Gold Price: The Long Good-bye

The world is topsy turvy. One branch of the State borrows money from another branch of the State and everyone cheers madly. Does this accounting fraud describe the Greek version of Peter paying Paul? No, it is the current policy du jour called quantitative easing (QE) of which our central bankers are now hopelessly addicted. To pay for their government’s spending and deficits, central banks simultaneously printed money in massive amounts using different mechanisms to sterilise that money so it wouldn’t be inflationary. However, the rounds and rounds of quantitative easing have worked through asset prices rather than real investment and the resultant imbalances and expectations of unwinding the huge sums accumulated through bond purchases have caused a dramatic erosion of the credit quality of both consumer and governments.

Today central banks have become part of the problem. As handmaidens of our politicians, they created huge amounts of money debt which gave a false sense of prosperity with every round of money printing. Easy money inflated a series of paper asset bubbles pushing up the prices of stocks, bonds, homes, classic cars, and Picassos. Quantitative easing is without historic precedent and has led to a compression of yields, squeezed investment returns and pushed investors to take on more risk in the search of yield. Risk costs nothing today. Unfortunately, the central banks’ policies have led to the same preconditions that sparked the last financial meltdown. However this time, the central banks are the protagonists and rather than the lax bank lending that led to the last implosion, the economy is kept afloat by ultralow interest rates. When rates rise, as inevitably they will - the burst bubble will impact the entire financial sector, not just housing.

Maison Placements Canada

Shifting Sands, Dictate Change

The problem is that even today countries around the world are awash in debt, raising the spectre of yet another financial crisis eclipsing the 2008-2009 period. Economic growth remains moribund. In the US, first quarter growth was a meagre 0.02% despite three rounds of quantitative easing made worse by a deteriorating financial situation where debt is 100 percent of GDP. What ballasts the American financial system is debt, and its weight is palpable. Europe surprisingly looks more appealing despite the likelihood of a Greek default already factored in everyone’s thinking. Noteworthy is that the repercussions will be made worse since the rest of the world particularly the West, is hopelessly in the red, only seven years after the last global meltdown. Everyone seems to be binging on debt because money is nominally “free”. Today over half of the world has negative interest rates. Central banks are using zero interest rates as a subsidy and a way to debase currencies in a race to the bottom, reminiscent of the Great Depression period. And worse, policymakers seem paralyzed to do anything about it, satisfied with the gamble to rely on this experimental quantitative easing.

But soon the party may be coming to an end, and the clean-up could be messy. On a global basis, the shifting sands between bonds, currencies and equities have changed with bond markets falling out of bed. Trillions are at risk and, following a rise in rates in the United States, yields on French, Italian and other European debt, skyrocketed to two year highs. Ten year German debt, the benchmark for European rates quadrupled in days wiping out three months of gains. In the past few weeks, investors around the world were caught off guard by one of the worst bond crashes since the 2008-2009 crisis. We believe the markets have finally objected to the central banks’ prolificacy. We also believe the move is a reflection of the rebalancing of risk. Investors are simply demanding more.

Green Shoots of Inflation

How did these central banks lose room to manoeuvre? What else can they do? What would happen when these same central bankers need to stimulate the economy when they have used up their traditional policy arrow of lower rates? The answer is rooted in the central banks’ misguided experimental policy of subsidizing interest rates. Bond markets no longer have the capacity to behave rationally, given the distortion of risk which has been exacerbated by the central banks and high frequency traders’ spoofing. Investors are simply sceptical about the integrity of the bond market which has lately been overshadowed by the “race to the bottom” currency war.

And inflation? The turning point has arrived with deflation relegated to the dust bin. The green shoots of inflation are now appearing, spreading from hard assets (paintings anyone?) to labour rates. And now there are large gaps in the labour markets (remember cost-push inflation?). Wal-Mart, TJ Maxx and Ross Stores have increased wages in response to mounting wage pressures.

