Gold: Do What They Do, Not What They Say

The Swiss National Bank (SNB) shocked the currency markets when it abandoned the three year currency peg to the euro. Switzerland spent billions of francs to cheapen the franc, loading up its balance sheet which doubled to over CHF1 billion equivalent to 86 percent of that country’s GDP. In one of the biggest changes since Bretton Woods, the move left big losses, particularly in the carry trade. The decision to unpeg was due to expectations that the European Central Bank (ECB) would begin a round of quantitative easing (QE), printing yet more euros, making existing euros worth less.

Central banks are supposed to be stewards of our money, not creators of money. Historically they were able to limit the financial and economic damage of recessions. They were also to be independent but increasingly their role has been politicized tending to various vested interests. Lately they seem to be full of surprises from Zurich to Copenhagen and Ottawa with its decision to lower interest rates. The markets were shocked because until lately, central banks were reluctant to allow markets dictate the currency rate. We believe the Swiss move is a wake-up call for the complacent view that our central banks are always defending our interests. The Swiss move is simply part of the stealth currency war of competitive devaluations. Devaluations tend to boost exports and reduce imports to revive economic growth. Japan’s devaluation boosted exporters’ earnings after a 23 percent devaluation over one year. It is our view, that the consequence of this fiat currency war is the end of fixed exchange rates because of the failure to protect nations already choking on dollars. Devaluations are also ultimately inflationary. Investors have been warned.

Investors traditionally valued Swiss assets and in the past, these “hard” assets served as a refuge. However, that refuge with its credibility was eliminated. We believe the SNB action is a prelude to what will happen to the United States. The Fed’s balance sheet too exploded from $700 billion to a whopping $5 trillion, thanks to repeated rounds of QE that flooded the world with cheap dollars. Except this time because of its liquidity and reserve currency status, the dollar has soared with the money going into their stock market and real estate. The difference however is more than 50 percent of US debt is held by foreigners’ and a reversal would cause a sharp drop. Gold has moved up lately as investors tire of the printing press and volatile currencies. Gold protects investors whose currencies are losing lost global purchasing power. While gold was essential flat against the US dollar, gold outperformed eight other leading currencies last year. In fact, in loonies gold is within $300 of the old high. We believe that the Swiss reversal will prove to be a catalyst for gold to go to new highs as investors realize that fiat currencies do not protect assets. Also, markets have again learned that central bank promises are just rhetoric. QE was supposed to boost currencies but not surprisingly is a mechanism that pushed currencies down as the printing press worked overtime. Confidence in the central banks’ ability to steer the world’s economy is fading. The emperors have lost their clothes.

Instead markets should watch what central bankers do, not what they say. Russia and China both made headlines by snapping up enormous stocks of gold. The Netherlands and Germany are repatriating their gold and nineteen central banks bought gold last year. When the Swiss fixed their currency to the Euro, gold peaked at $1,940 an ounce and the euro and Swissie were at parity. Gold is up 85 percent in rubles.

Déjà vu

Markets today also have a distorted vision of reality, reinforced by the talking heads of the 24/7 news cycle, who seem to echo a one dimensional party line, most often found in emerging nations, but best describes the United States, where daily highs are celebrated by CNBC, Wall Street banks, and self congratulatory politicians. For example, the current groupthink is that falling crude prices will give a boost to the economy, and of course that big bad wolf, Russia is getting its own just desserts. And the economy is alive despite 47 million Americans on food stamps. Oh yes, the other myth is that China is slowing because growth is 7.4 percent, falling short of the 7.5 percent forecast a year earlier! All is well. Wrong.

No one however notices that the punch bowl has been taken away. Markets are to face staggeringly higher rates in 2015 and after years of money printing aka quantitative easing, the series of bubbles are slowly being deflated, one by one. First, gold, iron ore and now oil. The stock market bubble is set to tumble in a crisis of confidence. Ironically, Mr. Draghi after promising to “do whatever it takes” to get the economy going is following America, Britain and Japan on a programme of asset purchases. The euro will fall regardless. Central bankers acknowledge that while QE loaded the big banks with reserves, lending did not expand much. Also fixed income market yields were distorted as investors chased yields in a falling interest rate environment. Beggar thy neighbour devaluations are spreading globally as currencies race to the bottom.

Interest rates and currencies race to the bottom

In another case of déjà vu, the euro too is at its lowest level ever. Ireland, Italy and Portugal all have public debt to GDP ratios in excess of 125 percent. European growth is anemic. Rhetoric has not matched the reality. Greece faced yet another election and Greek shares plunged over fears of a Grexit, reminiscent of only four years ago. The reality is that Greece and the other Eurozone members only deferred their problems while their debt crept higher.

