Safehaven | Gold: Be Careful What You Wish For

May 24, 2005

Gold: Be Careful What You Wish For
by John Ing

Rumblings of troubles at some of the biggest hedge funds raised fears of market contagion, particularly following the downgrades to junk status of former icons, General Motors and Ford Motor Co. Huge losses were linked to the liquidation of exotic credit derivatives or as Warren Buffett calls them, "weapons of financial destruction". In 1998, Long Term Capital Management was considered too big to fail, then as now, the hedge funds are over-leveraged. As overall returns from stocks and bonds dropped in recent years, the largely unregulated hedge funds have accumulated more than $1 trillion of assets promising above average returns. Many are forced to unwind their leveraged positions causing an uptick in the dollar to offset mammoth derivative losses and the dumping of oil, Canadian dollars, and gold. Alan Greenspan reinflated the credit balloon in everything from oil to real estate to hedge funds but now after eight successive interest-rate increases, $50 oil and the credit downgrades, the after shocks are being felt as the hedge funds unwind their big derivative bets.

Amidst contagion, gold historically has been a good thing to have. Let's look at the fundamentals.

The US economy averaged about 4 percent growth over the last three years and GDP growth this year is forecasted at 3.7 percent which is well within the norm despite a spike in the price of oil to $50 a barrel. However, this growth has come at the expense of unprecedented large deficits and a large drawdown of US savings, mortgaging America's future. The cumulative effect of these deficits is a large increase in indebtedness, to the point that the Americans have become the largest debtor in the world. The trade deficit alone requires nearly $2 billion of external funding a day. According to the US Treasury, net portfolio inflows in the US dropped to $45.7 billion in March from $84.1 billion in February which was not enough to cover March's $55 billion trade deficit. At the same time, the Asian economies are not only attracting direct foreign investment due to their more promising growth opportunities but are also accumulating large stocks of international reserves, principally in dollars. As a consequence they are running large account surpluses and in holding more than half of the American deficit, they are subsidizing America's lifestyle. This is clearly unsustainable.

A Financial Marathon

"We are escalating the rhetoric and time is running out", said US Treasury Secretary John Snow.

China - bashing has become de rigueur. The United States is pressuring Beijing to allow its currency to appreciate to help cut the American deficits and Congress talks of punishment, if China does not do so. Amidst this red ink, Washington has placed huge international pressure, rattled its sabres, targeting China and its fixed exchange rate regime for America's trade woes, which could spill over into other areas. The US Congress is trying to impose a whopping 27.5 percent tax on goods from China. Bush would veto such a bid since it breaks World Trade Organization rules, but it serves to fuel protectionist measures on behalf of "special interests" groups. However, floating the yuan would not cure the US trade deficits but would more likely will lead to a global slowdown hurting the very groups that seek protection. Rather than renewed protectionism or finger pointing, in our view, policymakers should look to correct the fiscal imbalances before they further erode the underpinnings of the global financial markets, causing a financial meltdown.

In the first quarter, China racked up a huge trade surplus with the United States and Western Europe. Chinese exports in the quarter rose to $155 billion, up 35 percent from a year ago. China's biggest trading partner is with Japan. Yet China's trade surplus with the United States jumped $21 billion in the first quarter, up from $12.4 billion, a 73 percent increase. Last year, China had a $162 billion trade deficit with the United States, the largest ever recorded. China sends one third of its exports to the United States, accounting for twenty-five percent of the US trade gap. Most of the exports are manufactured products made by workers earning a fraction of the US factory wage.

Here Is The Problem

The US Congress overlook the most obvious fact that the main source of the deficit is not China's fixed exchange rate but its abysmal US savings rate and profligate government expenditures. The underlying and wider problem, the US current account deficit, reached another record in March because of the sharp drop in personal savings and out-of-control federal spending. For a higher level of investment and a reduced trade deficit, the United
States must have higher savings. Today's negative real interest rates will not encourage Americans to save more. Time is running out on the Americans, not the Chinese.

In 1985, America's current account deficit was at 3.5 percent of GDP compared with 6.5 percent of GDP today. Now, America has become the world's largest debtor and China its creditor. China holds more than $600 billion of dollar denominated securities and has made intentions of diversifying its large foreign exchange holdings. And the current round of China bashing will not be lost on China's policymakers. If the Americans cannot make the tough political choices on revenues and spending to contain their deficits then China and others will be forced to take the necessary actions.

