Gold: Four More Years

By: John Ing | Tue, Dec 21, 2004
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The election in America is now history. Politicians and investors alike can confront the real problems of deficits, oil prices and a hostile geopolitical climate. While the Dow Jones has skyrocketed in the wake of the Bush victory, the US dollar has ominously collapsed. Indeed, since the ill-fated September 11th attack, the dollar has fallen 21 percent, the Dow Jones increased 11 percent while gold has jumped 62.7 percent. Gold stocks have done even better jumping 80 percent. Gold has outperformed everything except gold stocks.

And why has gold done so well? Part of the reason is that no matter how much the war on terrorism, Iraq, and Middle East dominated the news, Mr. Bush has become the biggest spender in American history. When Mr. Bush was inaugurated in January 2001, he inherited an almost $200 billion surplus. This year Mr. Bush's guns and butter policies caused the deficit to swing $600 billion in only one term. Never once did Mr. Bush veto a spending bill. And next year, he must present a new budget, which will make $2 trillion in tax cuts permanent. And because this president will be the first to collect social security, Mr. Bush is expected to ambitiously tackle the underfunded social security and medicare problems. His biggest quandary is funding that spending. It is this concern that sent the dollar into decline and gold on an upward path.

America the debtor

America has become the world's biggest debtor. Once again, the White House reached its debt ceiling and for the third time since Bush took office Congress raised the ceiling from $7.4 trillion to $8.2 trillion. Simple arithmetic shows that the mounting interest expense on $8.2 trillion of national debt is over $320 billion a year. The US must set aside more of its income each year to pay interest and dividends to foreigners. And now, like a highly leveraged debtor, the US finds itself having to pay higher interest rates to keep creditors lending.

America's twin deficits are the world's biggest problem because the private savings rate has fallen to its second lowest on record. The US government spends $400 billion more than it takes in, reaching 4.2 percent of GDP. This budgetary crunch is aggravated by the largest current account deficit in US history, which has ballooned from 4.5 percent in late 2003 to 6 percent of GDP, or double the previous trough in 1988. Because the United States saves so little, it has soaked up 80 percent of the world's excess savings. The aggregate current account and budget shortfalls now accounts for more than 10 percent of GDP, which in our view is the tipping point to a major collapse of the US dollar.

Herein lies the problem. The deficits are only sustainable as long as foreigners were willing to lend the US large amounts of money at the rate of $2 billion every day. Over half of the deficits are financed by Asian official institutions, more than $1.8 trillion now. America's external financing needs are exploding at a time when foreigners have slowed their acquisition of dollar denominated assets, leading to further downward pressure on the dollar. And at long last Alan Greenspan has warned that the dollar situation is unsustainable and foreigners are growing reluctant to hold ever more dollars. Japan, the biggest buyer of American debt was a net seller in September for the first time since October 2002. In today's China-centric world, the Chinese central bank has been an important buyer of American debt. But it's deputy governor Li Ruogun recently scolded the Americans, "The savings rate in China is more than 40 percent. In the US it is less than 2 percent. So the problem is that they spend too much and save so little."

America had simply "outsourced" its financing problem. We believe the subsidization of America's economy is over. The twin deficits are only part of the debt equation since in addition to the $7 trillion of government debt, there has been an explosion of household debt amidst growing corporate financial leverage. Americans are going to start feeling the cost of repaying this debt. Four more years? America cannot afford it.

The tremor in China's interest rates produced a seismic event in the global market as investors feared the tweaking in interest rates would slow the American economy (although, having just returned from China, the impact is more psychological than real). America's trade deficit with the Middle Kingdom alone is estimated at a whopping $160 billion a year. China has become the world's financier enjoying a tenfold increase in reserves, providing capital to the needy, including the United States. Today the size of the global imbalances and the vulnerability of the dollar is raising questions at to whether China will loosen the dollar peg. In the near term we believe the dollar peg will remain but the trading band will instead widen. However, China with a whopping $515 billion of reserves will eventually lessen its dependence on the dollar replacing the yuan's dollar peg with a link to an Asian bloc of currencies to facilitate trade and lessen dependence on the dollar. We will have a yuan bloc, euro bloc and dollar bloc and ironically this too would push the dollar even lower.

