Gold: The Only Certainty Is Uncertainty

Too much has been written what Mr. Trump can or can't do. In his first days in office he ambitiously reshaped trade, healthcare, immigration and American law. Dodd Frank is next to be scrapped. And in disturbing everyone, the only certainty is uncertainty.

Trump’s “America first” policies of tax cuts, less regulations, infrastructure spending and building the Mexican wall will widen America’s budgetary deficits which could usher in the second of many rate increases by the Federal Reserve. Ironically a rate increase would lead to an even stronger dollar wiping out any possible advantage for Trump’s manufacturing proposals. Moreover, the multitude of conflicting Trump’s proposals on tariffs would certainly boost import prices, hurting his own constituency and aggravate his trade deficits, risking a worldwide trade war. And with the dollar rising to 14 year highs despite running up considerable trade deficits, he even started a war with the dollar bulls, signaling that the dollar is too strong. Since then the dollar has fallen for seven consecutive weeks of losses.

In less than a month, Mr. Trump has created wars on many fronts, sometimes with a stroke of the pen, others with a tweet. To his critics, of which there are many, he is reckless and dangerous. In fact, we believe the recent dollar correction is not because of his bully pulpit, but because of a growing Trump “uncertainty discount”.

In bypassing the media, his Executive Order photo-ops are vying with Press Secretary Sean Spicer’s daily press briefings as the ultimate reality show, leaving the country and the Democrats in a state of daily surprises. But the ramifications are all so real – ask the acting Attorney General who was fired. To be sure, Trump’s rise to power and his policies will have an impact on the global economy. However, the dilemma in the longer-term is that many of Mr. Trump's ad hoc solutions to the complex problems are actually non-solutions. The classic Trump trade then, is to buy gold.

Trump vs Yellen

Overlooked by Wall Street is a potential war with the Federal Reserve. The Federal Reserve was set for a series of three rate hikes this year in order to “normalize” and shrink its bloated $4.5 trillion balance sheet built up after a near decade of ultra-loose monetary policies, five times pre-crisis levels. However, such a move would tighten financial markets at a time when Trump’s programmes call for a boost in Treasury borrowing. Ominously, any unwinding would risk unleashing a hyper-style inflation because much of the trillions of cheap credit printed under successive quantitative easing programmes, remain trapped on the Fed’s balance sheet, as excess reserves.

We believe the first battle will be at the next FOMC meeting on March 14-15 but already, it appears that the Fed has backed down, causing the dollar to slip. While Mr. Trump has signaled that he wants investment to jumpstart the economy no one, including Trump has said how he is to pay for this. The Federal Reserve, on the other hand does not seem ready to finance or give the economy another fiscal stimulus boost. Trump may have won the first battle with his tweets, but there are rumblings that the next battle is over the appointment of a couple Federal Reserve appointees, setting up an inevitable clash with Janet Yellen, Chairwoman of the Fed. To be sure his fight with the Fed would make the Mexican conflict seem quite small. Gold again will be a good thing to have.

Watch What He Does, Not What He Says

As Tom Brady, the iconic quarterback of the New England Patriots showed, the best defenses are told to watch what he does, not where he feints. We believe Trump’s method behind the madness of his unorthodox positions are behind his tweets or surrogates’ statements and like Brady’s feints, are just diversions. It is his actions such as the cabinet appointment of experienced business types and not former government mandarins that will provide an entrepreneurial environment or his unflinching loyalty and appointments of his inner circle that are clues to the man. The rest might be just noise or feints. And, amid this chaos, his nominees have been confirmed and of the 20 or so Executive Orders, only one has been challenged by the courts. Meantime, under everyone’s radar, his party and cabinet are fashioning the biggest tax cut in history and while the Bannons and Conways attract fire, his appointees are pushing for regulatory reform ie cutbacks. And for the worrywarts, he has slowed down on Obama Care and stepped back from a confrontation with China. Fortunately despite the noise and war of words, he has shown by his actions that he is a deft chess player. To be sure, no one will test his red lines.

