Geopolitical Games Of Chance

A geopolitical game of chance seems to have dragged the investing world back into the mire. The current boom was in response or consequence of the series of quantitative easing and loose monetary policies adopted to escape the 2008 financial crash. The flood of capital pushed rates to negative yields with the price of stocks and bonds having risen dramatically to nosebleed levels. Sovereign credits became the new borrowers. However, the tables have turned. Geopolitical games are heralding a new era involving the rise of nationalism, territorial acquisitions, sectarian conflicts and a crisis of capitalism.

Specifically, geopolitical games of chance are being played out in the Middle East. We believe the series of deadly attacks in Paris and Mali have increased investing risk and a source of turbulence in our financial markets. Allies have become enemies, while enemies have become allies. In its struggle against terrorism after 9/11, the West and Russia, former pariah, has cozied up to Iran, a former axis of evil member but today the new found ally of America. Both are pushing to keep Assad in Syria and Russia is hoping to enlist Iran’s aid to fight in this multi-sided war to counter the Islamic State (IS) militants, the common enemy of the West. Syria has become the linchpin.

Mr. Assad and Iran are Shiites and both are deeply distrusted by the Sunnis whose territory was lost to the radical Islamic State. The ongoing sectarian struggle between Sunni and Shiites is overlain by the clash between America and Russia and the rivalry of the regional powers like the Sunni backed Saudi Arabia, the Kurds and Turkey who appear to have conflicting agendas and eliminating IS is not at the top of their list. Yet the longer the fighting in Syria goes on, the more it will fuel the radicalism now being fought in our own backyards. In joining the fight, Russia has increased its influence in the Middle East, filling the power vacuum left by Mr. Obama’s tepid response and reluctance to cross even his own red lines. Ironically, in building its own coalition against the Islamic State, enlisting America’s long standing allies from Saudi Arabia, Jordan to Israel – the path of peace passes through Moscow, not Washington. Left aside and ignored of course are Russia’s Catherine the Great ambitions, Mr. Assad’s tenure and Iran’s centrifuges.

What if sometime next year the consequence of the Middle East problems would be a rebound in oil prices? Russia, with the help of new found ally, Saudi Arabia is the world’s largest exporter could try to boost oil prices in a quid pro quo realignment. The oil price is global and the Middle East produces one of every three barrels of seaborne crude. After year and a half of engineering the price collapse, with budgets written in red ink and pressures to maintain government spending, OPEC is believed to want higher prices now that production outside the cartel has fallen. Russia and the Saudis are the top oil supplier to China and their burgeoning ties further isolates the West. Long an opponent of higher prices, America, the world’s largest consumer of oil could be left out in the cold as the Russians, Iran and Saudis change Middle East dynamics and oil prices. At a minimum, the Middle East was become a major destabilizing influence again.

Mighty Middle Kingdom

Another geopolitical concern that could change the risk equation is China, which was supposed to lead the global economy up, not down. China is set to grow at its slowest pace in 25 years but at near 7 percent will still outpace the West’s tepid 2 percent growth. The losers of course are those with close trade links to China, like Australia, Canada, Japan and the US. Ironically, those same players are signatories to the Trans Pacific Partnership (TPP) which created a free trade zone among 12 countries around the Pacific, excluding that elephant in the room – China. China in turn cut a free trade agreement with Australia even before the ink was dry on the TPP trade pact. China’s push also reduced trade barriers, tariffs and has even reformed its state owned enterprises (SOE). Further in an address before 16 central and eastern European countries, Premier Li Keqiang said China is looking to invest more than $1 trillion overseas and import more than $10 trillion in commodities, over the next five years.

We believe China’s economic muscle and the infrastructure “One Belt One Road” plan will spur growth despite much handwringing in the West. China’s ambitious “Marshall Plan” links some 64 countries along China’s ancient trade routes financed in part by Chinese financial institutions like the China Development Bank and $40 billion Silk Road Fund. And China’s emerging middle class saw “Singles Day” shoppers spend a record $10 billion, surpassing America’s Black Friday sales in the first hour alone. And, while China’s devaluation surprised many, the move to market forces lessens its dollar dependency and is part of the uncoupling between the US and the world’s second largest economy.

Promoting the internationalization of the renminbi is a key element of China’s intentions to influence the global financial system. The International Monetary Fund’s (IMF) inclusion of the renminbi to the SDR basket gives a higher weight than either the Japanese yen or British pound and is a major part in making the renminbi the key vehicle for investment in assets linked to China. The move also elevates the renminbi alongside the US dollar, yen, sterling and the euro, confirming the “redback” as a liquid investment in which central banks can safely park their wealth.

