Gold: Comedy of Errors
It is an immediate truth that timing is everything. And an almost immutable truth that no one gets it right.
In 2008, the US economy and financial system was brought to a precipice because of too much debt. Reality quickly set in and today a similar adjustment lies just ahead, as the market surges to historic record highs while gold struggles to maintain a trading range, between $1,180 and $1,400 an ounce. Low volatility (VIX) has also lulled the markets into a false sense of security. The consensus view is that we could just muddle along despite rising debt loads and we don't need gold. Why the disconnect? We believe the performance of the bond market and equities suggest markets are being driven less by economic fundamentals and more by easy money, underscored by the recent dip of 10 year Treasuries to 2.6 percent.
While too few savvy investors insist on buying gold as a hedge, more seem to enjoy the inflation in asset prices and worry less about the need to rein in monetary policy. However tellingly, America's largest debtor, the Chinese have voiced concerns that the excess supply of dollars has eroded the attraction of American money, which is a problem since over half of America's debt is held by overseas investors. We believe that we have entered a new and likely terminal phase of the current cycle, when bond yields will soar and the global bubble economy will come to an end.
The European Central Bank's (ECB) move to cut interest rates below zero follows the US and Japanese easy money policies because borrowing requirements are too large to be financed by private capital alone. The printing press is the only mechanism to ensure the financing of governments' deficits without a dramatic spike in interest rates, necessary to maintain investor confidence at a time when fundamentals continue to deteriorate. We believe any catalyst such as an Iraqi civil war, the fall of Eric Cantor, another Argentine default or Gazprom cutting off gas to Ukraine could upset this complacency. The truth is nobody knows what the tea leaves say but in such unprecedented times, gold is an antidote for that uncertainty.
The Emperor Has No Clothes
Quantitative easing (QE) has resulted in a flood of dollars whose value is extremely vulnerable to any change in global sentiment. The complacent view is that as long as the US can finance its debts at attractive interest rates, no one really cares that the ratio of total US debt (public and private) to GDP is over 400 percent. Foreigners however are losing patience and by assuming America's debt, there is a straight transfer of wealth that they no longer want. These transfers do not represent a productive use of capital and is not sustainable. US government borrowings have taken up more and more of the world's savings leaving much less for the rest of the world. It is our view that the illusion of the United States as a good credit has ended. The emperor simply has no clothes.
Moreover, this lack of economic leadership has countries pursuing a more independent approach.
The slowdown in China has accelerated America's reckoning. The Chinese authorities are coping with slower growth but still have excess capacity at a time when final demand is a question mark. The renminbi has weakened in part to boost China's trade with its Asian partners, a bigger market than the United States. China has also pursued a tighter monetary policy in the aftermath of an intentional deflation of their real estate and financial bubble, something that America and Europe should pursue.
Since the beginning of 2008, the Fed has used a variety of tools that in a very experimental way has no parallel in modern history. While, the Fed's mandate is to promote maximum employment and lower inflation, instead the Fed became the chief architect of debt for money, creating vast sums of money. We believe this policy became a form of social engineering whereby the unintended consequence vastly restructured the world's banking system making it more vulnerable and dollar-centric.
Quantitative easing was an experiment by central banks to create money to purchase financial assets. While the multi-trillion dollar quantitative easing programs saved the world economy from going over the abyss, the major economies are still mired in a recovery phase. The US economy shrank in the first quarter despite trillions of money printing. However, the Fed's easy money injected financial steroids into the capital markets and the avalanche of dollars has chased too few assets in a financial inflation. The prime beneficiary was Wall Street and the banks became bigger and bigger. Until 2008, central banks used money creation as a last resort because of its history of creating inflation. However, in one swoop, the US government changed the inflation calculator and increased the stock of money so that the Fed's balance sheet quadrupled to some $5 trillion of assets (used to be called liabilities). The stock of money is now four times that in circulation. And, the Fed became the biggest buyer of their own paper.
For some time, we have said that the central bankers' exit would not be painless. The threat of tapering has already unleashed a currency war. We believe the exit will be difficult. So far politics has deterred the Fed from reducing a balance sheet which can only be achieved by selling assets and of course shrinking those all-important bank reserves. Balance sheets were never as large but how to shrink the Fed's balance sheet which is choking on debt? Some believe that the Fed's portfolio could simply shrink as they allow debt to mature. However, the Fed's balance sheet of Treasuries, agency debts and mortgage backed securities are so large that they could swamp the existing market. It is an "owl market". To who? We believe that when the Fed sells securities, normalized interest rates will ensue.
