Gold: Inflation Is Dead, Long Live Inflation
Seventy odd years ago, the US established the dominance of the dollar enshrined by the Bretton Woods Agreement. Since then, the US supplied the world with greenbacks to run everything from balance of payments to budgetary deficits and of course, wars. However the deficits undermined confidence in the dollar and in August 1971, the US unilaterally terminated convertibility of the dollar to gold. The greenback became a fiat currency and as a result the dollar is much lower. Today, the world has drifted into regional powers, weakening hegemons and currencies. The biggest money printing exercise in the world has resurrected alternatives to fiat or paper dollars. US policies themselves have added to this volatility. And now, the ebbing of Obama's authority and the potential loss of the Senate this fall ensures gridlock on Capitol Hill.
Surprisingly, the Dow records daily highs and US ten year treasuries are at yearly lows. Inflation was declared dead. Hot money has morphed into overvalued stock markets with computer algorithms dominating the trading environment such that HFTs and incalculable derivatives have prospered so much it took a book, "The Flash Boys" for regulators to investigate practices that are still going strong in Canada. Simply Wall Streets' flash boys became their own best clients. It is no coincidence that there is a near 100 percent correlation between the Fed's balance sheet and the level of the stock market. This monetary stimulus is illusory. US national debt is simply out of control. Central banks are using the wrong tools. Instead of stewards of money, they have become creators of money. The system has become debt dependent. Inflation is alive, but in our capital markets.
Dangerous Global Debt Bubble
The bulls however tell us that Washington still has ammunition to overcome a liquidity crunch, with yet another round of quantitative easing to keep interest rates low. Debt however is almost 100 percent of GDP and doubling the government's debt is possible only if rates could be kept low. Quantitative easing has caused a shift to bonds in the biggest bond boom in history as well as a rising stock market and a rising US deficit. Even Greece can raise money. Low interest rates have had a significant effect on the distribution of income. Much of those newly minted funds have not gone to finance business investment, but Wall Street. And we believe ultracheap rates have undermined the value of all fiat currencies, leading to the popularity of the alternatives to money, like Bitcoins, classic cars, farmland, and wine.
The slide in both asset quality and risk premiums has led to a lack of faith in the government's ability to protect individuals' wealth which resulted in a loss of trust in our financial institutions. Wall Street, for example, was bailed out by the taxpayer with so little benefit to the taxpayer. Then there was the "bail-in" or seizure of depositors' savings to save Cyprus' banks. Policymakers seem more intent on protecting Wall Street than Main Street in a "quid pro quo" relationship exacerbating the relationship between taxpayers and business. The Federal Reserve has even given its surrogates two more years to comply with the much feared Volcker Rule's restrictions on derivatives. Are taxpayers again willing to bail out another problem? Capitalism is under attack from within.
The Debt Hangover Has Only Begun
Barrack Obama has racked up more debt than all other presidents before him with a fiscal expansion financed by deficits and foreign borrowings exposing America to sudden capital flow reversals. His Affordable Care Act already has cost $1 trillion and the world's richest health care program will still have an uncovered population equal to that of Canada's lacking coverage even after ObamaCare is to be fully implemented. In bureaucratic fashion, ObamaCare has turned into a camel when it was to be a horse.
President Obama has deepened the differences between his party and the Republicans. To no surprise, his latest budget received a chilly reception from Capitol Hill. For example, more than a half trillion dollars is allocated for the Pentagon but, only $39 billion was cut or 0.06 percent. While his spending cuts were nominal, Mr. Obama's revenue projections are overly optimistic. The overall effect is another smoke and mirror effort and ever bigger deficits. In 2008, the government spent $2.9 trillion. For fiscal 2015, spending will approach $4 trillion or 21.4 percent of GDP. Oh yes, ObamaCare which was supposed to be close to self-funding, will cost $6 trillion by 2024.