Be Careful What You Wish For

The Chinese for example, are hinting that they too are losing their appetite for piling up more dollars, which fund the twin US deficits. Time is running out. The loss of China buying would cause the dollar to collapse, soaring interest rates and a recession. It is not about subsidies, it is not about low wages, nor is it about China's fixed exchange. It is about America's indebtedness with the world. Trade makes up less than 12 percent of the American deficit, so China bashing is a red herring, and more accurately a simple revival of old fashioned protectionism spawned by a beleaguered auto industry.

China bashing is also an empty threat because many of the American multinationals have major operations in China, thus a floating yuan would do little to reduce the trade gap. A lot of China's exports are by American businesses, such as Wal-Mart, so tariffs would only be hurting themselves. The Americans will find that globalisation is a double-edged sword.

The move to decouple the yuan would also trigger a wider revaluation of currencies around Asia. And if the yuan were allowed to float upwards, demand for foreign goods would shift simply to Japan, India or other countries. Letting the yuan rise however would lessen the cost of importing oil and iron ore to China making their goods even more competitive.

Equally important is that there is no economic rationale for balanced trade; indeed there are more countries with trade imbalances than balanced. And should the yuan float upward, US real interest rates would go higher in order to compensate investors for taking increased currency risks. The Chinese and others would be forced to cut back on buying those Treasury Securities, forcing interest rates even higher at the same time the Fed is pushing up rates. Asian central banks would have another reason to sell their surplus dollars. Indeed the Chinese probably have more say on US interest rates than Alan Greenspan.

In our view, a stronger yuan would also result in painful foreign exchange losses in the holdings of the Asian central banks. The peg to the dollar allowed China to survive the wrenching 1997-98 Asian crisis and has been in existence for more than eleven years. America's problem is that they import too much goods, oil, and money. The Chinese recently responded to American criticism, telling the Americans to fix their current account deficits by curbing its spending and save more - good advice but no one is listening except the Chinese. Time is running out.

So what to do?

We believe the Chinese will eventually loosen their currency regime in a gradual, deliberate manner and on their terms. Most likely they will widen the trading band slightly. Eventually, however they will leave the dollar, but link the yuan instead to a basket of Asian currencies. Ironically such a move would cause the yuan to be more sought after and that would be a good thing. By linking to a basket of its Asian neighbours' currencies, foreign exchange markets would have an alternative to the dollar bloc and euro bloc. China, Japan and South Korea together hold over a third of the world's central bank foreign exchange reserves. Such a basket would also require gold. Perhaps the European sellers could accommodate the Asian buyers?

Gold, The Ultimate Hedge

Meanwhile gold has been backing and filling in a trading range and might again retest the lower range. However, we believe that the next direction is a prelude to a breakout that measures to an upside target of $510 an ounce which would represent the second stage of this intermediate rally as the greenback suffers another retest having failed five times to rally. The sell off of gold and peaking of the dollar is reminiscent exactly of one year ago. Gold's recovery will coincide with the long awaited breakout in euro terms. As Bill Dickson, our professional trader of gold stocks notes, that although bullion is close to its sixteen-year high, the stocks have not cooperated falling thirty percent. In hindsight, gold stocks are leading bullion down. Indeed some of the junior stocks have recorded new lows. The lack of performance of the stocks was covered in our April 15 report, "Gold: Debt - Supersize Me", so the pullback we are experiencing is not unexpected. In our view, the current correction caused by the hedge funds meltdown is a classic purchase opportunity. Time is running out.

The spate of first quarter earnings reveal a telling fact that even with gold near its sixteen year high, gold companies cannot make money mining gold. South Africa, which is the world's largest producer saw its total output drop to a seventy-five year low last year. This year, industry forecasts call for a five percent drop in supplies. Meanwhile gold mining costs have increased due to not only higher energy prices but also to the fact that many gold mines are in a decline mode. Barrick's cost increased 25 percent, Placer Dome's rose 19 percent and Newmont's cost jumped 12 percent in the quarter.