No one is listening. Global central banks have fostered another housing bubble through their money pumping and near zero interest rates. And now the world's central banks are mulling how to prick their own man-made housing bubble to avoid the next crisis. The shadow banking system is bigger at more than a quarter of the world's financial system. Collateralized loan obligations (CLOs) have now reached levels not seen since the height of the credit bubble in 2008. Junk debt is back. Bonds have enjoyed such a lengthy record boom that the spread between junk bonds and sovereign credit have narrowed. At the same time, global loans to finance leveraged buyouts rose 55 percent last year to $1.6 trillion which will be surpassed this year. Another unintended consequence is that savers have been punished while debtors are rewarded for stretching their balance sheets.
Meantime, the geopolitical climate has become murkier. The problems get even worse. Russia has a big financing gap. Russia too has turned towards the East after becoming a pariah following the annexation of Crimea. Russia's gas deal only cements the trend towards the East. American troops are returning only three years after they retreated from the Middle East. America hopes a former enemy, Iran will help them defuse a worsening sectarian war which has destabilized the Middle East.
In Europe, we have a monetary union in name only and that dated architecture has yet to be tested. Despite Mr. Draghi's experiment of negative interest rates, the European Union is in trouble. Even Greece has been able to load up on bonds. Yet two years after the almost breakup of the EU, little has been done. Fiscal union is impossible with member countries failing to reach their growth targets. Deficits still grow. Still, there is no central euro budget. Political complacency and mounting debt are again the norm. That threat has created a currency war where each country weakens their currency in an effort to boost exports. In fact, there is an attack from within as the recent EU elections saw a surge in support for the anti-EU parties who want to make Europe more Europe. The probable outcome will be further frustration and dysfunction. A few years ago, Europeans were adept at kicking the can down the road and now with the next parliament, kicking the can will require less effort.
The End of US Dollar's Hegemony
America's seignorage of the world's currency gave it a financial weapon of mass destruction used infrequently in the past. The US controls the dollar which is the keystone to the international settlement financial systems and source of Washington's power. However in the past few years, the United States has crippled Iraq and Iran with financial sanctions and now threatens Russia with sanctions. Also in the quest for revenues, America's regulators have neutered the Swiss banking system, closed Cypress' tax haven and now threatens France's largest bank with $10 billion of fines. In turn, Russia reduced its holdings of US treasuries in March and bought gold instead. China reduced its Treasury holdings for the third month in a row and still remains the largest foreign holder of US treasuries at $1.3 trillion. Japan is the second largest holder at $1.2 trillion. In recent years, one of the big holders of dollars were the Saudis, who swapped their oil for dollars. Today they accept euros and hold fewer dollars. China has swapped oil, not for dollars but for renminbi. China's gas deal with Russia is for renminbi. The renminbi is being internationalised. Australia plans to put 5 percent of its reserves in renminbi. Nigeria's central bank holds about 10 percent of its assets in renminbi joining Japan and Malaysia.
The move from dollars is the beginning of the end of US dollar's hegemony, as the usage declines because nations are pursuing alternatives to protect their economies from US foreign policy swings, the greenback's value and US monetary policy.
Risk has Been Mispriced
Under the Basel rules, government securities are ranked "risk-free", without the need for more capital. That Greece and Argentina have reneged on their debt are lost on those Basel regulators. Banks are currently choking on sovereign debt and sky-high real estate exposure. Yet, the lesson of the last crisis was that the markets mispriced risk. Sovereign debt is not risk-free. The experiment with fiat money did not start in 2008. In less than 20 years there has been a Mexican financial crisis, Asian crisis and Russia and Argentina both defaulted. After years of monetary experimentation, the inflationary consequences are only now being felt. The seeds of inflation have been planted. We are in an environment that is eerily similar to 2007-2008, but with even more fundamental problems. Nothing has changed.
Meantime, the central banks' surrogates are being kept on a short leash amid endless financial scandals. Regulators have charged and fined the big banks for rigging everything from LIBOR, to the $10 trillion foreign exchange market. Credit Suisse was fined $2.6 billion. The UK's financial regulator fined Barclays Bank and one of its derivative traders $44 million for fixing the 95 year old London gold fix. Indeed we believe that this is just the tip of the iceberg because the massive precious metal derivative market also influences the London physical market. Government control over the banking sector has tightened as they investigate the litany of scandals. The industry has become the government's favourite whipping boy. Ironically the big banks are still buying government bonds giving politicians a blank cheque, borrowing even more. Unfortunately the scandals reveal that the banks are in a cosy nexus of political and business interests. Crony capitalism is very much alive.