Unfortunately that is typical of government misspending today, but not only in America. The European Community (EU) is contemplating spending more money and paying for it through "quantitative easing" program. Or, heavily indebted Japan, who after raising the consumption tax, discovered that was it was not enough and therefore they too will embark on a second round of unorthodox money easing. Governments have been the big winners of a cheap money policy that enables them to monetise their debts and keep servicing costs low. Sadly, the fundamental problems have not been resolved.
True, the Arab Spring, the Orange Revolution and the recent uprising in Ukraine, brought down regimes but also generated unintended consequences. In the biggest crisis since the cold war, Russia's annexation of Crimea raises the geopolitical temperature. Overlooked however, is that Ukraine has more than $73 billion of debt and owes some $12 billion this year. Russia owes $53 billion this year, made worse by a capital flight of $64 billion in the first quarter. Much of that debt is owed to the European banks who have not yet recovered from the last crisis. Also, with Russia no longer a cornerstone of Obama's foreign policy, the Syrian, Iranian, and Iraqi dominoes must inevitable fall. Energy again, is the common denominator. We believe Ukraine's financial problems will lay bare the precariousness of the global financial system at time when everyone thought it was safe to come out. The US and Russians are on a "game of chicken" which will support higher gold prices.
The most worrisome issue is that the Fed has promised withdrawal or tapering three times now. We believe unwinding the Fed's balance sheet won't be painless. Still interest rates remain low, and markets have become addicted to cheap credit and with inflated bubbles everywhere, central banks have introduced "guidance "as another stage before "normalized" rates. The central point is that central banks are pussy-footing over rates because of fears that their economies cannot withstand higher credit. In addition, with "headline" inflation so benign, markets have become complacent. We believe that it is not headline interest rates that we must watch but the inevitable rise in prices. Prices are the sherpas of money printing. Cheap credit is the symptom and the consequences are yet to come.
While the Federal Reserve's balance sheet exploded to $4.5 trillion from $1 billion in 2008, fears of "tapering" resulted in unrealized losses of $500 billion, no small amount and almost ten times the Fed's capital base at $55 billion. The liabilities to asset leverage is 73:1, surpassing the levels of 2008 when Lehman Brothers and Bear Stearns imploded. Of course, the Fed could always recapitalize but that would require an act of Congress. Who will bail out the Fed?
The Next Panic
Yet to many, we sound like Cassandras and are told, it is different this time. It is not. Deficits don't seem to matter yet debt is close to 100 percent of gross domestic product. Wrong. Real or inflation adjusted rates during 1995 to 2005 were 1.5 percent and 2.5 percent with growth at 3.5 percent. Rates then were 5 percent to 6 percent. However, when the economy collapsed after 2008, rates dropped to near zero as the banking system's bad debts were absorbed by the government. The prevailing logic was that with subpar growth, we should have subpar rates. However, debt increased and the Fed kept buying paper. While the Fed has been successful printing dollars, they can't print renminbi or rubles. Today more than half of America's debt is held by foreigners whose economies are growing faster and holders have demanded an inflation premium and after Ukraine, a risk premium. America's rosy scenario is dependent upon them remaining an island of zero interest rates but tell that to America's creditors. Since America's recovery is debt financed as never before, a sinking dollar must translate into higher domestic prices. Rising inflation then is inevitable. Gold will be a good thing to have.
Another reason for the market's complacency about inflation is that we are told that the central banks are not really printing but instead simply financing the needed deficits through bond issues and not, as in the past, money creation. Few ask how the government pays for those issues and fewer question the unorthodox monetary policy that sees central banks keeping interest rates near zero. We believe that this "stealth money printing exercise" is a rebranding if you will. This can't go on indefinitely. Cheap credit has caused a stock market boom, debt boom and a borrowing spree that has financed trillions of mega-mergers. It is unsustainable. It is inflationary. History shows that the great inflations of the past were caused by profligate governments resorting to deficit financing to pay for everything from wars to tax cuts. It is not so different this time, only the debt load is the highest ever in American history. Inflation is alive.
