined as foreign central banks channel more of their savings to their own economies rather than finance America's deficits. The International Monetary Fund reported that the greenback's share of foreign reserves has declined to 61.6 percent by the end of September. Among developing and emerging countries, the dollar accounts for only 55 percent of reserves. By comparison, the euro now accounts for 26 percent and 31 percent among emerging countries.

The problem is not new. In the 1920s the key currency was Sterling. But weakened by British war debts Sterling declined between 1914 and 1931 and Britain had to abandon the gold standard in 1931. Sterling was then replaced by the US dollar. The dollar fell between 1960 and 1971 when the dollar convertibility to gold ended. The US was forced to abandon the gold standard in 1971 in the wake of war debts and twin deficits as they too debased their currency by printing dollars. What followed then was the great inflation bubble ended only by Paul Volcker. Today's system depends on the dollar backed by the credibility of the United States. But the system again is falling apart. This faith based currency is collapsing under the weight of a huge growth in money supply and foreign exchange reserves. The Fed freed from monetary discipline has fed bubbles abroad and at home undermining the dollar's role as an anchor currency.

With Asian property prices soaring, gold breaking daily records, and stock markets in Shanghai making new highs, there are fears that these newly created bubbles will burst. These so called bubbles have also raised fears of future inflation in goods and services, akin to the tech or housing booms. But this time those new bubbles are not built on layers of debt and leverage, instead are the beneficiaries of the flood of dollars created by Washington. And this time the supply of dollars continues to outpace the growth in the economy raising the spectre of future high inflation. Without confidence in the dollar, there is no valid reserve currency. If Obama cannot soon restore confidence, there will be increased calls by America's creditors for a replacement. This is happening today as some central bankers already view gold as an alternative investment to the dollar.

The New World Order is The Old One

To calm nerves, the government is talking of an exit strategy but like an addict addicted to crack cocaine, the US is reluctant to take the needed steps to bring the deficit under control, stop printing cheap money or even raise taxes (except for bankers) because of the adverse political consequences. Unfortunately the die is cast. As such, to hedge against a depreciating dollar, central banks have become net buyers of gold rather than sellers for the first time in twenty years. The biggest buyers last year were China, Russia and recently India. Smaller nations such as Sri Lanka, Mauritius, Philippines and Mexico also added to their gold reserves. The new world order is the old one where gold has emerged as the traditional store of value, replacing the dollar.

On the demand side, the official sector is the largest holder of almost 30,000 tonnes of gold and central banks have turned from being net sellers for the last twenty years to becoming net buyers. Net sales from central banks fell 90 percent last year to the lowest level in more than two decades. After all, the central banks are overinvested in dollars. China with a $2.4 trillion foreign exchange cushion last year boosted its own holdings by 75 percent to 1,054 tonnes yet holds only 1.6 percent of its reserves in gold. We believe that China has been buying gold from its producers and will increase its stake. The Americans have about 75 percent of their reserves in gold held at Fort Knox. The European Community has their euro backed by about 15 percent of gold. Globally most nations have about 10 percent of their reserves in gold. Should China decide to increase its holdings to a mere 5 percent or half of the world's average, it would require the entire western world's gold production in the next two years.

Also pushing up the demand for gold have been the exchange traded funds or ETFs which has created a new investor class. Investment demand actually bought more gold than jewellery demand for the first time in three decades. Institutions have been buying ETFs as a legitimate portfolio diversification move and because many cannot hold physical bullion, ETF positions now rank as the sixth largest holder of gold, ahead of the holdings of Japan and Switzerland. We believe that the emergence of these vehicles will be an important component in the demand for bullion, as investors look at this new asset class as another way to buy the metal and protect their assets.

On the supply side, there are two forces at work. Mine supply peaked around 2001 and output has fallen 10 percent since then. There have been fewer discoveries and mines have become deeper and more expensive. South Africa, was the largest producer in the world supplying ninety percent of world's output, now only 15 percent of world supply. China has replaced South Africa but its mines are short lived. The other important supply is from the central banks but as mentioned earlier they have become net buyers not net sellers. Even the gold producers which once supplied gold through their hedging policies are less of a factor particularly since Barrick repurchased their hedges at a whopping $5.6 billion loss. We do not think the gold producers will be as foolish this time around.