After Justice Gorsuch is confirmed, the Republicans will control all three branches of the federal government leaving the Democrats in opposition amid their internal backbiting, name calling and bitter partisanship; certainly not away to win elections. The US Constitution provided for the separation and thus independence of the three branches of government; legislative (Congress), judicial (courts) and executive (White House) with checks and balances. However, the forefathers never envisioned the growing polarization, politicization and partisanship on Capital Hill and the judiciary. Today, Mr. Trump signals a new era in US politics. The idea of an independent judiciary went out with the selection of jurists on ideological grounds. The Executive Orders that imposed the immigration ban was one of many by Trump but before him, the record holder was Mr. Obama and even Ronald Reagan conveniently used the orders to circumvent that second branch, Congress. Today the third branch, the judiciary has struck back. But dangerously he has initiated a war with the judiciary and another war with Congress threatening the ‘nuclear” option to bully Democrats to support his Supreme Court pick. His botched immigration ban shows that control and autonomy are not the same thing. In the art of deal, he learnt that like building his hotels, it will take “give and take”, and in overturning his immigration ban, a beginning of the separation of the three branches.

War And Peace

Of greater concern, there is the prospect of a full blown trade war. We simply can’t afford it. America is the superpower of the world with substantial natural resources but in the last forty years, evolved to become more of a consumption based economy. Emerging countries took advantage of America's markets, with China, Japan and India becoming the workshops for the world, generating of course a chronic global trade imbalance. However, not to be forgotten is the flipside benefit that allowed the US to be funded by those Asians, enabling Americans to consume more than they produce and live that “American Dream”. At best, their own American icons such as Apple, Walmart and GM benefited from the creation of global supply chains taking advantage of the arbitrage of lower labour costs. Then there are the vast integrated food, agriculture and auto supply chains benefitting North American consumers. That arbitrage yielded more employment at home and of course profits.

A trade war would collapse these intricate supply chains, hurting American consumers costing badly needed jobs. Trade is not a zero sum game. Yet it is not America’s trade deficits that determines their performance. US consumer spending has been the key driver which grew at a 2.5 percent clip resulting in a subpar 2 percent growth. The dilemma for everyone is that the global economy is slowing down, recording its slowest economic growth in five years and Trump’s policies or not, the US economy will slow down further.

Little wonder then, that without American markets, emerging countries will have to turn to other markets already exacerbated by Britain's Brexit, elections in France and Germany, and a festering Greek bailout crisis. Trump’s poke at Germany which enjoys a huge current account surplus of almost 9 percent of GDP, and suggesting theymake a bigger contribution to NATO was predictably met with a dour reception. Quietly, however Germany has repatriated almost 600 tonnes of gold from America and France in a move to better safeguard its reserves. However, of greater concern is France’s populist Marine Le Pen (Madame Frexit) threatening to renege on France’s debt which would amount to the largest sovereign default in history, surpassing Greek’s restructuring by 10 times which could cause the breakup of a weakened EU.

Deficits Must Be Financed

The US trade deficit reached half a trillion dollars last year and Trump faces obstacles including the strong dollar, the lack of national savings and a national debt at $20 trillion or 100 percent of GDP. Shaky demand overseas and the likelihood of another whopping budgetary deficit boosted by the largest tax cuts in history together with an increase in government spending will mean the twin deficits must be financed. Mr. Trump has accused America’s major trading partners, China, Japan and Germany of weakening their currencies to gain trade advantages, yet those same countries are asked to finance America’s debt. Problematic is that America continues to consume more than they produce and the new world order will make the world’s largest creditor beholden to its rivals.

The harsh reality is that Mr. Trump harkens back to the golden days when America became a great superpower initiated by the growth in the first half of the 20th century. The post war recovery from the Great Depression and the Second World War saw demand for America’s surplus manufacturing, food and other war related needs. Later the Vietnam War caused a surge in economic activity in the United States, which was reinforced by Lyndon Johnson's Great Society. Unfortunately, this period had to be financed and America soon faltered in the Seventies under the weight of near hyperinflation caused by the excessive printing of money which had to be ended by Volcker’s double digit interest rates. Again today, Americans believe they can have it all. However, America has underinvested in physical and human capital, becoming more of a consumption based economy. Those imbalances have caused a skewing in incomes and the rising inequality paved the way for the populism and election of Mr. Trump. Ironically in 2008, while Americans overwhelmingly opted for “change”, they never got it. Trump promised change and in delivering change everyone is screaming – or are they? Change has come, unpopular as it is.

