Gold: Wall Street’s Lucre

Lu•cre: money, especially when regarded as sordid or distasteful or gained in a dishonorable way.

The shock of the Panama Papers rippled with sensational headlines involving over 100 politicians from Iceland, Russia, China, United Kingdom and Argentina amid allegations of illegal offshore accounts set up by Mossack Fonseca, a Panamanian law firm. A whopping 11.5 m leaked documents exposed collusion among some of the world’s largest law firms and more than 500 banks which helped their clients over a 40 year period to set up offshore structures. Panama is now known for more than the site of the canal or Noriega. To date a sustained global crackdown has closed former tax havens like Switzerland, Luxemburg, and Cyprus, ironically leaving America as the largest tax haven of choice because Nevada, South Dakota and Delaware do not have to disclose beneficial ownership of shell companies incorporated in their jurisdictions. How strange then, that among the Panama Papers’ 2.6 terabytes of data, there are so few US players.

Part of the reason is that populist governments, desperate for revenues to close their budgetary deficits are looking for ways to fund their existence in the wake of the 2008 financial crisis and subsequent recession. Politicians too have capitalized on the rising anger of voters unhappy with the idea of giving wealthy companies tax breaks. The release of millions of documents from Mossack Fonseca served as a lightning rod for public anger at the one percenters perceived to be using offshore structures to stash their cash. This newly created Black Swan attack has unsettled the stock markets crushing underlying players like the big hedge funds (inversions), corporate lawyers (Panama Papers) and big investment banks (billion dollar fines). No wonder the cost of insurance against defaults have skyrocketed.

More is now clear. The Panama Papers and tax inversion issue (or lack thereof) have become part of the White House’s Robin Hood policies of attacking big money, despite having the highest tax rate in the corporate world. The voters, street protesters in Europe and supporters of Trump/Sanders are mad as hell with the establishments’ inertia to keep their promises which have fueled a rage transcending political boundaries. And, institutions like their central banks are also under fire because most investors have no idea what central banks are really doing with their trillion dollar experiments.

The Tide Turns

Plenty of problems are in evidence. There is deep concern that America is mired in legislative gridlock, due primarily to partisan rivalry with the November election turning both parties into a mud-fest and the likelihood of an “open” convention. Oft promised tax, healthcare and social security reform were shelved. Most significant is that the Fed’s insatiable requirement for credit remains unfulfilled with a buyer strike of US Treasuries, led by the Chinese and offshore players who are balking at the negative returns. And, growth of the world’s second largest economy, is pegged at 6.5 percent, insufficient to pull other Asian countries along as worries continue that China’s pump priming will inflate already large bubbles. Yet, everyone misses that the sums owed are primarily to the government which has abundant lending room. And for those worried about capital shortfalls, the Chinese appetite for overseas assets (other than Treasuries) were at record highs in the first quarter reflecting China’s biggest export to date, cash.

Elsewhere, the refugee crisis has caused the European Union’s leaders anguish as voter hostility to immigration has caused a dip in political popularity in line with the increased social services expense. Then there was disappointment that “do whatever, it takes” Mario Draghi’s big bazooka fired yet another blank. Italy has unveiled an “Atlas” bank rescue fund too small to fix the problem. Both Italy and Greece are saddled with the heaviest public debts with Greece at almost 200 percent of GDP and the IMF has not yet extended the necessary loans for a third bailout. Problems remain. The UK Brexit referendum in June not only threatens the EU itself but its Schengen open border policy as well. These cans can’t be kicked down the road.

Topsy Turvy World

Against the backdrop of slow to nonexistent growth and awash in a red tide of debt, the Fed is reluctant to raise rates after increasing them a modest quarter point in December. Fed Chair Janet Yellen with little room to maneuver is reluctant to move rates amid mixed economic numbers as well as being seen to influence events in the shadow of a presidential election year. How did the Fed lose room to maneuver? The answer is rooted in Obama’s misguided economic policies. Repeatedly the US has spent more than they earned, borrowing trillions from abroad just to balance its books. And, Bernanke and now Yellen’s wholesale money-printing (aka debasement) has become the policy du jour. At 110 percent of GDP, America’s debt stands at $19 trillion, the largest in the world. Meantime, the market’s fear of stagflation has caused the markets to swoon.

We believe funding the largest debtor in the world will be a problem this year. While property bubbles eight years ago were deflated, they have inflated again as a consequence of over-easy monetary policies. Another boom (and bust) was fueled in part by overseas buyers. Ironically, homeowners blinded by cheap mortgages, loose lending standards, and greedy banks are due for another bust. Home prices have exceeded wage growth in nearly two-thirds of US markets. The average homeowner needs to spend 30 percent of monthly wages just to make monthly payments. Déjà vu.