In sum, with the shift in supply and demand, our view is that gold's rise is justified by fundamentals. Growing investment demand will outpace supply. And, America's problem and the demise of the US dollar will attract additional interest. Gold is not in a bubble but undervalued. As long as the US monetary and fiscal policies remain debt-based fuelling future inflation, gold's bull market run has only just begun. Money is no longer money. Wall Street may have just discovered gold, but gold's role has withstood thousands of years of history. We remain convinced that gold will soon trade at $1300 an ounce and in the long run push beyond over oft-stated $2,000 an ounce target.


Recommendations

Allied Nevada Gold Corp.
Allied Nevada brought its 100 percent owned Hycroft gold/silver heap leach mine into production. Allied Nevada is currently mining the oxides but there is a huge sulphide resource. In addition the company recently reported drill results which showed higher silver values than its published resource. Allied Nevada completed a drill program last year to outline the resource at Hycroft and the existence of higher silver grades together with a boost in silver recoveries could increase Allied Nevada's value by a third. We continue to recommend this junior producer.

Agnico Eagle Mines Limited
In bringing on three mines in six months, Agnico ran into some temporary operational difficulties which hurt short term performance. Nonetheless, Agnico has one of the strongest growth profiles. Goldex (Quebec) and Kittila (Finland) start up problems plus foreign currency losses hurt last quarter's earnings. Significantly, Agnico will double production this year to 1.1 million ounces from a disappointing 500,000 ounces last year. Moreover, the company remains on track to produce 1.4 million ounces by 2013. Meadowbank (Nunavat) is expected to produce about 380,000 ounces this year. Agnico expects to commission this mine this quarter which is a feat, given the startup is in Canada's Arctic. Goldex is averaging 7,300 tonnes a day, which is above capacity of 6,900 tonnes. In terms of tonnage and costs, Goldex has performed much better due in part to management's tweaking this huge low grade deposit. Tweaking is still needed at Kittila which has had recovery problems. Already, Agnico has modified the autoclave and the mill has been averaging 3,000 tonnes per day with a gradual increase in recoveries to 80 percent. Agnico will spend $75 million on exploration this year, targeting 3 million ounces. The Company's balance sheet remains rock solid with only $270 million to be spent on capex this year, down significantly from $600 million last year. Agnico is in strong shape. We expect this year to be a break out year and continue to recommend the shares.

Aurizon Mines Ltd
Aurizon will produce almost 155,000 ounces this year down from 160,000 ounces last year due to lower grades. Recoveries averaged 92.6 percent at Aurizon's 100% owned Casa Baradi in Quebec. The Company continues to add to reserves. Aurizon's second potential mine at Joanna is expected to complete a 28,000 metre drill program which will support a final feasibility study this year. Aurizon will have fourteen drill rigs turning this year. We continue to recommend Aurizon as an undervalued producer.

Centerra Gold Inc.
Centerra reported production of 675,000 ounces last year with the Kumtor Mine in the Kyrgyz Republic, accounting for about 525,000 ounces. In Mongolia at the Boroo Mine, production was affected by a strike and the mine only produced 150,000 ounces last year. Significantly, Centerra had a strong last quarter and we are encouraged with the piling up of over $320 million in cash. Centerra plans to boost operations at Kumtor and the Company has a goal of producing 1.5 million ounces annually. This year, Centerra is expected to produce 700,000 ounces without labour disruptions in Mongolia as well as the processing of oxides. Centerra plans to expand its mining fleet and expects to spend $150 million at Kumtor, on everything from maintenance to underground development and pit development. We continue to recommend Centerra as one of the more undervalued gold producers and expect the Company to be an acquisitor of assets.