Mario Draghi, the president of the European Central Bank (ECB) promised nearly two years ago that he would do "whatever it takes" but without a much delayed banking union it might not be enough to save the euro this time. Economic conditions remain grim and debt is still too high and the political consequences are only being felt now. Mr. Draghi's promise is likely to be tested this year. Even the Swiss franc, the hardest of all currencies has also slipped in value. However, the problem is that in an environment of falling currencies, inflation is the inevitable consequence. Of more concern, is that history shows that after competitive devaluations, more protectionist measures like Keystone XL are brought in because competitive devaluations are only, a short term palliative. Again, the age-old discipline of supply/demand has not been suspended and the dollar has only one way to go. That will be good for gold, it cannot be printed.
Can't See the Forest From the Trees
China had its first domestic bond default raising fears of a crash of its financial system. The default raised the issue of moral hazard and, of course focused attention on the shadow banking system and whether China will face its own Lehman moment. Highly unlikely. First, much of their debt is owed to the State and defaults are managed as in the past. Second, their central government has low debt levels and unlike Western governments can easily absorb "private sector" debt. Third, the government continues to direct the economy and the focus on infrastructure investment will receive a larger amount of funding making debt servicing manageable.
We believe that the anxiety over China's growth and debt levels are overblown. It is always difficult to rely on China's economic statistics, like the ability of seeing the forest from the trees. Much is made of home sales falling 7.7 percent which was not surprising given the State's intention to cool that sector. GDP growth at 7 percent plus is needed because China must create some 10 million new jobs a year. Tax breaks and infrastructure spending, particularly for railway investment are targeted fixed asset investments and are to be among the biggest drivers of the Chinese economy. True, investment has slowed down in bloated industries like real estate, cement or steel, but fixed asset investment will continue to make up over half of China's GDP.
Since 2005, the renminbi has climbed 35 percent against the greenback. China's renminbi is now a competitor to the dollar as Beijing plays a financial role commensurate with its economic clout. In fact, since the Dalai Lama met President Obama in mid-March, the renminbi was fallen 2.5 percent. We believe the slippage is part of the global competitive devaluation war caused by America's tapering as most nations no longer allow the US dollar to weaken without consequences. The game of "pass the potato" is haunting the markets. Countries are racing to devalue their currencies in a desperate move to stimulate exports. To be sure, the recent weakness only restores equilibrium with China's main trading rivals. However longer term, falling currencies raises domestic inflation rates. While China continues to enjoy a sizeable currency account surplus, attracting hot money, the newly weakened renminbi shows speculators that currencies can move down as well as up. Importantly, we believe the move is part of a step towards making the renminbi one of the world's major reserve currency. To date, Standard Chartered Bank estimates some forty central banks have invested in renminbi assets, paving the way to establishing the renminbi's status as a reserve currency. America's dollar hegemony has ended.
We believe debt burdens have become extreme and will have inevitable consequences. Cause and effect. Gold is the ultimate store of value and its emergence lately reminds investors that this safe haven is outside the control of policymakers. The ebbing of America's financial and military powers has shaken confidence in the dollar and America's abilities. Gold is an alternative investment to the dollar. Gold has been the most trusted store of value of value for centuries and will be long after fiat currencies, man-made derivatives or other proxies are discredited. The recent turmoil in Ukraine reminded investors of its role as a shelter.
There has been another reason for the rise in the gold price. Nowhere is the perception of growing America weakness so strong as in China. China is the world's largest creditor. In February, China bought 111 tonnes or 11 percent more than the 100 tonne monthly average last year. In fact, China has bought up most of the gold liquidated by the gold exchange traded funds last year consuming over 1,200 tonnes or 28 percent of global physical demand. China has overtaken India as the biggest consumer of gold in the world. Sales from ETFs are exhausted. It is believed that Chinese imports are much higher since deliveries or withdrawals from the Shanghai Gold Exchange (SGE) are not included. Thus, with the lack of ETF sales and continued buying from China as wealth increases, gold will top $2,000 this year. We believe the unwinding of global debt will push gold to even higher levels next year.