Of concern is a slowing China is akin to the tail wagging the dog, particularly when the US suffers from stagnation, political dysfunction and the need to refinance a mammoth debt load. China is the latest entrant to join the world currency war, with the renminbi falling to five year lows against the dollar. China is divesting its dollar hoards in favour of piling up commodities and gold. What if China and others dump the dollars of debt dependant players like the United States?

Rates will go up. Definitely. Maybe.

What if US debt is no longer risk free? The Paris attacks saw the dollar move up and even outpaced gold as investors sought liquidity. The safety of numbers from quantitative easing and America’s deficit spending created a deep pool of dollars whose liquidity is unparalleled. Supply it seems is infinite. Or is it?

The Fed and others have pushed the return on cash to zero. After stumbling with a tepid rate reduction, Mr. Draghi, President of the European Central Bank, fueled the global market by doubling down his “whatever it takes” promise with “QE is here to stay”. In Switzerland, you actually pay to hold cash where interest rates are negative.

Money has become too cheap, having been debased by supportive central bank policies which pushed rates to historic lows. The US financial system is choking on debt made worse by an older demographic population. In the Seventies, total non-financial debt (corporate, government and individuals) was 140 percent of GDP. Today it stands at 250 percent. As a result, the bond and stock market are overpriced and risky at a time when there is zero premium paid for risk. As in 2007, Wall Street again is more interested in the rewards, rather than risk, making big leveraged bets on the next best thing, ETFs instead of sub-prime mortgages. Wall Street has slipped into old habits. And of course, our politicians in an election year have stoked a “them versus us”, endangering capitalism itself.

Debt still builds higher. In 1984 the US alone once was a creditor at $33 billion. Today, the US owes $18.5 trillion over 100 percent of GDP, much of it to China. Since 2007, the Federal Reserve has created more than $5 trillion from the thinnest of air. Moreover the world’s biggest borrower needs “artificially” low rates to service its exorbitant debt. Still the greenback has risen 6 percent since mid-October on expectations that after 10 years, the Fed will finally raise rates on December 17. We believe the well-advertised is already priced in the market, including the next hike. The market has already moved. When Draghi moved less than expected, the bond market sold off and the euro strengthened, not weakened.

The rate increase will not be in response to a pickup in core inflation, nor a series of news suggesting a rip roaring economic recovery. Instead economic data remains a mixed bag, particularly when Zimbabwe’s economy will grow faster than the United States next year. While some believe this rate increase is a return to “normalized” rates as symbolism, we believe the rate increase and the next to come reflects a desperate need to finance America’s chronic deficits now that foreign money like the Chinese have balked at financing America’s profligacy.

Our view is that supply will be constrained, beginning December 17, 2015. The swamp is draining. China is running down its stockpile of dollars to stabilize the renminbi and buy gold. Russia, Brazil and Taiwan are also dumping US government debt with the Middle East oil players running down their reserves to pay bills with 50 cent dollars. Offerings are piling up. The big sovereign pension funds have shifted into property, cashing their low yielding treasuries. Money has shifted from the sterile capital reserves into the real world and soon those funds will fuel the inflationary fires as those trillions seek a home. Global real estate properties are already flashing an alert. Eventually the laws of physics will prevail and the excess supply of dollars will erode its value. Then the loss of confidence in the Fed will cause everyone to look for an exit at the same time causing a rush into gold just as swiftly. Caution is in order when risk picks up.

Buy On Mystery, Sell On History

But it is the inverse relationship between the dollar and the reaction of the world’s central banks that make gold an attractive bet. Gold is trading at six year lows due to the market’s complacency. Between 2004 and 2006, the Fed raised the federal fund rate 17 times in a row to 5 percent. However, during that same period, gold increased 50 percent. Although, we believe, the first rate increase in 10 years is unlikely to match previous periods because of the precarious recovery and of course the election cycle next year, the old adage, “buy on mystery, sell on history” will prevail.

The financial industries’ biggest asset is confidence. Currently the markets are complacent despite dramatic swings. We believe the increased volatility, changing geopolitical games of chance and confusion over the policy decisions of central banks together with the consequence of their past moves will contribute to a sea change in that confidence. The combination of too many dollars, economic stagnation and a riskier geopolitical climate makes gold a better store of value as the record amounts of money finally catches fire and ignites reflation. Gold will go up exponentially.

There was a time when gold was money. In today’s paper dollar era, part of gold’s allure is its traditional status as a safe haven when everything from stocks to just sitting in a Paris café is considered risky. We believe the arguments for a resumption of the bull market are compelling. It is cheap in an overvalued world. There is a further twist. Consumption remains strong in Asia. The Chinese are buying 50 tonnes of physical every month as a hedge against devaluation. In addition, declining supplies can only help support higher prices. Gold is a commodity that provides an early warning of trouble. Our view is that the recent geopolitical events dictate caution and quite likely that as the world’s geopolitical temperature rises, so will gold. Next year, we believe gold will trade at $2,000 per ounce.