Missing Anchovies

Four hurricanes, damaged oil rigs, and $50 oil has dealt the U.S. economy a setback similar to the "missing anchovies" off the coast of Peru in 1970s. Then as now, the "missing anchovies" were thought to be a benign factor but later impacted the economy through higher inflation. Today, there are similarities with the value of oil and the problem of little spare capacity, reliable oil supplies and a seemingly insatiable demand. Yet investors are again complacent under the false illusion that the economy is invincible and inflation has been conquered. In the run-up of the 1970s, one of the consequences of higher oil prices was huge economic losses, inflation and a recession. Again this time, investors are seemingly complacent over the seemingly lack of impact of $50 oil. Yet few point out the $6 billion losses suffered by airlines that face higher fuel bills. And few, other than our Josef Schachter point out that the oil industry is spending less money on exploration. And like the seventies, financial markets are shrugging off the impact of higher prices and the spectre of inflation.

Inflation is not a problem today, but there are signs that it is about to become one. We believe the recent period of underinvestment and complacency will result in a prolonged impact of higher energy and commodity prices. And, the arrival of China Inc. with a stronger economy, bloated treasuries and skyrocketing commodity prices will eventually cause higher prices forcing the Fed to raise interest rates. Like the seventies, the Fed was slow to grasp the effect of the structural changes on inflation and monetary policy. History shows that inflation erodes the value of money. And, the continuing slide of the dollar itself carries inflation risks because it puts pressure on importers to raise prices.

In our view, inflation and dollar depreciation will ultimately undermine international confidence in the dollar as a store of value. Gold is a good thing to have while they make the same mistake again.

Fiat Money

For sometime we raised concerns over America's indebtedness and its monetary errors predicting a collapse of the greenback. We have been accused of crying wolf too often. The dollar has fallen 30 percent since 2002 and it has taken a beating since the election. Despite the dollar slide we remain concerned. For over two decades, the US dollar enjoyed the pre-eminent role as the world's most widely used reserve currency. Today those financial liabilities are denominated in dollars as are its claims. Unlike the early seventies when a run on the dollar resulted in the suspension of the convertibility to gold, this time the US dollar is backed by America's balance sheet. But that balance sheet is covered in red ink. Instead, when the Americans need more fiat money, they simply lift the debt ceiling and print more money as legal tender.

America's new strategy of "benign neglect" in allowing the dollar to weaken carries huge risks. By allowing their currency to depreciate against other currencies, the heavily indebted Americans can repay this debt in a depreciated currency. With the dollar sliding once again, foreign players such as the Asian central banks with their bloated reserves of dollar treasuries are losing money. And with the US administration needing to borrow even more dollars over the next four years, a dangerous spiral of falling currencies and asset prices has been set in motion. The dollar's bear market has only just begun. Four more years?

The Buck Stops Where?

Gold recently touched a sixteen year high extending the rally that began in April 2001, coinciding also when President Bush was first sworn into office. Gold is a traditional safe haven hedge and has been pushed up by the dramatic collapse of the dollar, which has sunk to its lowest levels since the US abandoned the gold standard in January 1971. Gold has pulled back amid profit taking and the usual Christmas dollar rally. Yet we believe this second leg has only just begun. We expect the US dollar to slide another 15 percent, having broken below the 17-year support base.

Between 1985 and 1987, the dollar fell by 50 percent while inflation and bond yields rose and, in October 1987, the stock market crashed. Gold jumped 100 percent. America's current account deficit was only half of today's current account deficit. But we believe there are more disturbing parallels with the 70s when the greenback's devaluation created significant economic instability. Like today, the 70s was a time of huge budget deficits, rising oil prices and the cost of a crippling war. Then the Bretton Woods agreement of fixed exchange rates collapsed, the dollar fell 70 percent, and inflation peaked at 20 percent. Gold went from $35 and ounce to over $850 an ounce. Today, the sum of all the "war of terrorism", a record current account deficit and massive budgetary spending will mean the Americans must devalue to honour its debt obligations. Today, the aggregate costs already equal the 70s percentage of GDP. Four more years? We've only just begun.

