Gold: The United States of Crisis
Last year it was Wall Street's debts, this year it is sovereign debt problems. Just when everybody was told it was safe to go into the water, once again investors are told that yet another bailout is needed to stem the threat of a default. This time it is sovereign defaults. Taxpayers are again being asked to pony up as governments pile up more debt, further devaluing their purchasing power. When will it end? Investors are losing confidence in propping up heavily indebted governments, banks and corporate entities, either explicitly or implicitly. Inflation and currency depreciation is next.
To make matters worse, Mr Obama looks out of his depth. President Obama did not cause this recession, but seems locked in its past. He pledged to give us more economic freedom but instead promoted more state handouts. His government has swung to the left whilst America remains centre-right. His banking system is broke and he continues to spend. He doled out stimulus money to the banks instead of the taxpayer and now calls for bank reform. With the economy mired in recession, he opted instead for a $1 trillion healthcare plan and he is on track to become the biggest spending president since Franklin Roosevelt in the Thirties. Mr. Obama has become the Pierre Elliot Trudeau of American politics who once lifted Canada's public hopes but took the country on a Keynesian path of financial destruction leaving behind the much hated National Energy Program, big government and a legacy of debt. Canada took years to recover. American does not have the time.
Debt, Debt and More Debt
Spurred by the loss of a Senate seat, President Obama has decided to tackle his ballooning national debt, for which he bears considerable responsibility by announcing the setup of a 18 member commission - how very Canadian. To solve the debt problem, he does not need a debt commission to study a public debt of more than $14 trillion or about $40,000 per American. He does not need a debt commission to resolve a $1.4 trillion budgetary deficit that is three times the previous 2008 record. He does not need a debt commission to tell him about America's profligacy with overall debt at 85 percent of GDP and still climbing. And, the bills of Wall Street are still coming in, particularly the growing debts of Fannie and Freddie Mac which continues to drain on America's finances. Obama only has to look at what is happening in Greece today, to know what is going to happen to his country tomorrow.
Meanwhile like the wolf at the door, central banker Bernanke threatens to raise interest rates as part of his exit strategy. Yet, in light of the growing US debt load, Bernanke must print more dollars to support the huge twin deficits, fed by America's insatiable need for cheap oil and desire to live beyond its means. Another element, while he threatens to blow the house down, rates remain near zero. Still he continues to buy assets with freshly minted dollars while his bloated treasury is filled with almost $1.4 trillion of mortgage linked assets and other toxic securities. At one time, the asset side of America's balance sheet consisted largely of Treasury securities with a bit of gold. And despite the threat, he continues to support the government's spending orgy, citing the threat of a recession as the rationale to keep on spending. Fast rising debt is worrisome and unsustainable. Bernanke's exit strategy is untried and untested.
The US has been living beyond its means for some time. The government has taken a bigger role in spending and borrowing but left unsaid is that by increasing spending, it takes away from the private sector. Bernanke doesn't even seem to be concerned nor about the prospects of $800 billion interest payments on the national debt by the end of this decade up from $207 billion this year. Save for the World War II expenditures, spending on average will reach the highest levels in American history to 25.2 percent of GDP, significantly above the 20.7 percent forty year average. While President Obama prefers to blame much on George Bush, he will take the gross debt to 103 percent by 2015. Both public and private debt totals 370 percent of GDP. Also missing is a discussion of what to do with the trillions of dollars of unfunded off balance sheet liabilities related to mandated Medicare and Social Security. To be sure, previous time honoured solutions for improving the economy such as slashing spending, eliminating the mountain of regulations or lowering taxes are not part of Mr. Obama's strategy. Instead we have a Keynesian mixture of increased spending, larger deficits, higher taxes and an agenda of redistribution of whatever is left over.
Beware Of Greeks Bearing Gifts
Meantime debt dependent Western governments continue to prop up the economic recovery with a dose of cheap money and government spending, but without the consumer. As a consequence of bailing out Wall Street, the US government has transferred private sector debt onto the government shifting debt repayment from shareholders to taxpayers. Indeed concerns about the level of sovereign debt prompted Moody's Investor Service to warn that even the United States and the United Kingdom were risking losing their blue chip Triple A status. First Iceland, Greece, and now Portugal. All need to put their fiscal house in order, with an exit strategy of lowering their lifestyles by raising taxes and slashing government expenditures. The dominoes have fallen.