And on a per share basis, gold stocks became serial fundraisers but have not shown much growth due to the rash of equity offerings which rebuilt balance sheets, but caused too much dilution. No new reserves or production were found on a per share basis. Of equal concern is to replace their reserves, the companies have unveiled massive mega-projects which must be financed - no mean feat when the financing window is closed. The good news is that the seeds of gold shares' recovery has been planted amidst this bad news since fewer gold mines will mine less gold and eventually, higher prices well make existing producers' gold inventory worth so much more.

Agnico-Eagle Mines Ltd.
Agnico-Eagle reported a strong first quarter with a low cash cost per ounce of $67. La Ronde continued to process ore at 8,000 tonnes per day. Output this year will be a disappointing 270,000 ounces due to the nature of the orebody. Results from 100 percent owned Goldex, located 35 miles east of La Ronde confirmed earlier reserve estimates of 1.6 million ounces and an internal feasibility study is expected next month. Goldex will be Agnico-Eagle's next mine after Lapa which could be in production by late 2008, producing 125,000 ounces of gold at a cash cost below $200 per ounce. Agnico-Eagle would require only $80 million of additional capital. Agnico-Eagle has made a whopping $150 million paper bid for all the remaining shares of Riddarhyttan Resources which is a development prospect in Finland. Six drills are currently operating on the property and there is an indicated resource of 1.7 million ounces and an inferred resource of 1.1 million ounces. The creation of none paper will press the shares and they are likely to go sideways for awhileand thus are dead money for a time.

Bema Gold Corp.
Bema Gold shares were beaten up despite the wise decision to call off its bid for the remaining shares of Arizona Star, which would have created more dilution. Bema reported yet another loss, due in part to 100 percent owned Petrex mine in South Africa, which is bleeding money. Bema has been spending money at Kupol in Russia, which is the company's main strength. Mega-projects such Cerro Casales are too far off and iffy from a financial standpoint, so Bema's growth prospects are dependent on near term Refugio and developments at Kupol. At current prices, the shares have been beaten up so badly that the shares should be bought for the rebound.

Crystallex International Corp.
Crystallex reported results which were in line with analysts' expectation. Additional news on the developments of Las Cristinas was also released. The company has made steady progress and committed more than $100 million in equipment orders and construction contracts but they are still waiting for the all important Permit to Impact Natural Resources. That permit is holding up construction as well putting a lid on Crystallex shares. The permit is expected to be received before June 30, and thus Crystallex will at long last begin construction. Initially the company plans a 20,000 tpd rate expanding later to 40,000 tpd which would average over 490,000 ounces a year at a total cash cost below $200 per ounce. We believe that Las Cristinas is one of the few 12 million ounce deposits and would be an attractive tidbit for one of the majors who desperately need additional reserves. The project enjoys local and national government support and is financially and technically feasible which should offset any uncertainties about Venezuela. As such, we continue to recommend purchase at current levels.

Goldcorp Inc.
Goldcorp reported an excellent quarter and the company is on track to produce 1.1 million ounces this year. Goldcorp has major assets in Canada, US, Mexico, Brazil, Argentina and Australia. We endorse the merger due in part to the belief that Wheaton River needed a world class asset such as the Red Lake Mine located in northeastern Ontario. Red Lake is one of the highest grade, lowest cost mine in Canada. Since Goldcorp was a product of a share exchange, we believe that it will take anywhere from six to nine months for this excess paper to be absorbed by the market. As such, we think the shares will go sideways for the next little while.

Glamis Gold Ltd.
Glamis is in need of an acquisition and we expect this Company to make moves in the next little while. Glamis reported lower earnings of $0.02 versus $0.07 per share due primarily to $4 million spent on fees in their unsuccessful bid for Goldcorp. Glamis has $24 million of cash and is expected to try the acquisition game again because of its high priced paper. At newly commissioned El Sauzal in Mexico, results were within budget and there appears to be few start-up problems. Glamis should produce about 400,000 ounces this year. Nonetheless we would prefer to play Meridian or Kinross at this time.