Four more years

The new high in gold is sending a message. Debt is too high and the US dollar, which has lost more than 29 percent of its value since 9/11 will depreciate further. So far the President and his treasury team appear nonplussed about the deficits, talking up the old "strong dollar" policy but pursuing a policy of "benign neglect". We continue to see further dollar weakening. The game is changing. And like the seventies, when the Bretton Woods system broke down, the deterioration in the structural deficits will erode the dollar's status as a safe investment. Gold, we believe, will continue to outperform the dollar and the world stock markets, as it has for the past two years. Gold is a barometer of investor anxiety, it is an asset class that not only provides a safe harbour but is the ultimate store of value while investors wait for the financial accidents ready to happen. Four more years? Be prepared.

Recommendations: $700 gold

The rise in the price of gold through $450 per ounce was the first time since June 1988. Part of the reason for the move in gold was the launch of the StreetTracs Gold Trust (ETF) on the New York Stock Exchange, which attracted almost $1.3 billion in buying, equivalent to 96 tonnes of gold in less than a week. The ETFs give investors an alternative, popularizers gold ownership by allowing pension funds, endowment funds and trust groups who could not before hold the physical commodity to own gold. We expect the ETFs to fuel growing investment demand for gold reinstating gold's role as an asset class alternative to paper. We believe this pick up in investment demand is the tip of the iceberg since there is latent buying and a desire by institutions to diversify their portfolios. Further fuelling the demand for gold is the investment demand coming from Asia as both central banks and institutions alike have used gold as a means to diversify their holdings, partly to hedge against the collapse of the dollar.

We continue to expect gold to hit $510 an ounce, and our next target at $700 an ounce is expected late next year. Gold stocks in general have been laggards in part in the belief that gold bullion would spike and fall back. Part of the reason for this divergence was due to investor scepticism over the sustainability of the current move in the price of gold. We believe that this disbelief is similar when the oil price moved and the oil shares lagged until oil broke above $40 a barrel. Gold investors appear to have bought their tickets to the show, sat in their seats and have been waiting for the show to start. Gold has taken took off but the stocks haven't.

We believe the gold stocks are an excellent buy here. Once investors realize the gold train has left the station, they will stampede into the stocks as they did with the oil stocks. We believe that the current laggard performance is temporary and thus presents a marvellous purchase opportunity. We believe there will be growing interest in North American producers. The introduction of a stiff royalty in Chile, hostilities in Peru, and Meridian's Esquel problems have made, South American more hostile. Mining will continue but that South American mining gold goose has been plucked too often. As such, we see a shift in interest toward the North American producers. We would overweight portfolios to gold.

We continue to recommend Agnico-Eagle, Meridian, and Kinross, because of their growth prospects and the likelihood that one or all will be involved in merger and acquisition opportunities next year. Among the majors, we like Newmont and Placer Dome for its Cortez Hills play. The best opportunities however are in the junior producer stocks, and we particularly like Bema, Eldorado, Campbell Resources, and Northgate Exploration. For some time, we have been concerned about the lack of new discoveries, due in part to the reluctance of the gold industry to invest in exploration. Looking at next year's budgets, we see that the industry itself is only spending about a third of the $3.5 billion peak in 1977 on exploration. Thus the timing is ripe for the junior explorers like White Knight Resources, and Claude Resources.

Bema Gold Corporation
Bema Gold shares jumped due to the release of about 40 additional drill holes at Kupol in Russia. Bema raised $100 million overnight with the funds to be used at the Kupol property a joint venture between Bema and the government of Chukotka. Bema is earning a 75 percent interest and there is likely a five million ounce resource.Kupol is expected to be Bema's next big producer and a feasibility study is scheduled for the second quarter of next year. At 50 percent owned Refugio in Chile there was a slight delay until the second quarter of next year but this reopened mine with partner Kinross is expected to be in production averaging 240,000 ounces a year at $230 per ounce. Meanwhile at Bema's South African Petrex mine there was an improvement in production, which offset in part the strength of the South African rand. Bema has been aggressive in replacing reserves but the Petrex Mines is an albatross. Offsetting the South African assets however is Kupol which is a potential company builder with the potential of 440,000 ounces of gold and 4.4 million ounces of silver. We believe that Bema will continue to be aggressive and expect them to be a participant in the consolidation of the mining industry. We continue to recommend purchase.