Los Angeles has increased the minimum wage. Food prices have edged up, thanks to the California drought. Over the past two months, oil prices have rebounded by thirty percent. Inflation is a dynamic animal, fed today by the trillions looking for a home. Gold anyone?

The systemic financial crisis of 2008-2009 was caused by overleverage, booming stock markets and “a made in Wall Street” derivative implosion. A major cause was the scrapping of the Glass-Steagall Act by President Clinton. Eight years after scrapping Glass-Steagall, Wall Street’s alchemy almost sank their creators. The government itself eased lending standards in order to reduce down payments so that everyone could have a house. Subprime mortgages and other derivatives were “sliced and diced”, then sold to unwitting investors. The government’s main players such as Fannie Mae and Freddie Mac aided and abetted the banks and needed a government bailout after buying the subprime mortgage packages from Wall Street. Between 2007 to 2009 the Fed provided some $13 trillion to bailout just three banks (Citigroup, Morgan Stanley and Merrill Lynch). Government owned Fannie Mae and Freddy Mac are bigger and more bloated as well as Morgan and Citigroup.

Coup D’état by Governments

America’s Fed again is headed down a familiar path, pursuing the same approach that helped set the stage for the last financial meltdown. Its balance sheet has increased five-fold since the meltdown. And consider that all this is being foisted on the same taxpayers who provided billions for the last bailout. Since the crisis, Wall Street naturally became a convenient scapegoat. Congress stepped in after being silent for so long, passing the Volcker Rule to prevent the next financial crisis. Introduced to unscramble the dismantling of the Glass-Steagall Act, the Volcker Rule unwittingly allowed US financial institutions to buy US treasury debt but not the debt of other governments in a round of subtle protectionism. Banks were induced to hold more equity. Yet none of this was a factor in the 2008-2009 financial crisis. Today the sheer complexity of modern finance rules have added to risk including over-regulation like the 2,300 page Dodd-Frank financial reform act enacted in 2010. Ironically there are freer markets in China than in the centre of the capitalist world. Perversely had Dodd-Frank been in existence, the financial meltdown would have happened anyways. It was the lack of regulation over the shadow banking system’s derivatives which played a major role in the 2008 crisis.

Markets have experienced a coup d’état by governments following the global meltdown where policymakers have introduced more and more regulations under the guise of protecting investors. And yet, institutions have become so big that some are classified as just “too big to fail”. Actual reform hasn’t happened. Capitalism is under threat. As governments wield enormous powers under the guise of protecting investors, they have brought in more regulations and of course, billion dollar fines, threatening the once innovative financial infrastructure. Who is to bailout the government this time?

Move Over US Dollar

For centuries, the world economic powers adhered to a system of fixed exchange rates but at the turn of the last century was forced to abandon them when some nations spent more than they produced. After Bretton Woods, currencies were allowed to float against the dollar under the premise that market forces would determine exchange rates. The dollar became the world’s currency. Then in the seventies, the benchmark US dollar came under pressure and America went off the gold standard. Reform didn’t last long. In the nineties, the Asian crisis saw much suffering as a consequence of the floating currency. Today, the reverse has happened. While the US dollar has become a safehaven, it recently lost and regained four percent in weeks as countries were forced again to grapple with currencies in motion. Today some are concerned about the excess of dollars and the integrity of the massive sovereign debts such that some nations are looking for alternatives and ironically there is talk of a return to a fixed environment. Therein lies the appeal of gold, which unlike the dollar cannot be printed with the click of a mouse. Last year, nineteen central banks purchased gold with some repatriating their gold for security reasons. Austria recently repatriated 110 tonnes, following Germany’s 120 tonnes and the Netherlands repatriation of 122 tonnes, last year.