Another reason for the belief that we have reached the bottom is the number of junior mining economies that are turning themselves into medical marijuana companies, or "green gold". Never has so much money been thrown into an industry with so poor fundamentals. First, there are only a dozen or so (one was dropped recently for poor product quality) authorized licensed producers by Health Canada. However, there are some 200 plus companies that have applied with many stating they have a "conditional license" which is non-existent under the Marijuana for Medical Proposes Regulations (MMPR). The rules are strictly controlled as are premises and the participants. Nonetheless, the sector has attracted so much hot money that the failure rates is destined to be high particularly since the entire market consists of some 40,000 users of which many grow their own supplies. The market is also limited because there are so few healthcare practitioners that can actually supply the necessary medical scrips. Caveat emptor. Fool's gold? We would rather have the real thing.
Despite at least two "flash crashes", gold has outpaced the markets increasing almost 9 percent. Gold mining shares have increased as much as 18 percent in the same period. Gold recorded a triple bottom at $1180 ending a yearlong correction. Gold stocks became better performers because of the industry's new mantra of cost reduction, returning capital to shareholders and a "back to basics" philosophy. In addition, many of the CEOs have been replaced and their chastened replacements sworn off capital busting acquisitions and the usage of shares which caused massive dilution in the past. The "back to basics" push also saw a stabilization of costs in the latest quarter. Many also shelved dubious projects and to be sure, less gold will come to the market in the next few years.
With average costs approaching $1200 an ounce and less gold coming to market, the gold miners have exhausted themselves on the downsize. In fact, the next few years we expect only a handful projects to come on stream. Yet almost overnight there was a series of deals like the bidding war for Osisko or the proposed mega merger of Barrick and Newmont that heightened the rivalry among the world's top gold producers. Has anybody learned? What happened to the new discipline? It is different this time. The shortage of low cost deposits has resulted in a fevered quest for low cost ounces in the ground. Rather than explore in geographic unfriendly jurisdictions fraught with risk of confiscation or higher taxes, there is a premium developing for "friendly jurisdictions". Our view is that the buying frenzy is a clear sign that the industry views in-situ gold reserves a "buy". Investors take heed.
We continue to recommend the more seasoned producers such as Barrick which has turned the corner and discounted everything but the kitchen sink. We also like Agnico-Eagle for its track record of successful acquisitions and growth profile. Among the mid-tier we like Eldorado and B2 Gold which has shown impressive production growth, Detour Gold is a trading opportunity having a geographic advantage over others as well as a focus on profitability. We also like some of the more junior silver producers like Excellon and focus on the junior producers such as McEwen Mining and St. Andrew Goldfields for its robust production, strong management team and low geographic risk.
A Golden Merger?
The struggle to merge Barrick Gold and Newmont underlines the appeal of buying versus build. The world's two giant producers shelved their merger discussions for a second time which would have produced a new global giant larger than Rio or BHP.
The Barrick/Newmont deal would have narrowed the focus and the emphasis on gold, after decades trying to diversify to other commodities would have presented major cost savings. The deal focused on each firm boosting low cost ounces and de-emphasizing the high costs, maturing mines. Business 101. Newmont's problem has been that they were harvesting ounces with a portfolio of too many mature mines and assets in risky jurisdictions. At the same time, execution was a problem for both companies. By emphasizing core assets and efficiencies, the combined entity would attract a wider investor base. To be sure, deal-making with all the various pieces would have been a key part of the strategy.
The merger would have allowed for richer efficiencies and the creation of a spinoff would have created a new producer. The new entity would rival Newcrest Mining with two million ounces plus from Australia, New Zealand, Papua New Guinea and Indonesia. Most importantly, the combined company would have more than 200 million ounces of in situ reserves, cheap even today. The merger would also combine shareholder bases and where Newmont has the bulk of their shareholders in the United States, Barrick has a proportionally larger stake in Canada so the combined entity would have broad North American representation. And finally there would have been sufficient cash flow to manage some $20 billion of combined debt. After, a cooling off period, will it be three times a charm?