Kinross Gold Corporation
Kinross reported higher output for the first quarter but could not release its results due to a protracted delay in filing its financial statements. The problem is the valuation of goodwill associated with the TVX and Echo Bay acquisition. This assessment of goodwill was necessary because of the request from the SEC which is reviewing the acquisition of Crown Resources in the United States. Kinross has had to retain Standard Poors, Roscoe & Postle, as well as its own auditors at Deloitte to come up with a book valuation. Unfortunately this is taking a long time, casting concerns that something is wrong with Kinross. There is nothing wrong at Kinross other than the accounting marathon that shareholders and company must endure. As such, we would suggest taking advantage of the pullback in the shares since one of these days the SEC and auditors will get together and approve the purchase of Crown. The new President, Tye Burt comes in at an attractive time and is expected to prune some of the non-core assets and put Kinross on a path to increase its reserves (is a Norilsk deal in the cards?). Paracuta was an excellent acquisition and we believe that Kinross will be a major player in the consolidation game. Buy on this weakness.

Northgate Minerals Corp.
Northgate's results were disappointing due in part to the labour disruption. While production was on target, the company plans for Kemess North is taking shape. Kemess North is needed but investors are concerned that environmental permitting and First Nation negotiations will delay production until 2008, at the earliest. As such Northgate is need of a second mine and we believe that the company will one of the participants in the takeover game. Buy.

Click to view larger image in new window:

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

Disclosures:
Rating Structure
Analysts at Maison use two main rating structures: a performance rating and a number rating system.
Performance Rating: Out perform: The target price is more than 25% over the most recent closing price. Market Perform: The target price is more than 15% but less than 25% of the most recent closing price. Under Perform: The target price is less than 15% over the most recent closing price.
Number Rating: Our number rating system is a range from 1 to 5. (1=Strong Sell; 2=Sell; 3=Hold; 4=Buy; 5=Strong Buy) With 5 considered among the best performers among its peers and 1 is the worst performing stock lagging its peer group. A 3 would be market perform in line with the TSX market. NR is no rating given that the company is either in registration or we do not have an opinion.
Analysts Certification: As to each company covered in this report, each analyst certifies that the views expressed accurately reflect the analysts personal views about the subject securities or issuers. Each analyst has not, and will not receive, directly or indirectly compensation in exchange for expressing specific recommendations in this report.
Analyst's Compensation: The compensation of the analyst who prepared this research report is based upon in part; the overall revenues and profitability of Maison Placements Canada Inc. Analysts are compensated on a salary and bonus system. Some factors affecting compensation including the productivity and quality of research, support to institutional, investment bankers, net revenues to the equity and investment banking revenue as well as compensation levels for analysts at competing brokerage dealers.
Analyst Stock Holdings: Equity research analysts and members of their households are permitted to invest in securities covered by them. No Maison analyst, or employee is permitted to affect a trade in the security of an issuer whereby there is an outstanding recommendation for a period of thirty calendar days before and five calendar days after the issuance of the research report.
Dissemination of Research: Maison disseminates its hard copy research material to their clients using the postage service and couriers. Samples of our research material are available on our web site. Electronic formats are available upon request.

General Disclosures: This report is approved by Maison Placements Canada Inc. ("Maison") which is a Canadian investment- dealer and a member of the Toronto Stock Exchange and regulated by the Investment Dealers Association. The information contained in this report has been compiled by Maison from sources believed to be reliable, but no representation or warranty, express or implied, is made by Maison, its affiliates or any other person as to its accuracy, completeness or correctness. All estimates, opinions and other information contained in this report constitute Maison's judgment as of the date of this report, are subject not change without notice and are provided in good faith but without legal responsibility or liability. Maison and its affiliates may have an investment banking or other relationship with the company that is the subject of this report and may trade in any of the securities mentioned herein either for their own account or the accounts of their customers. Accordingly, Maison or their affiliates may at any time have a long or short position in any such securities, related securities or in options, futures, or other derivative instruments based thereon. This report is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell any securities discussed herein in any jurisdiction where such offer or solicitation would be prohibited. As a result, the securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. This material is prepared for general circulation to clients and does not have regard to the investment objective, financial situation or particular needs of any particular person. Investors should obtain advice on their own individual circumstances before making an investment decision. To the fullest extent permitted by law, neither Maison, its affiliates nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the information contained in this report.

For more information, please visit our website: www.maisonplacements.com