China too, like other trading nations, has a big stake in this fiscal free-for-all with over $1 trillion parked in US treasury debt. Conversely, China resents America’s financial hegemony and is pushing for a more multipolar world order. China has reduced its dependency on the dollar by cutting back its stockpile and instead is using the renminbi to amass physical assets around the globe. Equally important, Beijing has taken major steps to liberalize its capital markets. Last year it introduced the Shanghai-Hong Kong Stock Connect, which allows mainland investors to buy stocks in Hong Kong while allowing global investors to buy selected mainland companies using the renminbi, of course. This program boosted volumes both ways with Chinese and Hong Kong markets recording daily highs since.

Chinese Gold Standard?

The upcoming five year review of the International Monetary Fund’s Special Drawing Rights (SDR) basket will formally be placed on the IMF agenda in October. This summer, China will be part of the negotiations to include the renminbi in a basket of the IMF’s defacto currency alongside the dollar, the yen, the euro and sterling. The move that would see it recognized as an official reserve currency is more than symbolic, it is a major step in making the renminbi more liquid since it would trigger a reallocation of investors’ global portfolios. China has liberalized restrictions as part of that process, such as removing the administrative cap on bank deposit rates to outsiders and lessening restrictions on inflows into its fixed income market. China has also swiftly removed capital controls with some thirty central banks. Beijing sponsored institutions like the Asian Infrastructure Investment Bank (AIIB) with 57 founding member countries and CIC were set up in part to offset Western hegemonic institutions.

Importantly the renminbi has been one of the few currencies to hold its value against the dollar. The United States is the largest holder of gold in the world at 8,100 tonnes but the holding is pale in comparison to their indebtedness. Currently the US dollar makes up almost 63 percent of the world central bank holdings while the Euro is at 22 percent.

Standing in China’s way is the lack of sufficient gold reserves at only 1.1 percent of reserves according to the last update in 2009. We believe that China’s current and seemingly insatiable purchases of gold is a key part of a move to make the renminbi an international currency and attractive as a store of value. Making the renminbi a reserve currency would require China to disclose its gold holdings which is a paltry 1,059 tonnes. In fact, for China to hold just 10 percent of its reserves in gold, equivalent to other industrialised countries’ holdings, China would need to purchase the next three year’s world output. Bloomberg has estimated that China has already tripled their reserves. China remains the largest producer and consumer of gold, importing 410 tonnes in the first two months of this year alone. Chinese and Indian consumer demand make up more than half of global consumer demand, according to the World Gold Council. China needs a lot more gold. The Shanghai Gold Exchange (SGE) has already overshadowed Comex with some 50 tonnes delivered in only one week. As a potential source for gold, China has created a $16 billion gold investment fund through the country’s Shanghai Gold Exchange with some 60 member countries to fund gold mining projects across the Silk Road as part of China’s golden agenda.

Recommendations

If China questions the US and its currency, then others too may have doubts. What damages trust in the United States, damages the world. After the financial meltdown, investors wonder who they can trust. We believe foreign investors have become more and more cautious about financing America’s profligacy, particularly at nominal rates. The recent bond crash is a warning signal. Another is gold’s breakout and quadruple bottom. Gold is an alternative investment to the dollar. It is a store of value when everything else seems risky. We believe that gold’s inevitable breakout from its trading range will be the most important global movement in the current decade.

Demand among central banks remains high. The World Gold Council reported quarterly demand increasing 16 percent over 12 months. Meantime the gold producers reported a mixed quarter due to the difficulty of making money at current prices. After cutting costs and focusing on generating free cash flow by reducing exploration and sustaining capital, even high grading appears to have reached its limits. Gold mines have bottomed.

To be sure a barbell approach has opened up between the best and worst performing gold producers. Companies with low costs, including Barrick, Agnico Eagle, B2 Gold and Eldorado continue to be favoured. Barrick sold Cowal at a premium and 50 percent of PNG to Zijin and is well on the way to its targeted $3 billion debt repayment. Higher cost mines such as Yamana Gold, IAMGold, Kinross and now Goldcorp are on the other end and have lately underperformed. We believe portfolio managers must be more selective with an emphasis on low costs, long lives, cheap valuations and an executable pipeline of development prospects. Further we continue to believe as new discoveries dwindle, merger and acquisitions will become more attractive because producers must eventually replace diminishing reserves. However, with the low hanging fruit picked, there are in our opinion, too few plums out there, particularly under the current low price environment. Within that group there are a number of projects worth watching. Among that group we would include Asanko Gold., St. Andrew’s Taylor, B2Gold’s Fekola or Lundin’s Fruta del Norte gold deposit in Ecuador.