Allied Nevada Gold
Allied Nevada reported a robust first quarter profit from flagship Hycroft Mine in Nevada producing 60,000 ounces. Randy Buffington released a new prefeasibility study by M3 Engineering and Technology for the Hycroft mill expansion. The prefeasibility study called for lower capital costs with two phases and a new mine plan. The capital cost was lowered to $1.7 billion with a 26.5 percent IRR. M3 is to complete the feasibility study by yearend. We like this project and financing will not be a problem. Allied should have a good year due to the start-up of the Merrill-Crowe plant. We like the shares here.
Agnico Eagle Mines Ltd.
Agnico Eagle reported another strong quarter, reflecting the solid contribution from all mines. Open pit Meadowbank in Nunavut and flagship La Ronde in Quebec were strong contributors (50 percent of cash flow). Pinos Altos' operations in Mexico and newly commissioned La India mine also had solid production. Agnico has a strong management team and the acquisition of Canadian Malartic for less than 17 percent dilution will add to Agnico's low cost ounce portfolio boosting output to 1.2 million ounces. All in costs will be about $990 per ounce. Agnico has a rising production profile, reserve position and with operations in Canada, Finland and Mexico will trade at a premium to its peers. We like the shares here.
AuRico shares have picked up after producing 54,000 ounces in the first quarter. Investors are focussing on the ramp up of the Young Davidson mine in northern Ontario. El Chanate mine in Mexico produced 19,000 ounces. The key will be the flagship Young Davidson's underground development and execution. We prefer to stay on the sidelines.
B2 Gold Corp
B2 Gold, an emerging mid-tier player with three operating mines, had a strong quarter due to improving performance from La Libertad which offset low output from its Masbate mine. B2 Gold acquired CGA Mines and Volta Resources which are excellent acquisitions. B2 Gold is a mid-sized gold producer with a robust pipeline and a record of execution. Cash cost is less than $700 ounces. Otjikoto in Namibia is on budget and production is planned before yearend. We believe that B2 Gold shares will do well in a rising gold market providing leverage and an excellent development pipeline.
Despite a good quarter, Eldorado shares have been in a funk. Operation are strong and Eldorado has a healthy development pipeline in Turkey and Greece and China. Eldorado is still waiting on permitting on Eastern Dragon but plans suggest approval is in the offing. All in cash cost remain at $994 and we like the shares here.
Mexico's highest grade silver producer, Excellon reported a strong quarter with $9 million cash in the till. Miguel Auza is operating at only 55 percent capacity, so Excellon is attempting some custom milling in order to take advantage of spare capacity. Excellon had a robust quarter with strong recoveries. Flagship La Platosa's all in cost are less than $17 an ounce and output should top 2 million silver equivalent ounces. We continue to recommend the shares here.
Goldcorp's problem remains. Goldcorp hostile bid for Osisko Mining failed predictability. With problems at Penasquito and maturing Red Lake, Goldcorp is in need of a fill-in project. The locals broke a stalemate at Goldcorp's Los Filos mine by ending the blockade for higher rent. The local Ejidos have historically been difficult. Goldcorp's Penasquito remains problem prone and that mine has been a drag on management's time as well as Goldcorp's results. On the positive side, Cerro Negro in Argentina will contribute as will Eleonore and Cochenour which will help Goldcorp's output next year. Goldcorp has $1 billion of cash and is expected to be a acquisitor. Down here we prefer Barrick Gold to Goldcorp.
Kinross has done a good job of retrenchment paring Tasiast's price tag in Mauritania to $1.6 billion but the project remains troubled. A new mine plan will boost production but the market will take a wait and see approach. Fortunately, Kinross intends to wait, until 2015 to make a decision, of which we endorse because we are not satisfied with the skinny rate of return. Kinross bit the bullet on
|Company Name||Trading Symbol||*Exchange||Disclosure code||Rating|
|Agnico Eagle Mines||AEM||T||5|
|St. Andrew Goldfields||SAS||T||N/A|