Eldorado Gold Corp.
Eldorado had a good quarter at flagship Kisladag mine in Turkey which performed well. Eldorado is one of the lowest cost producers, with costs around $150 an ounce. Eldorado is a mid-tier gold producer that will produce 600,000 ounces up from 342,000 ounces last year due to the acquisition of Sino Gold. Eldorado's 90 percent owned Tanjiahshan in China has eliminated its bottlenecks and the mine is producing well, following a commissioning of the roaster last year. The Sino Gold acquisition has increased Eldorado's footprint and is now the largest foreign owned gold producer in China. Eldorado has three operating mines in China with a fourth under construction. The Jinfeng mine is China's second largest mine and is a combination open pit and underground operation. Sino's second mine, White Mountain in Jilin China is an underground mine with conventional CIL plant. We continue to recommend Eldorado as one of the fastest growing mid-tier producers with footprints in Turkey, China, Greece and Brazil.

Gammon Gold Inc.
Gammon Gold continues its record of disappointing investors. Production in the latest quarter was disappointing due again to rain and mill problems. Gammon operates the large tonnage Ocampo and El Cubo mines in Mexico. Despite spending over $100 million, Ocampo remains problem prone. We prefer Eldorado which has a better growth profile and better quality assets.

Goldcorp Inc.
Goldcorp will boost its production to 2.6 million ounces, up from 2.4 million ounces last year. Goldcorp continues its acquisitive ways with the $298 million acquisition of Canplats, however its deal with New Gold's El Morro has resulted in duelling lawsuits with Barrick. Barrick had acquired El Morro from Xstrata but 30 percent owner New Gold Inc exercised its first right of refusal. Goldcorp financed New Gold's first right of refusal to buy Xstrata's 70 percent stake thwarting Barrick who cried foul and filed suit. Meanwhile, Canplats is a tuck-in acquisition near Goldcorp's $1.6 billion dollar Penasquito mine in Zacatecas, Mexico which will be in production in 2011. Goldcorp's Penasquito project is on schedule and the first sulphide circuit is completed. We continue to be cautious on Goldcorp because Penasquito is a major bet for the company. In addition, Goldcorp's string of billion dollar acquisitions, from Gold Eagle to Eleonore, are still development projects, while worthy are not yet producing mines. We prefer Barrick or Agnico Eagle at this time

IAMGold Corporation
IAMGold surprised the Street with the "retirement" of Joe Conway as CEO, who has built IAMGold into an intermediate gold producer with mines in Africa and the Americas. IAMGold will produce 930,000 ounces this year but 90 percent owned Essakane in Burkina Faso is to be a company builder offsetting the Quebec operations. Joe Conway is not only to be given credit for building up IAMGold but also the integration of the different operations together with the acquisition of Essakane. The stick handling of its various international operations was a testament to Conway's abilities, so his departure is a major loss. As such we prefer other producers.


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Analyst Disclosure
Company Name Trading Symbol *Exchange Disclosure code
Barrick Gold ABX T 1
Eldorado ELD T 1
Kinross K T 1
Disclosure Key: 1=The Analyst, Associate or member of their household owns the securities of the subject issuer. 2=Maison Placements Canada Inc. and/or affiliated companies beneficially own more than 1% of any class of common equity of the issuers. 3=<Employee name> who is an officer or director of Maison Placements Canada Inc. or it's affiliated companies serves as a director or advisory Board Member of the issuer. 4=In the previous 12 months a Maison Analyst received compensation from the subject company. 5=Maison Placements Canada Inc. has managed co-managed or participated in an offering of securities by the issuer in the past 12 months. 6=Maison Placements Canada Inc. has received compensation for investment banking and related services from the issuer in the past 12 months. 7=Maison is making a market in an equity or equity related security of the subject issuer. 8=The analyst has recently paid a visit to review the material operations of the issuer. 9=The analyst has received payment or reimbursement from the issuer regarding a recent visit. T-Toronto; V-TSX Venture; NQ-NASDAQ; NY-New York Stock Exchange

 


 

John Ing

Author: John Ing

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

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