Glamis Gold Ltd.
Glamis reported a disappointing quarter despite the appearance of a successful startup at El Sauzal in Mexico. Problems at Marigold in Nevada contributed to the shortfall as production fell and cash costs increased. It appears that the expansion at Marigold is behind schedule but the next quarter should see some catchup. The initial startup has been successful at El Sauzal, this operation will be Glamis' main operation next year. We remain cautious on Glamis due in part to the teething problems at Marigold and cautiousness with respect to the El Sauzal mine. Glamis gold has offered $3.4 billion of paper for Goldcorp for a 22 percent premium. Although Glamis had earlier discussions with Goldcorp, this bid is considered hostile. In our view, Glamis shares are expensive and thus Goldcorp shareholders might prefer relatively less expensive Wheaton paper.

Goldcorp Inc.
In a surprise move Goldcorp plans to buy Wheaton River Minerals Ltd for $2.09 billion on the basis of four Wheaton shares for one Goldcorp share. Rob McEwen will move up to Chairman and Ian Telfer will run the combined entity. The deal provides for a 20-day look-see and is expected to close in February. The combined company will produce 1.1 million ounces with proven and probable reserves of 10.5 million ounces. What is surprising is that Goldcorp is largely gold whilst Wheaton has a healthy exposure to copper and silver. If Goldcorp is gold and gold is money, can copper be money - we hope, it's worth more than a penny. Goldcorp shareholders should hold here, now that an auction process has begun.

IAMgold Corp.
We can't believe we are still talking about IAMgold. IAMgold's merger with Gold Fields Inc. appears unlikely now that Gold Fields shareholders have rejected the combination. Of concern was the legal costs fighting off the bid from Golden Star and the aborted merger with Wheaton River Minerals. IAMgold spent more money on the lawyers than it earned mining gold. Fortunately at quarter end IAMgold's cash balance was still $45 million and the company's operations at Sadiola, Yatela, Tarkwa, and Damang contributed, although production fell short by 10,000 ounces in the quarter due to shortfalls at Sadiola and Yatela. The new mill began operation in this quarter at Tarkwa and next year should see a major contribution. While the shares of IAMgold appear to be stuck in a time vortex because of the lengthy merger, the shares should be bought below $9.

Kinross Gold Corporation
Kinross acquired the remaining 51 percent interest of the Paracuta mine in Brazil from RTZ for $260 million and at the same time in a nifty accounting trick, wrote down the goodwill associated with this mine. The purchase of the balance in Paracuta added 1.5 million ounces to Kinross' production profile and significantly adds to its reserves life. Kinross has a strong balance sheet and no hedges. Re-opening Refugio in Chile, boosting Porcupine and the Kettle River project will help next year. With twelve mines to its credit, Kinross is well leveraged to the gold price and we continue to recommend purchase. Kinross will produce about 1.7 million of unhedged ounces and we continue to believe that this company will be the answer to a great many of the gold companies who are suffering from bloated hedge books. Buy.

Meridian Gold Inc.
Meridian shares have outperformed its peers due in part to the excitement of the newly discovered Dorada structure at El Penon in northern Chile. El Penon is a low cost high-grade gold/silver mine. Meridian will update its reserves at yearend and the addition of the Dorada resource will extend the life of El Penon. Dorada's ore can be hauled to the mill which is only a kilometre away. In addition since the Dorada material is richer, this ore can be blended and will improve overall grade and costs. With over $200 million in cash, Meridian should produce 350,000 ounces next year up from 315,000 ounces this year. Long forgotten Esquel remains dormant but Meridian is still working with the local community. We continue to recommend purchase.

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John Ing

Author: John Ing

John R. Ing
Maison Placements Canada
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