The bigger problem is the need to finance their gargantuan liabilities at a time when there are trillions of government debt to be rolled over in the next year or so at a much higher cost and in direct competition with other deficit sovereign states. The United States alone must borrow nearly $2 trillion in 2012 to bridge its projected budget deficit and to refinance existing debt. This time, no one is too big to fail. By transferring the debt from its banking sector to the public sector, the United States only forestalls the inevitable as Greece found when it transferred its Olympian sized debt onto its own books. There is no easy way out. US debt today stands at 85 percent of GDP, compared with 115 percent for Greece, 59 percent for Spain, or 66 percent for Ireland. Yet the explosion of public debt continues as the White House projects that gross federal debt in public hands will exceed 100 percent of GDP in only two years. The US is in a much sorrier state than the other European ailing nations.
Obama's whopping $3.8 trillion budget will produce a $1.4 trillion deficit this year and trillions more over the next few years. The non partisan Congressional Budget Office (CBO) reveals that President Obama's fiscal 2011 budget would add almost $10 trillion to the national debt over the next decade. But to pay for those deficits, the US government must borrow one out every three dollars with the majority coming from foreigners. Other than a drop in the greenback, the consequence of depending on foreigners has so far been fairly benign. However as America's deficits balloon, its national security, sovereignty and even control over their currency will disappear. How long can America count on the market's tolerance? Very scary was reports that Russia almost caused the failure of mortgage giants, Fannie and Freddie last year when they dumped their positions.
China too has repeatedly expressed warnings about the sinking dollar and the growing deficits, because of concern for the safety of its vast holdings of US government debt denominated largely in dollars. China has also warned that pressing the Chinese on its currency policy amounted to a new form of protectionism last seen in the seventies in a "beggar thy neighbour" currency war that saw the US go off the gold standard. China's investments once cushioned America's finances, but China recently unloaded $34 billion of US government debt in December. Worrisome is that the Chinese have reduced their purchases of Treasuries from 40 percent of new issuances in 2006 to only 5 percent last year. Yet, the US responds with threats, selling Taiwan $6.4 billion of arms and receives the Dalai Lama, inflaming an already tenuous situation. And worse, hoping to score political points, American lawmakers threaten to slap duties on Chinese goods. Who's zooming who?
The Failure of Derivatives
Derivatives are the cornerstone of the shadow banking system and its global reach no doubt accelerated Greece's worsening financial position. Wall Street still believes that securitization is one of the greatest innovations of finance in the last quarter century. We side with former Fed Chairman Paul Volcker who said that the banking industry's greatest innovation was really the ATM. While securitization has channelled vast sums of money into housing, giving everyone the American dream without having to pay for it, the derivatives market has grown from nothing to a notational value of $600 trillion.
To some, the usage of derivatives produces no economic or social benefit. To us they are the Achilles heel of the financial system and are all about leveraged bets. Europe is calling for a ban while the Americans caution that their institutions should not discriminated against. Warren Buffett calls them weapons of mass destruction. They are worse.
Of concern is that some of those derivatives, such as interest rate and currency swaps made famous in the Lehman collapse were used to camouflage Greece's overall finances to hide its debts and mask the full extent of the problem. In Milan, four banks have been charged with fraud for devising a swap for the city. And others used derivatives to fudge their figures. A 2,200 page report into the collapse of Lehman Brothers noted the usage of the same sort of obscure derivatives that allowed Lehman similarly to over-inflate its balance sheet to hide its problem as it collapsed. Derivatives also sunk Long Term Credit Capital Management. Does anything change? The common denominator are these exotic instruments.