Trump vs China

During Trump’s campaign it appeared that he was spoiling for a full blown trade war with inflammatory talk questioning China’s one China policy. In his first 100 days of election, Obama slapped a tax on Chinese tires but quickly dropped the tax when China countered. Of course, ramping up tensions, risks Chinese retaliation. Today, Apple phones and Boeings are likely targets. The bigger concern, however is that China stops financing America’s profligacy. China has imposed new regulations to staunch the outflow of cash moving offshore, including tightening approvals for foreign acquisitions, causing a shrinking market for the renminbi and raising rates to keep money in the country. China has even run down its behemoth foreign exchange reserve pool by a whopping trillion dollars, selling dollars aggressively to curb renminbi depreciation as well as purchasing huge supplies of gold as a currency hedge.

While only 2 percent of its vast foreign exchange hoard is in gold, China has stockpiled 1,833 tonnes of gold up from 600 tonnes in 2003 for a 200 percent increase making China the sixth largest holder in the world. China is the world’s largest producer and consumer, yet must import almost half of the world’s production to satisfy demand. We believe China’s moves are designed to reduce dollar exposure, knock currency speculators offside and importantly, build up an arsenal in anticipation of a potential trade war between the world’s two largest economies. While China and the United States appear to be on a collision course, it seems that the trade fight could be more of a re-establishment of the world order. Yet this time, Beijing has many cards to play.

Thus, Trump’s celebratory New Year phone call, albeit 11 days late to Mr. Xi Jinping and the reaffirmation of China’s One-China principle are steps in the right direction. Similarly, welcoming Japan’s Prime Minister Abe to a meeting and a round of golf and signalling 100 percent support for an ally is another positive sign that maybe the United States could share power, setting the stage for a peaceful negotiation of the potentially toxic trade irritants.

Geopolitically, a retreating America is highly destabilising. China by default would inherit the mantle. China has already filled the vacuum by taking up the cause of globalization using their domestic core markets as a base, allowing them to internalise their brands and markets. The result is a “state-owned” capitalism. At Davos, President Xi Jinping warned, without naming the US, about countries pursuing their narrow interests. Still China has strategic areas like gold and technology which are out of bounds to foreigners. Above all, China has been the major beneficiary of free-trade, supporting countries by financing the infrastructure they need. China today pays for Saudi Arabian and Russian oil in renminbi, bypassing the dollar. Ironically in pursuing its mercantilist policy, China has already filled the vacuum created by America’s retreat in Africa and parts of Latin America.

Today Mr. Xi’s “One Belt One Road” initiative will see trillions of infrastructure spending that will exert China’s growing political and economic influence among some 65 countries in Asia, the Middle East and Eastern Europe. China will also finance these entities through the China Development Bank, the Export Import Bank as well as the newly created Asian Infrastructure Bank (AIIB). Tellingly China's investments and new alliances would also offset the impact of a potential trade war with the US, ironically taking yet another page from America’s book.

Since the start of the year, gold is back in demand, rising 6 percent outperforming the major indices. It appears gold has taken on a Trump discount. We believe this Trump trade is a hedge against the possibility his presidency will be one of global disorder, pitting country against country, consumers against producers and debtors against creditors. Gold is also a hedge against the chance that the world central banks’ false solutions are again no better at boosting their economies than preventing high inflation. In addition, Trump’s tax cuts and spending programs will widen his deficits. Gold is a classic hedge as a store of value when two thirds of the world's assets are denominated in the fiat currency issued by a country whose authorities are taking policy actions which leads to debasement. Since 1973, gold has averaged 23 percent gains after the first year of the inauguration of a Republican president in contrast to only a 5 percent rise under Democrats. Money is no longer money in the central banks’ war against savers so the prospect of building an economy on gold certainly has serious luster now that gold has become an alternative investment to the dollar for many central banks. Gold is a good thing to have.

Recommendations

Gold has rebounded from the lows of $1,140 an ounce after reaching a peak at $1,940 an ounce, six years ago. Meantime jewellery demand tapered off in India but remains strong in China yet both countries still make up of 60 percent of demand. By contrast, investment demand surged with large purchases by ETFs. We continue to believe that the resumption of gold’s uptrend will see gold at $2,200 an ounce.