Recommendations

Exploration is dead and drilling crews are idle from Timmins to the Northwest Territories. Rather than move rigs, the drilling companies are leaving their rigs on site. The gold mining industry is focused more on survival than finding the next ounce. Companies are reviewing even their office space and the corner offices are disappearing faster than the drilling rigs. The retreat has been chronic and has not been helped by the gold price threatening $1,000 an ounce level. Given the long lead times, peak gold has arrived to the industry with the number of new mines coming on stream next year can be counted on one hand. And, the cheque writers have also disappeared finding more profitable investments elsewhere with even the marijuana turned miners not prospering. But capital is the lifeblood of the mining industry.

Where Are the Corner Offices?

One would think that our regulators, specifically the Toronto Stock Exchange would be looking for ways to help one of their major client base. After all, Canada is the world’s largest explorer of mining with Toronto, the mining capital of the world. The TSX Venture Exchange is one of the few practical capital raising options for investors and issuers alike. However our hide bound lawyers, bureaucratic regulators and legislators share equal blame. For example despite the discovery of the Ring Of Fire in northern Ontario, there is still no infrastructure, roads nor power that were promised to develop the area. Instead, Ontario is overhauling the mining act. Only, Quebec and Mr. Charest had the foresight to help miners by building the Plan Nord highway which will be paired with a railway in order to develop Quebec’s north. Recently Ralph Sultan MLA of the BC legislature gave a warning that the province itself ran the risk of seeing the mining industry in a death spiral despite the discovery of Eskay Creek and more recently Pretium’s Brucejack in that province. He said, “as a country, we know more about finding, financing, building, operational, and responsible closing down mines than anybody else in the world”. The industry needs more than just good intentions. It needs help.

Our legislators however are not the sole reason for the industry’s problems. Issuers must cope with layers and layers of bureaucracy plus the high cost of regulation. For example, the industry and its dealers are overseen by the Investment Industry Regulatory Organization of Canada (IIROC), plus the various provincial Securities Commissions like BC and Ontario. And despite efforts Canada does not have a central body like the SEC in the US. Each province, of course has a set of regulators and enforcement. Needed is one regulator to eliminate the expense of duplication and provincial rules. IIROC for example imposed rules that baby boomers may not be suitable for investing in speculative aka junior investments because of our age. – can’t the investor decide? Or there is IIROC’s three year study of High Frequency Trading (HFT) concluding that HFTs generally provided more liquidity and was a “mostly positive” force on markets. Yet in the same study, HFTs trading activity “has resulted in increased costs for both institutional and retail clients”. And, despite recent efforts to reach out to the industry, TMX tends to be not only rule-bound but bureaucratic-bound influenced in part by “Barney Frank regulation”, so popular in the United States. The losers are not only the industry, but also the investor. No longer are our exchanges user- friendly for both investors and companies. Exchanges are supposed to help companies raise capital, but it seems the morass of regulations stifle that effort.

What to do? Since exchanges are profit driven, there have been the introduction of layers and layers of fees and issuers are “nickeled and dimed” to death. There are transaction fees like private placements where companies must pay $5,000 just to issue shares. Or, if they want to buy back their stock, send $5,000 to the TMX. In addition there have been financial incentives (take-pay) to encourage trading but this is borne by investors and issuers. Needed then is the recognition that fees in running public companies have become prohibitive, particularly for the some 2,000 odd juniors on the TSX Venture Exchange. Then there are the archaic private placement rules, whether brokered or non-brokered which are overly restrictive. Or what about the example of a prospector who has a property that investors would like to invest in, or heap leach gold project which makes a lot of sense. The regulators often request not one but two separate valuations or economic assessments in order for them to decide what is good or bad for investors. Round pegs must fit into square holes. Yet at the same time our regulators allow crowdfunding while they put the industry in a “straitjacket” while any so-called accredited investors can invest in crowdfunding deals because of dollar size – truly the Wild Wild West. The securities market is supposed to be a fair and level playing field equal for all. Unfortunately, the regulators over the years have introduced more and more paternalistic regulations under the guise to protect the investor but really to protect the regulators. What seems in need of protection, despite the TSX Venture Exchange being around for some 100 years, are the investors – who don’t have the corner offices.

We believe the gold miners have seen their lows. While bullion made a new low this month, the gold index did not. Today, gold miners trade at a deep discount relative to their NPVs and record market cap per in situ ounce. We continue to recommend the big cap gold producers for their cheap long life reserves like Barrick Gold, Agnico Eagle and Eldorado. We also like B2Gold but continue to avoid Kinross, Yamana and IAMGold. M&A activity is still active with Kirkland Lake Gold acquiring St. Andrew Goldfields, for its rising production profile, solid balance sheet and large land position. Brownfields and exploration vehicles are dirt cheap.

