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Gold: Guns, Not Butter

"But let it never be forgotten: Peace will come also because America sent her sons to help secure it".

"I wish - with all my heart - that the expenditures that are necessary to build and protect our power could all be devoted to the programs of peace. But until world conditions permit, and until peace is assured, America's might - and America's bravest sons who wear our nation's uniforms - must continue to stand guard for all of us ".

The above quotes were from former president Lyndon B. Johnson's addresses to the nation in January and March 1968. Johnson convinced the nation that they could simultaneously have both the Great Society and the Vietnam War without raising taxes. However, it was his persistence to have both guns and butter that led to the economic mess that took years to fix. In March of 1968, Lyndon Johnson requested an additional $2.5 billion to fight the war that increased from $100 million in fiscal 1995 to $30 billion. Today, Mr. Johnson's words could easily have been said by President Bush.

Bush's request for a colossal $87 billion to rebuild Afghanistan and Iraq boosts federal spending next year to a record 20.5 percent of GDP. In 1969, President Johnson's war budget pushed federal spending as a percentage of GDP to a then record 19.7 percent. Once again, the painful lessons of the past would have been ignored. History will show that instead of tax cuts, President Bush and his advisors' fiscal recklessness not to raise taxes will again wreck the economy. One cannot continue to spend more than you earn. The consequences of ignoring that lesson? In the seventies, rapid inflation ensued and gold went from $50 per ounce to $850 per ounce. It's déjà vu all over again. Gold was a good thing to have then and is a good thing to have today. We continue to see gold at $510 per ounce before yearend and it will have further to go next year.

Having won the war, Mr. Bush may be losing the peace. No one has asked, "how is this war to be paid? " Is Mr. Bush to reverse the $2.2 trillion of tax cuts to help pay for the war? Unlikely in an election year. Or has he requested cuts in domestic spending? Also unlikely in an election year. Instead, he simply adds the $87 billion to the half a trillion plus pile of government debt. Like Johnson, Mr. Bush will discover that he cannot have both guns and butter at the same time.

America Depends On Foreign Investors

The U.S. dollar has been the world's premier reserve currency since 1971, when the gold backing ended. Since then the dollar's universal acceptability was backed by essentially the trust and confidence in America's financial system. However, that trust has been eroded with the steady depreciation of the U.S. dollar. Freddie and Fannie Mae's total debt outstanding is equal to 39 percent of the total outstanding U.S. debt. The dollar is in its worst slide since 1987 due in part to Snow's abandonment of the "strong " dollar policy, Greenspan's chicanery and more importantly, a growing lack of confidence in the Americans to resolve their financial problems. First there was Enron, then Fannie Mae and now Grasso. Thus it is no coincidence that the world's largest investment destination has suffered. The United Nation's Conference on Trade and Development recently reported that global investment flows into the U.S. sank from $314 billion in 2000 to just $30 billion last year, less than France and Germany. The risk today is that investors, particularly foreign investors might conclude that suddenly all those dollars they have been hoarding are not worth the paper they were printed on. Gold is a better parking place.

No longer is the world dependent on America's growth. China, India, Korea and even the Japanese are proving to be strong locomotives pulling the global economy out of the ditch. Greenspan's misdirection on "deflation " was a ruse to allow him to print more money. Here again, Bush's policy of guns and butter is expected to cause a fiscal deficit of half a trillion dollars, the highest in the country's history. The United States must attract $500 billion more in goods and services than it sends abroad for a record current account deficit of more than 5.5 percent of GDP, the same level as Latin American countries reached before their financial crises in the 1990s. When the U.S. current account deficit reached 4 percent of GDP in 1986, the greenback fell more than 70 percent against the D mark in the ensuing two years. To date, the dollar has fallen almost 24 percent on a trade-weighted base from its high in July 2001 fueling a whopping 55 percent rally in gold. Of concern is that more than one third of the government's financing needs come due within one year. Deficits do matter. Those massive and unsustainable deficits can only be financed by investment flows, and thus the U.S. is heavily dependent on the confidence of strangers.