And unlike Wall Street which had protection in the last bust, homeowners aren’t offered the same bailout. To be sure an increase in the cost of money would tip the economy into a recession. This housing recovery is built on sand. Instead, much of the Fed's intervention created cheap credit which benefited the financial engineers of Wall Street and its debt-financed M&A activity giving the White House an excellent opportunity to scapegoat business in an election year.

In this world of cheap credit, negative interest rates have produced a topsy-turvy world where debtors are paid to borrow. Savers are again penalized. What this means is that the underlying debt burden just mounts higher with increased volatility. Worrisome is that junk debt yields are estimated at 8.5 percent and the debt to asset ratios are creeping up led by leveraged energy stocks, recent M&A busts and share buybacks. Debt defaults have become a reality. Eight years ago the governments bailed out Wall Street. With empty government coffers, Cyprus and now Canada, have implemented a “bail-in” regime that leaves depositors with the bill. Not only must you pay the bank to hold your cash but it is at risk to bail out the very same institution. Gold is a good thing to have.

Gold Is The Ultimate Currency

Gold is a beneficiary of negative interest rates and its best performance in four decades is due more to haven buying on fears of fragile global growth exacerbated by our central banks’ lame attempts to revive the global economy, saddled with too much debt. After eight years of central bank intervention using unorthodox and experimental measures, our monetary maestros simply have run out of options. Gold gained 16 percent in the first quarter, reversing the three-year downtrend. A new bull market has just begun. Gold’s rise shows investors are nervous. There has been another reason for the rise in gold. Last year central banks purchased almost 500 tons of gold led by China and Russia. They remain big buyers with some repatriating their stores of gold moving their reserves “closer to home”. The year before, nineteen banks were net buyers of gold continuing a trend starting as far back as 2008. Yet their purchases have been largely price insensitive. China and Russia having more dollars than they want have become enormous purchasers of gold partly as a hedge against the currency debasement and inflationary consequences of the west’s central banks’ radical measures to revive the global economy. They also fear a collapse in the purchasing power of their dollar stocks. Instead of FX purchases, the gold purchases allow these central banks to hedge against a volatile greenback, lessening pressure on their own currencies and ironically, the inflation risk. Both countries have become the fifth and sixth largest holders, ahead of Switzerland, Japan, and Canada who sold its last ounce last year.

Gold is also a barometer of anxiety, and today there is much anxiety. The mighty metal is highly liquid and easily exchanged for other currencies. It's controlled supply serves as a limit for central banks from printing money, putting a cap on profligate government spending. Former Fed Chair, Alan Greenspan, once wrote that ‘without a gold standard in place, there is little to prevent governments indulging in wild credit creation.” The balance sheets of many central banks are stuffed with debt, so their gold holdings have become increasingly important. We believe their gold purchases and repatriation are part of the refashioning of the global monetary architecture, ending US financial hegemony. Of course, gold can go higher.

Recommendation

The history of the mining industry is that of a cyclical business with booms and busts. The problem is that three years ago, the boom caused a huge $70 plus billion debt burden as companies bought overpriced assets whose legacy weighed heavily on the mining industry's balance sheet. The hangover resulted in the industry being in a funk. Debt-heavy, the miners resorted to asset sales and debt restructuring last year, successfully reducing their AISC from $1,200 an ounce to $1,000 an ounce. Consequently, gold stocks have increased by some 60 percent since yearend and for a change, many are making a profit on every ounce produced. Some have emulated Barrick’s John Thornton “back to basic” strategies of debt reduction, free cash flow, asset sales and stringent cost control. Others have also bought back billions of dollars of debt. Barrick and Anglo recently completed $2.5 billion of bond repurchases. The buying back of debt levels is voluntary but it also means that during the next upswing, more money could be used rather than repaying debt, too bad governments don’t do the same. Goldcorp, it seems is about to begin the Barrick treatment. Still, others like Newmont and Iamgold with bloated overheads are harvesting their assets.

Since gold production is expected to be flat this year, M&A activity will remain popular since it remains cheaper to buy ounces on Bay Street than to explore. Peak gold has arrived. Single asset producers are becoming a rarity but we continue to expect more consolidation because of the dearth of capital for the single asset players. In our opinion larger, low-cost producers will attract money. Hit hard by the lack of capital, the industry will have to show they can mine gold at a profit. Even today, Kinross, Iamgold, and Yamana are expected to lose money. As such, we continue to recommend the senior producers with the greatest operating leverage, like Barrick and Agnico Eagle. Among the intermediate producers we like B2Gold and Eldorado for their production profile and, among the junior producers we favor McEwen Mining which has a solid production platform, strong balance sheet and its CEO owns 25 percent of the company.