Everything is Rigged
For example, gold prices have been manipulated in a coordinated fashion. First, the five banks responsible for the near century old London Gold Fix are being investigated for alleged manipulation. In fact, Deutsche Bank has resigned as a member following the allegations of unusual price volatility during the twice daily conference call, a practice that has continued for years. Similarly, volume spikes on Comex coincided with expiries raising regulatory concerns that the paper price of gold was manipulated by bullion players. The swamp is finally being drained.
Governments lie, bankers lie, accountants certainly do and traders sometimes lie. Gold tells the truth, it is the best reliable store of value. We continue to believe the gold price will reach $2,000 an ounce this year because the underlying problems that pushed gold to $1,950 remain in a world where monetary responsibility has been abandoned.
The dollar's days of dominance are over. Other countries are growing faster. The 2008 crash eliminated some Wall Street players, and measures taken to help recover from the crisis by keeping rates near zero and flooding the system with dollars, have caused the dollar to weaken, shifting the epicentre to the East. The growing demand for "safety" artificially buoyed the dollar but America owes half of its debt to foreigners. International trust in the US is very fragile. We believe gold provides protection against the government's push to create more inflation to lighten the burden of debt.
The monetization of debt resulted in currency debasement and the revaluation of gold. Gold is an alternative to the central banks' currencies and for that reason, Asian central banks and public have been buying gold. China already has more dollars than they want and have been diverting their reserves. Given the economic problems in Europe, the euro is no longer an attractive alternative. Gold is simply a rational solution to the excessive accumulation of dollars created by a profligate country that continues to live beyond its means. The cure will not be easy, but it is coming. Gold will be a good thing to have.
The mining sector has long relied on capital to finance exploration or development plays. However, the major suppliers of capital have moved on. In fact, some of the industry specific funds have seen outflows and they themselves are suffering from a capital shortage. Only the major gold miners have funds. B2Gold's acquisition was not only opportunistic but a reflection of the bargains that are out there and a preference to buy versus build. While the mining industry is dealing with a number of cross-currents, such capital; nationalism in foreign jurisdictions; rising costs and declining reserves, we believe that the risk reward parameters are finally favourable. The bell is ringing for gold stocks. Timing is everything.
A modern gold rush is underway as mining companies buy each other, suggesting to us that ounces in the ground are decidedly low at under $250 an in-situ market cap per ounce valuation. Gold miners' forward price earnings (PE) ratio is at a low 10 times versus the 30-35 times in 2005-2008. Investors take heed. Not only was there a bidding war for Osisko but the proposed merger between Newmont and Barrick would have generated multiple deals and created a behemoth rivaling the big mining giants. We believe that these deals will continue, reflecting the industry's cheap in situ ounces. One of the most interesting deals is the B2Gold acquisition of Papillion Resources for almost $600 million of shares at less than $140 an ounce. Deposits of 3 million ounces plus are rare and less than a dozen or so exist on a world-wide basis. China already the number one gold producer is expected to be on the hunt for new deposits because of its insatiable appetite for ounces. We believe gold stocks have bottomed and with many companies repeating the mantra of cutting costs and returning capital to shareholders, mining stocks are poised to show increases in line with improving gold prices. Gold miners are a leveraged bet on gold prices. We thus continue to emphasize big liquid Barrick Gold and the midcap producers such as Agnico Eagle, Eldorado and B2Gold which have little geopolitical risk. Without a merger, Newmont Mining is dead money since it is in harvest mode. We would also sell Iamgold because of its high cost structure and weak outlook.
Agnico Eagle Mines
Agnico is an intermediate producer with mines in Canada, Finland and Mexico. Agnico had a record quarter and its shares have rebounded after the successful acquisition of Osisko's Canadian Malartic Mines for less than 18 percent of Agnico. Agnico's flagship mine LaRonde continues to a major contributor with better grades and favourable cost profile. Goldex's low grade deposit contributed a full quarter of production. Commercial production from la India in Mexico came on stream and higher grades were mined at Meadowbank. Total cash costs fell from $740 an ounce to $537 an ounce (all-in at $990 per ounce). Canadian Malaric is in Agnico's backyard and we expect the Kirkland Lake ground to hold Agnico's next mine. We like the shares here.
Allied Nevada Gold
Allied Nevada has released a prefeasibility update at its flagship Hycroft mine in Nevada which is difficult in a capital short world because the capex is still too large. Allied needs money to make it happen. Allied will produce 240,000 ounces of gold and 2 million ounces of silver. Allied has a resource of 23 million ounces but the key is that much of the resource is refractory. Currently, Allied is a conventional open pit heap leach operation which accounts for its production but M3 Engineering's prefeasibility study is in place to mine the sulphides with an on-site oxidation circuit. Unfortunately, the billion dollar capital cost is too large for this one and we think a joint venture to finance phase one is more likely. Allied shares have weakened recently on concerns about the big capex but we still find the shares attractive down here.