Central banks should be listened to but investors would be wise to follow their actions, not their rhetoric. The slump in oil prices, and easing of German inflation has prompted the European Central Bank to conjure new euros to buy bonds with newly minted money despite the lowest returns ever. The successive rounds of money creation are to be shoveled into the system. Negative interest rates exist in Switzerland, Germany and Japan reminiscent of the Great Depression. Money is not money any more. Sub-zero interest rates are the norm. We believe that sooner or later, there will be a need for money and rather than a mass produced fiat currency, capital will flow to that store of value that can be created without a push of the button.

Ironically, six years after the collapse of Lehman Brothers, the same conditions that triggered the financial crisis are in evidence today. One difference however is that while the private sector is recovering from a heavy debt load, the government sector has borrowed ever more, piling on debt to record levels using that credit to prop up anemic economies and prevent a global collapse. But that debt failed to revive the private sector despite Keynesian-style low interest rates. Instead that debt boosted the balance sheets of central banks. Little trickled down to the economy. The problem is that the debt is secured by the faith and credit of the respective sovereign balance sheets. In more distressed nations like Greece, Venezuela and even Russia this now becomes a problem. Gold anyone?

The Dollar Is No Longer As Good As…

QE created “helicopter” money to buy sovereign bonds which boosted the stock market driving down interest rates. The central bank experimentation with QE, resulted in bloated balance sheets loaded up with sovereign debt, junk bonds, derivatives and equities. They have become glorified hedge funds. The unwinding of the Fed’s humongous balance sheet, ignores the reality that the balance sheet is actually larger than the market itself and the unwinding of the world’s largest hedge fund will not be pain free. Fueled by the biggest monetary stimulus in the world, the US dollar has enjoyed a resurgence reaching levels of eleven years ago, built on the promise that a Fed-led economy will grow to the sky. Not. The strong US dollar makes it more expensive for foreign borrowers, raising the risk of defaults in some emerging countries. Leverage works both ways. We believe the dollar is about to be tested and will prove to be another casualty of this stealth currency war. While, Wall Street has recovered from the Lehman debacle, its reserves are still not large enough to absorb a similar Lehman-like implosion. And then there is Russia. The news stream from Russia is bad, battered by falling oil prices, sanctions and recession. Little is said of the financial exposure of the western banks, particularly Europe and the environment of interconnected derivatives.

Risk has been mispriced

Our belief is that that risk again has been mispriced by the markets. We believe strongly that the world economy has entered an especially dangerous phase. Interest rate volatility, dollar depreciation, balance sheet implosions are only a few of the undercurrents that we see. Markets are priced to perfection and have not discounted these problems, particularly when yields on sovereign debt are at negative rates. Little is paid for an increase in sovereign defaults or the fact that the high level of debt is only sustainable if interest rates are kept low. Worse yet, the market as mistaken the decline in yields as a descent into deflation. Wrong. It is disinflation that we should worry about. Disinflation is a prelude to high inflation. Rather the decline is due to the cheapening or debasement of the underlying currency – no one has given thought to the value or lack of value in a world that prints trillions every day. The geopolitical climate is equally worrisome, particularly when the decline in US financial hegemony is spurred by China and Russia who are using other currencies. The deliberate devaluations around the world is a stealth currency war that has come to a head. Not only was the Russian ruble cut in half but the Indonesian rupiah has traded at new lows. The European Central Bank’s round of asset purchases will drive down the euro. After nine years of gains, China’s renminbi has joined the currency war declining three percent against the greenback. And knowingly, the holders of more than 50 percent of America’s debt, have bought gold as a means to recycle their dollars in order to support their domestic growth.

Another problem is that the collapse in oil prices has raised risks in the world’s interconnected financial system. The world’s biggest banks possess some $250 trillion of energy exposure which are mismatched while leverage remains high. Russia’s central bank has already bailed out a midsized lender and the country faces a repeat of the late nineties when it defaulted on its obligations despite some $400 billion of foreign exchange reserves. Can the ruble go lower?

Gold is a beneficiary of Quantitative Easing

Meantime, gold is a safe haven amid concerns of weakening currencies. The stealth currency war removes the last shock absorber to the system. Gold is a barometer of investor anxiety. Today, the consequences of the oil collapse, renewed tensions in the Middle East, the unraveling of Russia and a repeat of the Eurozone crisis makes gold a much more compelling haven than the dollar. Gold is a beneficiary of quantitative easing and has risen before every round of QE. Seven years ago, the Fed’s unveiling of QE was a catalyst in gold’s torrid bull run. Gold is also a hedge against central banks’ penchant of unpredictability in a world of competitive devaluations and negative interest rates. No one, it seems, remembers that it was massive monetary accommodation and rampant speculation that led to the bubble whose bursting caused the Great Depression.