Asia's Reserves And The Dollar Crisis

According to the Bank of International Settlements (BIS), foreign central banks have been increasing U.S. dollar investments and today own more than 46 percent of the U.S. government bonds. Among foreign buyers, Japan alone is the largest holder of Treasury securities, with some $442 billion at the end of June. China holds $122 billion of Treasury securities. China, the world's sixth largest economy, grew at a torrid 8.2% pace in the first half of the year despite the SARS epidemic. China's huge trade surplus with America has become a political issue, replacing Japan as the bogeyman as the cause of U.S.'s economic ills. The problem is not China's peg to the dollar but America's insatiable appetite for imported goods. China's trade surplus with America reached $103 billion last year 3 surpassing Japan's surplus for the first time ever. China has more than four times the foreign exchange reserves held by the U.S. and Asia as a whole. After all, China is now one of the few growth engines of the world economy and with this growth comes the surpluses and finances to help the savings-deficient Americans with their massive budgetary deficit and equally devastating trade account.

At the end of June, the central banks of Asia held an astonishing total of almost $700 billion of Treasuries and surprisingly have not yet used these reserves as a lever to gain economic or political leverage. The endorsement by the Dubai G-7 communiqué pressures China and Japan to let their currencies appreciate against the dollar and by implication effectively called for a long-overdue correction in the dollar.

In our view that call could backfire. In calling for "more flexibility in exchange rates ", the reborn protectionist Americans risk losing much of the funding that allowed them to finance their ballooning twin deficits. The U.S. needs to attract almost $2.7 billion of overseas capital every day. Having lost billions of Muslim investors, Americans stand to lose billions of important Asian investment funding which would cause a sudden shortfall of capital inflows sparking a slide in the dollar. And in pressuring the Asians, they also remove the favoured advantages of American companies such as Wal-Mart who have established important subsidiaries in the East. The Bush Administration should be careful what they wish for. An ancient Chinese proverb states, "burn a forest to farm and drain the pond to fish " achieves an end by all means where wittingly or unwittingly ignores the consequences. It seems unlikely this time that the inscrutable Asians will remain so stoic.

The appetite to keep lending to the U.S. has limits and when the Chinese and Asians decide to reallocate their reserves or indeed dump their dollars, the collapse will cause a huge rush for the door. We have been here before. In the 80's the twin deficits also skyrocketed and the dollar fell by over 70 percent. Today the gold market, which recently reached a sevenyear high, is warning us of the risks and also that inflation has not gone away. The recent upturn in commodities on a global basis implies that fears of inflation have displaced fears of deflation. Inflation is a dynamic animal and is prepared to come back in 2004.

In sum, we believe that like the seventies, the consequences of the U.S. economy's inability to finance both the civilian and military is unrivaled money and debt creation due to a significantly weaker currency, higher rates and sustained inflation. Gold is a good thing to have as a hedge against that day of reckoning.

Recommendations: Overweight

The gold mining industry is at a major watershed. The dramatic increase in the price of gold has created many winner and some losers. Among the winners are the non-hedgers and those companies which were quick to collapse their hedges like Newmont. The losers include heavily hedged Barrick which was once considered the premier gold company in the world.

The increase in the gold price also created a dilemma for the mining industry. How does the mining industry maintain their growth profile and replace rapidly declining reserves?

During the twenty-year bear market, the senior producers gobbled up many of the smaller companies because they were using reserves faster than they were finding them. Some of the intermediate sized companies also bulked up, such as Kinross, which now ranks among the senior producers. That strategy however has its limits, since the entire gold industry has a market capitalization of less than $100 billion. There simply are not enough gold producers. So what are the big producers to do if there are not enough dance partners? Some such as Newmont are building up core areas, such as Ghana, while Placer Dome has acquired assets in Australia and South Africa. Unfortunately the mining industry has poured little money into exploration. The economics of the business are such that even at $350 per ounce, the industry is simply not profitable. As such the industry does not have much room to spend on exploration.

However, exploration is the lifeblood of the mining industry and without that there are no future gold deposits. Other than Goldcorp, we do not see much support for grassroot exploration and thus the mining industry is stuck on this terrible treadmill. Eventually, we believe the industry will focus on those deposits that were found in the last cycle. Unfortunately there are fewer than ten world-class deposits that exceed five million ounces. Hence, we expect these companies to be among the next round of takeover candidates. We would however be cautious of the spate of recent offerings that have announced hyped results and promises of new discoveries. Many of these companies have "discoveries " that are too deep, too expensive and too isolated to be economic. History shows that because of the lengthy cycle of mining, many of these discoveries will be exploited but in the next bull market.