Hedge funds made huge speculative bets against Greek debt taking by advantage of swaps and over-exposed European banks. The centerpiece of the so-called swaps are the over-the-counter contracts that offer buyers the insurance against a default and the counterparty a premium for underwriting the contract. These contracts were written by insurance companies like AIG who originally hedged their portfolios. The seller agrees to pay the investor if the swap defaults. The swaps can be currency, credit, interest or even mortgage based. Acting as a middle man, Wall Street bastardized these instruments by underwriting these instruments to generate more fees without the need of ownership or capital of the underlying securities making "naked" bets on the direction. These instruments became increasingly complex. The more complex, the less the market understood.
And, since these instruments were really swaps without underlying assets or ownership, the credit default swaps morphed into an unregulated $50 trillion market, far exceeding the indebtedness that they were designed to protect. Furthermore, without the underlying asset, many institutions decided to syndicate or spread the risk among other dealers. When prices moved against the biggest underwriter AIG, Washington had to step in paying billions to bailout AIG and its counter-parties. AIG simply had too little capital of only $180 billion to cover a $2 trillion portfolio of derivatives. Financial markets have become so integrated that the failure of one, can cause the systemic failure of all. That is what happened two years ago. This time, having feasted on Wall Street's woes, the market is poised to feast on bigger prey, government sovereign debt.
And worse, the same big investment banks that turned themselves into commercial entities in order to be "first in line" when the Fed bailed out Wall Street are still recipients of the Fed's largesse with loans at near zero rates and their securities guaranteed by the taxpayer. The Federal Reserve was not so lucky, since today it is stuck with some $2 trillion worth of Wall Street's creations. These same banks today are lobbying the Senate to dilute President Obama's financial regulation package. Also unchanged is the mark to market accounting debacle that saw some assets inflated above their real worth. Worrisome is the apparent watering down of the Volcker Rule, which was to split proprietary trading from Wall Street's main lending businesses. There is also a need for less leverage as well as an overhaul of capital requirements and even level 3 assets. What is needed is a return to market discipline and to the basics of lending with collateral and of course proper due diligence. There is also a need for transparency, moving the liabilities and swaps to a regulated market, so regulators and investors could monitor and control risk. A simple move would be to list these liabilities on the world exchanges. Is anybody listening?
Obamanomics and Hyperinflation
Unfortunately for the Americans, there are only two realistic ways to bring the deficits down, either by increased taxes or spending cuts. How long will America's creditors continue to lend much of the money to finance America's spending? This is a lot of money. But the reality is that even with higher taxes, there is just not enough money to wrestle this and future deficits to the ground. For that, America could look for another Obama. The other alternative is for this President to inflate his way out through the monetization of deficits.
While the administration still believes that inflation is not such a bad thing since it reduces the real burden of debts, the reassurance to date about America's creditworthiness is somewhat suspect.
Inflation is an increase in money and credit. Once unleashed, it is a dynamic beast, not easily contained. Amazingly Obamanomics appears to include a healthy dose of inflation to give more room to reduce rates, equating the lack of velocity with tame inflation. How wrong. However, through the next decade, his eye popping deficits (current account, budget and public deficits) will increase and not decline.
The American dollar thus faces the most serious crisis. History shows that the consequence of debt-fuelled spending, is inflation when too much money chases too few goods. Inflation is a monetary phenomena. Hyperinflation is out of control inflation. Government deficit spending is the beginning of the downward spiral.US monetary base or raw money has increased 100 percent with dollars in circulation in excess of $2.2 trillion, the greatest expansion in American history. Hyperinflation of the dollar has already occurred. As Greece found, when the music stops or an auction fails, the crisis begins.
And then there is the ever-present inflation risk. Stories abound about the horrors of raging inflation. There was a stark reminder of this recently in Zimbabwe and Argentina which twice experienced hyperinflation and today Argentina ousted the president of its central bank after he refused to hand over its reserves to pay off debts. Or there is the Weimar Republic experience in the early twenties, when Germany burdened with paying the debts from war reparations, inflated their debts away causing the horrible inflation in the thirties. We once reviewed the hyperinflation episodes in China, France, Argentina, Germany and Zimbabwe. In each hyperinflation, those countries were running massive annual deficits, accumulating unmanageable national debt and each had a central bank creating or printing money. The US is nowhere near hyperinflation yet. However, common with other hyperinflation periods, America has seen a large expansion of money and credit, chronic budgetary deficits, excessive debt to GDP ratios and an unprecedented currency explosion. Is it really different this time?