Gold has been in a trading range in the last year and a half after more than a decade of successive highs. In recent months, gold has recovered, recording a triple bottom at $1,140 last year. Bullion is up 9 percent this year. We believe the base building has been completed and gold’s about face will see the metal top $2,000 an ounce this year or double Goldman’s “pick the bottom” $1,000 forecast. Meantime mining stocks have bounced off from lows after $100 billion of asset writedowns. Many miners replaced their CEOs with cost cutting with a renewed emphasis on profitably becoming the new mantra. Last year more and more miners sought mergers. As a result gold miners’ market cap in situ reserves have fallen to less than $200 per ounce. And, some gold miners’ balance sheets remain stretched, having borrowed billions to finance poorly conceived acquisitions, which have since been written down. We expect the M&A activity to continue particularly among the juniors as investors shun the juniors. Consolidation is inevitable. The uptick in the gold price has allowed the industry to replace empty coffers and the circle of life begins. However, dilution will ultimately hurt this industry, again.

The dollar is the world’s currency. Unlike the Swiss Franc, it has yet to join the competitive devaluation currency war. However, like the Swiss Franc, events beyond its control can dictate the future because dollar holders have a vote. Because the US consumes much more than it produces and owes much more than they own aboard, the world is awash with dollars. However someday, that will change. Other central banks (Canada included) are weakening their currencies. Gold is an alternative investment to the dollar for these central banks – it is the newest old global currency in the world and a good index of currency fears. Gold’s bull market has just begun.

Recommendations

The current quarter was a mixed bag for the gold producers, however most all-in costs were lower. In addition there was little change in guidance but noteworthy was that the producers took advantage of the better gold price and added $1 billion to their treasuries yet again. Shareholders need not remind these producers that the last time that became serial diluters they financed over $100 billion worth of acquisitions which were subsequently writtendown. Gold miners should also remember that the product they produce can’t be printed with a push of a button, ergo the reason for its scarcity and value unlike the shares of the gold miners which is one of the reasons that investors relegated them to the bottom of the investing ladder. In fact, the herd-like investors would have been wiser to buy these names a few weeks ago and saved themselves at least 20 percent. Nonetheless, we continue to favour the gold stocks because of our belief that bullion has bottomed and the gold stocks are the best opportunities for 10 baggers in a volatile market. We continue the recommended heavyweight  Barrick Gold, Agnico Eagle Mines and Eldorado Gold. We also like the juniors McEwen Gold, and B2Gold, which is becoming an intermediate. Until their recent secondaries are digested by the market, we would avoid Yamana Gold, Detour Gold, Asanko Gold, Romarco and Richmont. Meantime, Goldcorp’s bid for Probe is just simply part of the M&A activity that we expect. Noteworthy, however is that Goldcorp paid slightly more than $100 per ounce of resource for a deposit that has yet to produce a PEA. Goldcorp’s aggressive move is a sign that the industry has not yet abandoned their free spending ways. Caveat emptor.

B2Gold Corp

B2Gold operates three mines (two in Nicaragua and one in the Philippines). B2Gold had a record quarter of 112,000 ounces with a big boost from Mastabe mine. Also Otjikoto in Namibia and was completed on budget and ahead of schedule. B2Gold produced 384,000 ounces last year and its guidance will be between 500,000 to 540,000 ounces with full contributions from Otjikoto and Mastabe mines. Importantly, cash operating costs are expected to be $630 per ounce to $660 per ounce range. B2Gold’s main La Libertad mine in Nicaragua produced a record. B2Gold has an excellent operating team and a pipeline of projects including recently acquired Fekola project in Mali which is a potential 300,000 ounce per year producer. Early construction is expected to begin in February and a feasibility study is in the works. B2Gold is an emerging mid-tier producer with an excellent pipeline. Buy.