Barrick Gold

The world’s largest gold producer, Barrick walked the talk and reduced its debt by $3 billion targeting another $2 billion debt reduction for 2016. The company flattened its management ranks and introduced a partnership culture. Margins were restored with an emphasis on free cash flow. Seventy percent of its production will come from core mines with AISC under $800 per ounce. Barrick will also grow organically highlighting four brownfield expansions including. Goldrush, the Cortez Hill underground expansion as well as Lagunas Norte which will cost about $2 billion to add one million ounces between 2018 and 2020. While Barrick has a core group of long-life world-class mines, it is also planning joint ventures. Potential asset sales include Acacia and Lumwana. We continue to favor Barrick as the go-to company with almost 92 million ounces of in-situ reserves and continues to be the most undervalued on a market per ounce of in-situ reserves basis. Buy.

Eldorado Gold Corp.

Eldorado shares have recovered partly on hopes of progress at Olympias after receiving the installation permit while Skouries in Greece remains suspended. Eldorado recorded a whopping $1.5 billion impairment on their Greek assets and, while the Street does not put much value on the Greek assets, Eldorado's flagship assets in Turkey and China have supported the stock here. Consequently, any progress in Greece would boost the shares. Meantime, Eldorado maintains a healthy balance sheet with almost $800 million of liquidity, sufficient to support its six operating mines which will produce almost 790,000 ounces at a $500 an ounce cash cost. Eldorado has almost 25 million ounces of in-situ reserves with a pipeline including Perama Hill and Skouries in Greece, Certe in Romania and Tocantinzinho in Brazil. We continue to like the shares here.

B2Gold Corp.

We continue to favour intermediate producer B2Gold now that the funding at Fekola in Mali has been satisfied with the recent deal. B2Gold has lowered costs at its Libertad mine in Nicaragua and Masbate in the Philippines. Otjikoto in Namibia which recently came on stream is expected to produce a steady 170,000 ounces per year. B2Gold also reduced cash costs to $665 per ounce. We like the shares here with a base of four mines with two in Nicaragua, one in Namibia and in the Philippines, plus Fekola which is scheduled to be in production in late 2017. We like B2Gold’s growth profile which will attract the Street’s attention now that its balance sheet is better able to handle the Fekola build-out. Buy

Kinross Gold Corp.

Kinross announced that it would begin Phase 1 at money-losing Tasiast in Mauritania at an advertised cost of $300 million. The first phase will result in a larger SAG mill, crusher and the addition of three tanks. Kinross plans to boost throughput from 8,000 ton to 12,000 ton per day but downplayed that it must also spend $429 million for stripping costs to get down to the higher grade orebody. If one includes the stripping costs, the AISC would be significantly higher plus those extra ounces are not expected until 2018. Kinross has taken a much more slower approach to extract some benefit from its ill-fated $7.1 billion acquisition. The Company’s Phase II which calls for a 30,000 ton per day facility but we do not expect Phase II until a much higher gold price given the fact that the IRR is only a modest 17 percent. We believe, the economics of Tasiast remains questionable and while Kinross’ shares have increased, we do not believe that Tasiast will bring much of a return. While Kinross paid up to acquire Bald Mountain and the other half of Round Mountain from Barrick, it balances its geographic exposure, lessening their overall Russian exposure. Nonetheless, at current levels we prefer B2Gold here.

Goldcorp Inc.

Goldcorp reported a large impairment loss of $4.2 billion, reducing reserves by a whopping 18 percent as well as surprising the Street, lowering production guidance. Newly minted CEO David Garofalo will have his hands full in prioritizing and cleaning up Goldcorp. There were continuing problems at Eleonore and the shelving of Borden undermines Goldcorp’s Ontario and Québec strategy. Goldcorp. also reduced its production guidance due to a 75 percent reduction of Los Filo’s mine life, a surprisingly slower ramp up at Eleonore and lower output at Red Lake now that Cochenour was relegated as an exploration project rather than development. It appears that the legacy of the $2 billion acquisition of Probe and Gold Eagle was overly optimistic and both deposits appear to lack the necessary continuity. There is a need for a new model - so much money with too few results. Given the likelihood of more shoes to drop, we prefer Barrick here.

New Gold Inc.

Intermediate gold producer, New Gold initiated a hedge putting a $1200 an ounce floor and a ceiling of $1400 an ounce on its portfolio of four mines, New Afton in Canada, Mesquite in the United State, Peak in Australia and Cerro San Pedro in Mexico. New Gold is completing the build out of long life Rainy River in Ontario with production planned for mid-2017. New Gold with cash and cash equivalents of $336 million plus $184 million undrawn revolver is sufficient for the build-out of Rainy River. New Gold also arranged a $75 million Rainy River stream. Future development programs include New Afton “C” zone and Blackwater to offset short-lived Peak Mines and Cerro San Pedro. With 15 million ounces of in-situ reserves and 85 percent located in Canada, New Gold has an attractive long-life profile. We like the shares.

John R. Ing

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