Today, Currency Hyperinflation, Tomorrow?
Central banks are the stewards of money by controlling the supply of money. Until the early 1970s, most global currencies were linked to gold. Currencies were readily exchangeable. However President Nixon severed the link between the dollar and gold in 1971 in the widespread inflation following the Vietnam era. The dollar soon became the world's de-facto currency and cornerstone of the international monetary system.
The three leading nations of America, Japan, and Germany accepted that their currencies would float against each other. The US dollar became the dominant and convertible currency. Most other currencies tied themselves to the dollar. So it has been ever since. Previous monetary systems were linked directly or indirectly to gold. If a government debased their currency by printing money, the currency fell in value. Today, like credit default swaps, without the discipline of convertibility, the Americans have printed dollars at an unprecedented scale. The current crisis is rooted in a combination of overly expansionary monetary policies as the Federal Reserve fed an unprecedented global supply of dollars to cover its obligations. The result is a world-wide dollar bubble that caused the subprime defaults, sovereign-debt defaults and the near collapse of Wall Street. Hyperinflation is next.
Gold is a barometer of currency fears. Gold has moved up because the purchasing power of the US dollar has moved down. Gold has moved up because investors are concerned about the mountain of debt and America's debt fuelled spending. Gold have risen 350 percent from its lows. The warning signal is clear. The US currency is no longer the dominant currency nor is it the bedrock of the world's global financial system. America's biggest creditor, the Chinese are looking for alternatives and even the beleaguered euro has replaced the US dollar in some places. To be sure, the US dollar is overvalued and the combination of economic stagnation and volatility makes gold a better store of value.
Gold is even an alternative investment to the US dollar for central banks as they have become net buyers for the first time in two decades. Gold has outperformed stock markets and been a much better investment than equities and currencies. We are moving towards a territorial world where the dollar will have less influence and a "balkan" basket of currencies will replace the dollar. Official transactions for example would expand the use of Special Drawing Rights (SDRs), the major oil countries a petro based basket, the West would float against the much diminished dollar and the Asians, a basket tied to the yuan. Like the euro, all will have a gold component - after all gold is money. The loss of a senate seat reminds investors of the political cycle in the US. The disease is set but the cure is not. Gold and the dollar are telling us that a perilous adjustment is ahead. As such, we no longer expect gold to peak at $2,000 per ounce, it will trade higher.
Today gold is the only asset class protecting investors from inflation, the loss of purchasing power and depreciating currencies. There is simply not enough supplies to meet demand and that is something that Wall Street has yet to explore due in part to its dislike of gold. We believe growing concerns about the credit-worthiness of government and the consequence of bailouts will see more and more investors look to gold as an alternative.
Bullion and exchange traded funds (ETFs) have been beneficiaries of gold's price rise. ETFs are now the seventh largest holder of bullion dwarfing the gold stockpiles of most central banks. On the other hand, gold mining stocks have lagged despite a pickup in profitability. This will change. We believe the market has evolved into a "barbell" with the senior producers a beneficiary of interest due to their liquidity. At the other of the barbell, the exploration stocks are poised to move, since it is cheaper to buy ounces on Bay Street than for producers to explore. The midcap producers are stuck in the middle in a trading range and this group has lost investor interest due to their lack of growth in earnings, reserves and production profile. Yamana could not even replace its reserves last year and is suffering indigestion from its spate of acquisition. It appears that the former growth mid caps have hit the tread mill that has stymied many big caps. Importantly, we believe that gold mining stocks will emerge from their trading range because investors will soon discover that rather than buy ETFs or bullion at $1,100 an ounce or so, they can buy gold in the ground at under $200 an ounce.