Barrick Gold

The world’s largest gold producer’s shares have been under pressure in part due to the stale thinking of discounting the same event twice. In our opinion, the market has been lazy, forgetting or ignoring Barrick’s turnaround. John Thornton, the executive chairman has methodically checked off all the boxes that were the reason for Barrick’s shares to trade at a discount to its peers. In our opinion, Barrick’s problems have been solved. To be sure, the criticism of revolving executives, a cosy Board of Directors, delayed Pasqua Lama, stalled talks with Newmont and debt load have been adequately discounted and addressed. Also, the so-called flat growth criticism overlooks the Company’s push to boost profit margins and focus on profitability, which is frankly more important instead of growth for growth’s sake which almost sunk many of its peers. Barrick’s costs are the envy of the Street as well as the 100 million ounces of in situ resource which is valued at all-time low of $150 per ounce. Under John Thornton, Barrick has changed its board, streamlined management with technical expertise, reviewed every asset and divested of some, as well as reached out to China, the world’s largest consumer of Barrick’s products, all in less than one year. To be sure, there are further changes ahead. As for the Newmont merger, there is little question that such a combination should make sense, if not for the cost saving alone. However we believe that the logic of the deal combining of Nevada assets together with cost savings and potential spinoffs will more than both offset the resistance of Newmont’s Board. Barrick has an enviable array of first class assets. Acacia Mining (formerly African Barrick) produced 720,000 ounces and the turnaround under new management will serve as a cornerstone asset in Western Africa. The Street might complain about old problems, but we believe that this year they won’t complain about the results. We like Barrick here.

Centerra Gold Corp

Centerra Gold will produce almost 620,000 ounces last year at an all-in costs of $1,000 per ounce. However Centerra will produce 100,000 ounces less this year due to lower output from flagship Kumtor in Kyrgyz Republic. The good news is that all-in costs have shrunk. Centerra remains locked in negotiations with the Kyrgyz Republic government. Unfortunately these protracted negotiations have hurt Centerra shares and we do not see a near term resolution. Until there is a resolution, the tax regime and 2009 agreements remain in place. As such Centerra has looked at other acquisitions to be funded by a solid balance sheet of $400 million. We prefer other producers like Eldorado here.

Deter Gold Corp

Detour Gold reported mine rates increased to 214,000 tonnes per day in the last quarter up from 206,000 tonnes per day in the previous quarter. The key for Detour is to boost its mine rate and the better results are due to blast drilling productivity. In addition, Detour is expected to run the mill close to design capacity. With better ore grades, Detour should have a better year this year. Detour also issued $140 million of shares boosting its balance sheet. The Company had drawn down about $30 million from a $90 million facility. Capex will be slightly higher than last year but the cash position alleviates any balance sheet concerns. Detour owns 100% of the Detour Lake Gold mine in northern Ontario with over 16 million ounces of reserves. With only 20 percent of its ground explored, Detour has upside here.

Eldorado Gold Corp

Eldorado has operations and projects in five countries with seven operating mines. Eldorado produced 200,000 ounces at a low cash cost and met guidance at 790,000 ounces last year at all-in sustaining cost of less than $900 an ounce. Eldorado’s main drivers are Kisladag and Efemcukuru in Turkey. Guidance for this year was lowered by 15 percent due in part to the Kisladag Phase IV deferral. However, Eldorado has a pipeline of development projects and is the go-to-midcap because of its growth profile. However, the Greek uncertainties have put a cloud over the Greek operations despite progress at Skouries and Olympias. In China, Eldorado is still waiting for permitting at Eastern Dragon which is expected this year. Eldorado is toying with a spinoff of its Chinese assets which would be worthwhile to monetize. Eastern Dragon is a high grade deposit and Eldorado hopes to spend $35 million this year once the permit is given. We like the shares here. Eldorado has an excellent balance sheet of liquidity of $875 million including $562 million of cash.

Goldcorp Inc.

One of the fastest growing seniors, Goldcorp reported record production of almost 900,000 ounces in the fourth quarter resulting in a record 2.87 million ounces produced last year. Importantly, the all-in sustaining costs decreased to $950 per ounce. However, Goldcorp expects a 20 percent boost in output due to production from Cerro Negro and of course Eleonore which will contribute a full year of production this year. Goldcorp’s Cerro Negro mine, in Argentina, will likely result in a hefty writedown. Penasquito in Mexico was a disappointment but is expected to produce 250,000 more ounces this year. The Eleonore Mine in Quebec will produce 300,000 ounces this year offsetting the decline in flagship Campbell Red Lake in Ontario. Goldcorp has $540 million in cash and will spend $170 million this year. We believe Goldcorp’s $500 million purchase of Probe is rich but a long term solution to the expected winding down of Porcupine Mine, just 160 km away. Goldcorp’s bid was for paper, so it is a useful tuckin acquisition. We prefer Barrick at this time.

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John R. Ing

416-947-6040