The dollar and gold are telling us that a perilous adjustment in currencies and economies lie ahead. Since the price peaked in 2011, miners have since written off tens of billion of dollars of investments and repaired their balance sheets. The latest quarter was a good quarter for miners with improved prices and free cash flow and despite flat production, they are making more profits per ounce. The producers seems to be operating from the same playbook of reduced spending, costs and debt. Barrick has again led the way with improved margins. Newmont is bringing on a couple mines to replace lost production from Indonesia. Agnico Eagle is midway through a growth profile that will see a boost in production and reserves. Cash costs for the miners will be at the lowest in years and free cash flow at their highest in years. We believe that over the next few quarters, the miners will announce growth in exploration and an emphasis on organic growth as they try to replace declining reserves. For the last two years, the industry has not replaced reserves. We continue to like Barrick, Agnico Eagle and in the mid tier B2Gold and Eldorado. McEwen Mining is favoured for organic growth. New Gold, Goldcorp and Detour Gold face execution problems and are not favoured here.

Agnico Eagle Mines

Agnico Eagle mines will report flat production for this year with higher production from LaRonde offsetting lower output from Lapa and flat output from Meadowbank. Agnico’s future growth will be around its Nunavut base with expansion from Meliadine and bringing on the Amaruq satellite deposit sometime in 2019. Agnico has eight operating mines in Canada, Finland and Mexico with one of the best managements in the business. Buy.

Barrick Gold Corp.

Barrick had a good quarter with a solid contribution from 420 million pounds of copper production. Gold production will be flat and the rumored sale of its 50 percent owned Kalgoorlie in Australia has been stalled as the Chinese buyer faces difficulty securing funding. Nonetheless there are other buyers and Barrick should be able to sell Kalgoorlie for more than $1 billion allowing it to easily meet its debt reduction target. In addition, African sub Acacia is rumored to be sold but financing and the tentativeness of the talks remain in doubt. Acacia is a higher cost mine and is considered a non-core holding. Meantime, Barrick continues to pay down debt and is now on a disciplined internal organic growth pattern with a particular emphasis on the Nevada core operations, Cortez and Goldstrike. Barrick is the largest producer in the world with some 16 operating mines and all in costs expected to be less than $700 an ounce by 2019. Despite the shares up more than 80 percent, we like the shares here for its future potential.

B2Gold

B2Gold reported mixed results at year-end but much attention will be on its next mine, Fekola in Mali which is ahead of schedule and could be in production late this year. B2Gold has one of the fastest growth profiles among the intermediate producers having brought Otjikoto into production last year. To date Fekola is 60 percent completed and financing is in hand. Buy.

New Gold Inc.

New Gold shocked the Street and reported that Rainy River is going to cost more than projected. New Gold is a Canadian gold producer with four operating mines but will spend a likely $1.2 billion to bring Rainy River into production which is almost 80 percent more than originally projected. New Gold’s balance sheet once pristine is now stretched. The company requires another $200 million to complete the project and sold a gold stream on El Morro to Goldcorp. Ramp up will be delayed by three months. Consequently, Chairman Randall Oliphant stepped down and the operating team was beefed up to bring this mine into production. Execution is key here but New Gold has lost its sheen and investors will adopt a wait and see attitude.

Newmont Mining Corp.

Newmont has brought on Long Canyon in Nevada and the Merian mine which will add almost 300,000 ounces to Newmont's book. Still, the world's second largest gold producer will report flat production but a solid balance sheet and abundant free cash flow from 5 million ounces make the shares an attractive hold. The sale of Batu Hijau reduces geographic risk.

McEwen Mining Inc.

McEwen Mining met its guidance with output at almost 146,000 ounces, down from 155,000 ounces a year earlier. McEwen has plans to bring on Gold Bar in Nevada now that regulatory hassles will be less under the new administration. Gold Bar will produce 65,000 ounces annually at a cash cost of $700 per ounce, after spending $60 million for the heap leach project. McEwen has also consolidated his holdings by taking in Lexam VG Gold for its Timmins gold properties. McEwen Mining has a solid balance sheet with almost $70 million in cash. We like the shares here.

John R. Ing

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