To be sure among the exploration/development players there has been increased M&A activity. Kinross is acquiring tiny Underworld Resources in a friendly takeover. Lake Shore Gold has taken over West Timmins to consolidate its play. Osisko has bulked up with a takeover of Brett Resources. Balance sheets are stronger and in the junior sector, many companies are merging with the goal of getting up to the 100,000 - 300,000 ounce range. In addition, new money from the state-owned Chinese companies are actively acquiring a number of junior companies in order to tie up orebodies. Similarly some huge hedge funds such as Paulson and Soros are also actively pursuing large orebodies, believing higher prices will accelerate work on huge Donlin Creek and Galore Creek projects. In addition, some activist hedge funds are taking over the management of some of the gold companies in order to accelerate their development. To be sure, 2010 will be an exciting year for the explorers and developers.
Among the senior producers we prefer Barrick and Agnico-Eagle, with growth oriented Eldorado, Centerra Gold, and Centamin Egypt in the second tier. Potential takeouts include Detour, Rubicon and Lakeshore Gold as well as beleaguered Crystallex and Mag Silver. In our view, we believe that there are some attractive opportunities in the early stage exploration plays such as East Asia Minerals, Excellon, US Gold and St. Andrews. We believe that many plays can be acquired cheaply with market cap per ounce under a $100 per ounce. In addition, this group has above average potential to increase resources significantly and we believe that the market will reward them for exploration success. Consequently we would recommend the other barbell focussing on the explorers and developers rather than the more seasoned producers.
Aurizon Mines Ltd.
Aurizon successfully expanded and replaced its reserves and resources at its 100 percent owned Casa Berardi mine in northwestern Quebec. Aurizon will produce 160,000 ounces of gold this year from Casa Berardi and cash flow will be spent expanding Casa Berardi as well as an aggressive program at Joanna which has a 1.5 million ounce resource. Aurizon has a good exploration team and the company has consistently replaced reserves at a low cost. We like Aurizon as a value play.
Barrick Gold Corporation
The senior producers face a dilemma of flat growth anda treadmill. For that reason, the largest gold producer in the world, Barrick, is focussing more on organic growth and efficiencies. Asset sales such the african assets make sense as well as reducing the head count at head office. The midcap producers are vulnerable because they cause lack growth and certain projects face both project risk and recently political risks.
Barrick is the largest gold producer in the world, but surprised the Street with an IPO of African assets which netted more than $800 million. The divestiture lowered Barrick's cost profile and rid itself of some problem prone assets. Barrick has the largest reserve base and with the elimination of its hedge book, the shares are poised for an upward revaluation. Barrick has a strong project pipeline with the building of Pueblo Viejo in the Dominican Republic and is bringing on the giant Cortez project (permit problems have caused a short term delay. We like the shares as the premier gold producer with the largest proven and probable reserve position at 140 million ounces.
Comaplex Minerals Corp.
Comaplex is a development situation, with the Meliadine gold project in Nunavut. Agnico-Eagle is a major shareholder of Comaplex having an eye on the Meliadine gold project since it is near Agnico-Eagle's Meadowbank mine also in Nunavut. The Meliadine gold project is about 24 kilometres north of Rankin Inlet. It is a combination open pit and underground project. A scoping study sees Meliadine producing 230,000 odd ounces a year, over a ten year period with a capital cost of almost $450 million. The Meliadine property consists of Meliadine West and Meliadine East package, with total land holdings of 65,539 hectares. Comaplex also has some oil & gas assets which could be spun off.
East Asia Minerals Corporation
We continue to recommend East Asia for its 85 percent owned Miwah gold prospect in Aceh, Indonesia which has so far delineated more than 3.5 million ounces. All holes to date have ended in significant mineralization and the deposit is open in all directions. Miwah is a high sulphidization deposit similar to Pascua Lama and Pueblo Viejo. The company has delineated a 1,200 metre by 300 metre to 400 metre wide Main Miwah deposit with 650 by 350 metre wide South Miwah Bluff Zone with thickness is of about 200 metres. This summer the company will likely drill north towards Moon River and Sipopok, which is almost 10 kilometres away. To date, the company is using two drills and hopes to add a third as it expands its resource. Management is experienced under Michael Hawkins and the company recently received title through an IUP from the government giving them tenure. Of interest is that drill hole 18 is the deepest hole and a new tabular lower zone was found. The company has begun a deep hole to the north which could add to resources. We continue to recommend East Asia and expect a major will acquire Miwah. East Asia has an extensive project portfolio and like earlier would likely sell Miwah after it delineated the prospect, dividing up the proceeds and keeping enough to work on its other excellent properties. We continue to like the shares here.