Companies

Agnico Eagle Mines Ltd.

Agnico had a strong quarter, beating analysts’ estimates due in part to a dramatic reduction in all-in costs and higher throughput from Goldex and La India contributions plus better grades at Pinos Altos in Mexico. Agnico has a growing production profile with a strong contribution from fifty percent owned Canadian Malartic. In addition, the company update on Amaruq in Nunavut will lengthen Meadowbank’s life. Agnico’s balance sheet is always conservative and we like management’s ability to execute. Agnico paid down debt by $100 million in the last quarter. We recommend the shares here.

B2Gold Corp

Canadian-based B2Gold announced first quarter results in line with expectations including a contribution from Otjikoto. The Company also announced a $350 million credit facility which will be used to repay the company’s existing $200 million facility. The facility comes at a time when B2Gold is funding Fekola in Mali which is to pour its first gold bar in late 2017. Commercial production was declared in February at Otjikoto in Nambia and an expansion planned in September will result in increased production of approximately 200,000 ounces in the year after. The Fekola feasibility study will be released in June. Road construction began in February and this project should produce 300,000 ounces in the first year of production enabling B2Gold to produce almost one million ounces by 2018. Meanwhile production was better than expectations at B2Gold’s Masbate mine, producing 46,000 ounces in the quarter. A long term mine plan at La Libertad is also expected. We like B2Gold here for its rising production profile and with the recently signed revolving credit facility, B2Gold has a balance sheet capable of financing its ambitious plans.

Detour Gold Corp.

Detour had a strong quarter at 100 percent owned Detour Lake gold project in northeastern Ontario with gold production at 106,000 ounces for an all-in cost of $925 an ounce. The production ramp up continues with mining rates slowly improving. Grade is improving. Milling rates should be better in the current quarter after being impacted by cold weather and temporary operating problems. In the first quarter, mill throughput rates averaged 48,000 tpd including a month at design capacity of almost 59,000 tpd. Detour managed to repay about $124 million of debt. Nonetheless, Company reported a loss due in in part to noncash items. Cash at the end of the quarter was $118 million and Detour’s guidance remains unchanged between 475,000 and 525,000 ounces this year. Of interest is that the company will spend $8 million on 30,000 metre drilling program at Lower Detour. Over 80 percent of Detours’ ground remains unexplored so the Company has a lot of blue sky. We like the shares here, particularly since the teething problems are behind them.

Eldorado Gold Corp.

Eldorado reported a flat quarter of 189,000 ounces at an average cash cost at $521 an ounce and all-in cost of $729 an ounce. Eldorado’s six operating mines’ guidance is for 640,000 -700,000 ounces at all-in cash cost under $1,000 per ounce. Eldorado continues to spend on the Skouries development in northern Greece notwithstanding a lack of go ahead from the government. It also announced a positive feasibility on Certej in Romania. Eldorado’s flagship Kisladag operations in Turkey performed well with production at 79,256 ounces or 18.percent higher over than a year earlier. However at Efemcukuru, production was down 21 percent to 21,000 ounces due to weather conditions. Nonetheless the Company is on track to reach production guidance.

Eldorado has $450 million invested to date in developing Skouries and Olympias in the Halkidiki district in Greece and although Eldorado is one of the largest investors in Greece, the Company is stymied by the governments’ intransigence as far as permits. We expect the Greek government will give the go ahead notwithstanding the politics. Eldorado plans to spend $310 million at Skouries and at Olympias. While the geopolitical headwinds continue, Eldorado’s solid cornerstone mines and $870 million of liquidity remains its strength. Eastern Dragon approval is still pending in China and the go ahead remains up in the air. Still, Eldorado’s mines are long life (20 plus years), low cost and with a rising production profile, the shares are a buy here.