B2Gold's Masbate mine was a contributor and La Libertad mine in Nicaragua was a surprise. B2Gold will have Otjikoto in Namibia in production by the end of the year so the Papillon acquisition in Mali could help B2Gold's goal to produce 900,000 ounces by 2017. Papillon's Fekola mine is a high grade open pit heap leach operation that will cost less than $300 million, producing 200,000 - 300,000 ounces a year for an all-in cost of $725 an ounce. B2 Gold has been successful in execution and Otjikoto is coming on time and on budget. The strong performance from Masbate, La Libertad and Limon mines will see B2Gold producing 420,000 ounces this year. Next year B2Gold should produce 550,000 ounces as the Namibia mine comes on stream. We like the growing production profile and portfolio of development project. The shares are a buy down here.
Detour Gold Corporation
Detour has turned the corner at its 100 percent owned flagship mine in northeastern Ontario with a handle on dilution and controls at the Campbell open pit. The company expects to boost output to 61,000 tonnes per day with production expected to rise next year to roughly 540,000 ounces and close to 600,000 ounces in 2016. With more than 15 million in-situ ounces, Detour only has 20 percent of its property explored and recent drill results suggests that there are some higher grade deposits nearby which could be processed at the company's mill. Detour also has reduced its operating costs. Detour is an emerging mid-tier producer and is on track to be Canada's largest gold mine with a life of mine in excess of 15 years. We like the shares here.
We continue to recommend Excellon for its richest silver mine, 100 percent owned La Platosa in Mexico. Excellon continues to prove up more ounces and rather than chase ounces, the Company has been tweaking and developing its underground mine growing production and cash flow. Peter Megaw has returned and we expect that his guidance will help develop La Platosa into one of Mexico's bigger entities. While the quest for the large tonnage source continues, Excellon has better results by mining the high grade near surface mantos. Reserves are replaced every year. We like the balance sheet and we continue to recommend purchase.
Kinross produced 2.6 million ounces last year with a strong first quarter due to a big contribution from its Russian Dvoinoye mine. Kinross has focussed on reducing its costs but almost 30 percent of production comes from Russia, making Kinross vulnerable to any surprise. Still, total capex is expected at $675 million, down from $1.2 billion due to revised plans for Tasiast in Mauritania. A final decision on Tasiast is not expected until 2015. Kinross' net debt stands at $1.3 billion with no material maturities prior to 2016. Kinross however has little on the horizon and its Russian exposure makes it vulnerable to a surprise. Sell.
Lake Shore Gold
Lake Shore has put their problems behind them at Timmins West and Bell Creek mine in Timmins. Lake Shore's results in the quarter were impressive and costs are coming under control. Lake Shore has been building up its cash and has retired debt and under the Sprott agreement is poised to make monthly installments. Lake Shore has given guidance of between 160,000 to 180,000 ounces a year at a cash cost less than $700 an ounce. The mill has surpassed 3,000 tpd capacity. We expect the company will now be able to spend money on exploration. Lake Shore has turned the corner and the key is they have a couple potential company builders (Bell Creek complex, Gold River and Fenn-Gib) but will need a higher price to make that happen. We like Fenn-Gib which could be joint ventured. We like the shares here.
We like McEwen Mining which outperformed its peers due in part to a solid balance sheet and improvements at the El Gallo silver mine in Mexico. Rob McEwen owns 25 percent and has retaken the reins from Ian Ball. We expect Rob to maintain El Gallo's development which is to show 25 percent production growth next year. A resource update is expected in the next quarter. Surprisingly, the huge Los Azules copper product in Argentina is moving along with additional metallurgical testing but the project could be smaller. The 49 percent owned San Jose mine in Argentina contributed to earnings. We like McEwen Mining here.
Yamana Gold Inc
Yamana was successful with Agnico Eagle in jointly acquiring Osisko Mining. We believe that the Malartic acquisition is a positive step and diversifies Yamana away from its heavily weighted Latin American (Brazil, Argentina, Chile and Mexico) exposure. Yamana's Brazilian operations remain problem prone at Pilar, CI and Ernesto. However flagship, El Penon in Chile is still the crown jewel contributing over a third to results but lower grades as part of mine sequencing are expected for the next little while. Yamana shares have been weaker but with nine operating mines, management has been tested. We prefer B2Gold at current levels.
Rating: 5 – Strong Buy 4 – Buy 3 – Hold 2 – Sell 1 –Strong Sell
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