Companies

Barrick Gold Corporation

Over a year ago, John Thornton had the foresight to shrink Barrick’s portfolio, flattened the organisation and promised to reduce debt in moves that are in vogue today. Barrick paid down $3 billion of debt and closed the sale of non-core assets at almost twice net asset value. Barrick received better than expected value due to the healthy competition out there for quality assets leaving an American focused portfolio of 16 mines. At the same time, Barrick reduced its AISC and focused on a pipeline of four project studies expected to be completed by year end (eg Cortez Deep South). Barrick has 93 million ounces of reserves and 94 million ounces of M&I resource, the largest in situ resource. We continue to like the shares here.

Centamin PLC

Centamin`s flagship Sukari mine in Egypt will produce 430,000 ounces up from 370,000 ounces last year. The company plans to ramp up production including an expansion to 10,000 per day to produce 500,000 ounces in 2017 from a reserve and resource base of almost 14 million ounces. The company has begun mining underground. While Centamin has a world class orebody it is located in Egypt. The geopolitical risk and uncertainty overhangs the stock. Nonetheless the stock is cheap with $200 million of cash and no debt.

Goldcorp Inc.

Goldcorp’s Chuck Jeannes retires next year and David Garofalo from HudBay Minerals and Agnico Eagle is the surprise replacement. We view the move positively because Garofalo can be the player to optimize Goldcorp’s some 13 mine portfolio and prioritize its mega billion pipeline. Also he fits the bill to handle the heavy lifting execution at Eleonore in Quebec, Cerro Negro mine in Argentina, Cochenour at Red Lake and Penasquito. Goldcorp’s Eleonore still suffers from teething problems with excessive dilution hurting initial results such that Eleonore will produce about 250,000 ounces but at a loss. Grade and production are key here and a revised mine plan is expected. Goldcorp will produce 3.3 to 3.6 million ounces this year. We expect changes at Goldcorp so we would stay on the sidelines.

IAMGold Corporation

IAMGold’s four mines delivered poor results, except for the open pit Essakane in Burkino Faso. The newly commissioned Westwood remains a major problem due to poor ground conditions. Writedowns are ahead here. An update is planned around yearend. Sadiola in Mali and Rosebel in Suriname are at best harvest situations. While IAMGold has a strong balance sheet they have a poor acquisition record. The company plans to spend $230 million, however mostly at problem prone Westwood. We see nothing here. Sell.

Kinross Gold Corporation

Kinross acquired the 50 percent they did not own of Round Mountain from Barrick plus Bald Mountain for $610 million adding 430,000 ounces. Bald Mountain is an open pit heap leach operation but reserve life is limited. However with a 600 sq km land package, Kinross has identified potential extensions. While the price was steep, Kinross increases its geographic footprint in North America offsetting in part Russian based Kupol and Dvoinoye which represents almost 30 percent of production. However the shares has suffered from the perception that Kinross’ mines in Russia represent a healthy geopolitical risk and therefore vulnerable. Kinross Paracatu in Brazil was suspended for a month due to a lack of rain which cost about 16,000 ounces or so of lost production. At Tsasiast, plans to add grinding capacity and mill capacity might be boosted from 8,000 tpd to 12,000 tpd early next year in order to salvage something from the multi-billion investment. Kinross has mines in Canada, United States, Brazil, Mauratania and Russia. Sell.

New Gold Inc.

New Gold has a portfolio of four producing mines (New Afton, Mesquite, Peak, Cerro San Pedro) and two development projects (Rainy River, Blackwater) located in favourable mining jurisdictions. New Gold’s 100 percent owned Rainy River remains attractive as it complements New Gold’s other mines. New Gold has $750 million of liquidity, sufficent to finance Rainy River particularly since having sold El Morro to Teck. Construction has begun at Rainy River in Ontario, which will produce 325,000 ounces annually from almost 4 million ounces of reserves. Start-up is expected mid-2017 and $700 million needs to be spent. Significantly, the project is sensitive to the gold price. Blackwater on the other hand is a project for the next cycle. We like the shares here.

Yamana Gold Inc.

Yamana released positive results due to a boost in output from Canadian Malartic and Jacobina. Yamana has begun marketing Brio, a spinoff of its non-core assets which is a high cost producer being dressed up as a growth story. Metallurgical work at CI Santa Luz remains the key. We believe that Yamana has lofty value expectations and thus will have difficulty to market. Yamana’s problem is that the balance sheet is laden with debt. Flagship El Penon was mixed but better grades are expected later this year. Net debt stands at $1.7 billion with $227 million in principal payments required over the next three years. Debt is still too high and Yamana’s growth prospects are limited. Sell.

John R. Ing

416-947-6040