Eldorado Gold Corp.
Eldorado will produce almost 600,000 ounces of gold this year and plans to double its production by 2011. Eldorado is spending more than $65 million at its flagship Kisladag mine in Turkey and hopes to bring on the Efemcukuru underground mine in Turkey as well as the Eastern Dragon mine in China next year. Eastern Dragon could produce 90,000 ounces. Eldorado is a fast growing mine with bases in Turkey and China. We continue to like the shares here.
Excellon Resources Inc.
Last year we visited Excellon which is the highest grade silver producer in Mexico. The La Platosa mine is running well and with a cash cost of $3 per ounce, the company is throwing off significant cash flow. The 600 tpd mill at Miguel Auza, about 200 kilometres away is running well and is producing at about 200 tpd giving Excellon full control of ore processing as well as allowing the company to receive important by-product credits for lead and zinc. Excellon recently announced an exciting $1 million exploration program on Miguel Auza that could be a company builder as it tests six northwest trending Madera veins, which are high-grade epithermal targets. At the same time, Excellon's exploration team is spending $1 million a month to expand La Platosa looking for the source of its carbonate replacement deposit system. Excellon has a large underexplored land package in the middle of one of the world's most prolific silver districts and is one of the most attractive exploration plays. Buy.
Mag Silver Corp.
We like Mag Silver for the growing ounces at the Juanicipo Joint Venture in central Mexico with partner Fresnillo PLC. We expect that Fresnillo will return with a higher bid in order to exploit the nearby Valdecanas vein. Mag Silver also has an excellent property at Cinco de Mayo, a carbonate replacement deposit system. Carbonate replacement deposits account for more than forty percent of all of Mexico's silver production and are capable of containing more than 50-100 million tonnes ore. In addition, Mag Silver realeased good results from the Puerto Rico vein at Lagartos which is only 3 kilometres from the Juanicipo property and is one of eleven projects in Mexico. Buy.
Osisko Mining Corp
Osisko has made a surprise bid of $372 million for Brett Resources which has a 6 million plus ounce resource gold discovery near Thunder Bay in Northern Ontario. Osisko is already building the Canadian Malartic Mine in northwestern Quebec which is supposed to come on stream next year. Osisko not wanting to be a development situation has gobbled up Brett at a premium. Osisko itself is a potential target with Goldcorp owning 10 percent.
Rubicon Minerals Corporation
Rubicon has a great balance sheet and is actively expanding the high grade gold discovery F2 zone in the prolific Red Lake camp in northern Ontario. The huge 100 percent owned Phoenix property has a series of high grade shoots and an expanding mineralized system. Rubicon has been drilling mineralization near surface and encountered high grade intercepts a few hundred feet from an existing shaft. We expect Rubicon to become a classic takeover candidate with results to date resembling that of nearby Campbell and Red Lake mines.
US Gold Inc.
US Gold's major shareholder is Rob McEwen (21 percent) who founded Goldcorp. US Gold has a large land position in Nevada, along the Cortez trend and made a high grade silver discovery at El Gallo in Sinoloa Mexico. We recently visited the El Gallo high grade silver discovery, located 5 kilometres from the Magistral gold mine which is now on care and maintenance. The highly mineralized surface signature suggests this discovery has "legs". US Gold has drilled about 125 holes and released assays on 75 holes including Gaxo 55, which cut 390.9 grams per tonne silver over a thick 117.9 metres. US Gold is spending $18 million to fast track this play and will drill 100,000 metres this year. US Gold has three drills turning on El Gallo and one on Magistral. With over $44 million in cash and almost $3 million in bullion, US Gold is well financed to develop the discovery and has a large land position of 540,000 acres. We like this play.
|Company Name||Trading Symbol||*Exchange||Disclosure code|
|East Asia Minerals||EAS||V||1,8|