Goldcorp Inc.

Goldcorp missed analysts’ forecasts due in part to higher taxes, elevated capex spending plus the need to pay a healthy dividend. Also, a slower production ramp-up at Cerro Negro in Argentina and Eleonore in Quebec worried investors. At Eleonore, first quarter output was only 32,500 ounces but should pick up in subsequent quarters as better grades are expected. Investors are also concerned about Goldcorp’s balance sheet and the need to spend more money at flagship Penasquito in Mexico to extend that mine’s life. Finally the balance sheet appears constrained by the healthy dividend and capex of $1.4 billion this year. Cash on hand went down $117 million in the quarter. Production of gold, silver and copper was also lower year over year. At Eleonore, the production shaft was at 1,140 metres and ramp reached a depth of 887 metres. Finally, we are concerned over the handsome price for Borden deposit without a PEA. A bright note was that Red Lake production was up, but that was offset by a decline in production at Porcupine and Musselwhite. At Cochenour, the decline was 82 percent completed. It is the deteriorating balance sheet together with sizeable capex plans that are bothering investors. We prefer to invest in Barrick here.

Kinross Gold Corp.

Kinross’ results were in line with expectations due to a solid production from Kupol and Dvoinoye in Russia. Ironically, it is Kinross’ Russian exposure concerning investors because of the geographic risk. Kupol is a major contributor to Kinross cash flow, Maricunga milling was suspended. Kinross has also pared capex so its balance sheet has improved. There is speculation that Kinross may make an acquisition but we think that management is still fixing yesterday’s problems. We would avoid the shares here.

IAMGold Inc.

IAMGold is a mid-tier producer with four operating mines on three continents. IAMGold’s results were more or less in line with expectations although newly opened Westwood’s mine was a disappointment. Westwood is in the early part of a ramp-up and thus improvement is expected later this year. Of course, IAMGold has not been able to replace the solid contribution from Niobec which was sold. However, IAMGold’s balance sheet with $900 million of liquidity is strong but investors are very concerned that management will blow the bundle like they blew the last acquisition. Reserves were down 15 percent calculated at $1,300 per ounce. Essakane in Burkino Fasso has a 10 year mine life. Rosebel is in harvest mode. We would avoid the shares here.

Newmont Mining Corporation

The world’s second largest miner, Newmont had a solid quarter that exceeded analysts’ expectations due more to reduced capex. Strong contributors were Batu Hijau, Yanacocha and Twin Creeks. However, the Turf Vent shaft will add 100,000 ounces and Merian in Suriname will not come on stream until next year, so Newmont has very little to show. Newmont’s balance sheet remains strong with excess free cash flow in the quarter allowing them to pay down debt. Newmont’s guidance is between 4.6 million and 4.9 million ounces and unlike Goldcorp, the Company can continue a solid dividend policy. Newmont has a healthy exposure to the Asia Pacific area offset in part to its healthy exposure to Africa. We believe that despite the healthy

balance sheet, Newmont has very little on the horizon. Newmont cannot continue to defer spending, since it must replace reserves sometime. A merger with Barrick still makes sense.

Yamana Gold Inc.

Yamana’s results were disappointing with newly created subsidiary Brio Gold hurting results. Brio Gold only produced 31,000 ounces but its exceptionally high cash cost is making the eventual go public route suitable only when gold gets to be toppy. Jacobina and Mercedes were better with a 68,000 ounce contribution from 50 percent owned Canadian Malartic. Yamana is still rearranging its assets and the El Penon mine in Chile continues to be a crown jewel with increased silver output. Yamana did a heavily dilutive equity issue to reduce debt incurred from the Canadian Malartic acquisition. Management’s problem is that the other assets are just so-so and like others, in a harvest mode. We would avoid the shares here.

John R. Ing

416-947-6040