In the latest quarter, Canadian, South African, and Australian gold producers have been hit with a cost they did not expect. While gold has jumped, the Canadian and Australian dollars have jumped even higher, making it more expensive for those miners to produce gold. Since the beginning of the year for example the Canadian dollar has climbed more than 15 percent against the dollar. In South Africa, the producers have been extremely hard hit and thus even at today's gold price, many gold producers are not making any money. The appreciation of the currencies increases the miners' cost structure which will mean not only a delay of much needed exploration but will also spark another round of takeovers and consolidations as producers discover that it is cheaper to buy ounces on Bay Street than in the bush.

As such we continue to recommend our list of Top Ten Juniors because they produce gold and possess the deposits that will be brought stream during the current cycle. Our Top Ten juniors are: Bema Gold, Campbell Resources, Crystallex, Eldorado, High River Gold, Miramar Mining, Northgate Exploration, Philex Gold and St. Andrew's Goldfields. We like Bema for Kupol, Campbell Resources for Copper Range, Crystallex for Las Cristinas, Eldorado for Kisladag, High River for Bury, Miramar for Hope Bay, Northgate for Kemess North and Philex for Boyongon.

  52 Week Range Shares Market Prod'n Market Cap
Top Ten Juniors Symbol Price High Low Mil Cap 0z (000) per/oz
Bema Gold BGO 3.42 2.93 1.39 369.0 1261.98 270 4,674
Campbell Resources CCH .77 .67 0.29 73.1 56.29 35 1,608
Crystallex Intl KRY 3.10 3.95 1.00 125.0 387.50 95 4,079
Eldorado Gold ELD 3.54 3.24 0.99 237.0 838.98 95 8,831
Claude Resources CRJ 1.72 1.80 0.82 53.1 91.33 52 1,756
High River Gold HRG 2.10 2.45 1.28 110.0 231.00 150 1.540
Miramar Mining Corp MAE 2.25 2.40 1.05 123.5 277.88 130 2,138
Northgate Exploration NGX 2.15 2.05 1.10 193.0 414.95 290 1,431
Philex Gold PGI 0.70 1.45 0.41 40.2 28.14 0 0
St Andrews Goldfields SAS 0.23 0.33 0.15 190.0 43.70 0 0
15.79 Average 2606

Share prices for gold stocks are reaching their 52-week highs as gold posts a seven year high. Investors are still frustrated that the stocks are not even higher. Comparisons to where the gold equities were and the gold price is, misleading, since much of the recent supply of gold equities have recently been purchased by hedge players and a new generation of investors. Indeed, we find there is no correlation between where gold equities are today and where the gold was previously and its predictive qualities. Gold stocks move up or down on expectations of the gold price and these expectations change depending on variable factors. Share issuance and dilution are variables that are not always tied to the gold price so the argument that gold stocks are discounting a $700 gold price is bogus.

Based on fundamentals, we continue to advocate an over-weighted position in gold and gold shares. We to believe that we are in the initial stages of a multi-year bull market since the U.S. dollar correction has only just begun. Much of the recent strength is due to producer dehedging, speculative "longs " on the Comex and investors seeking a hedge against currency uncertainty. We continue to believe gold will reach $510 per ounce moves of $25 per day lie ahead. The key drivers of gold are:

  • An over-valued greenback
  • Unsustainable large deficits
  • Increasing inflation expectations
  • Declining mine production
  • Producer de-hedging
  • Asset class that is negatively correlated to unbalanced global trends

We suggest portfolios include hedge-free Newmont and Kinross among the majors, and Agnico-Eagle, Goldcorp, and Meridian among the mid-caps. In the current cycle, the market appears to have rotated from the senior stocks to the mid-caps and we detect a rotation next to the more exciting junior exploration companies.

Agnico-Eagle Mines Ltd (AGE)
Agnico-Eagle acquired the Bousquet property from Barrick Gold Corporation immediately to the west of Agnico-Eagle's LaRonde mine in northwestern Quebec. The purchase was a strategic acquisition in that Agnico-Eagle now controls more than eighteen miles of favourable ground along the Cadillac- Bousquet belt that hosts the LaRonde mine. We expect drill machines to be put on the property fairly quickly. Agnico plans to exploit the million ounce Lapa mine about seven miles from LaRonde. Ore from Lapa could be processed at the LaRonde facility. Agnico's shares have not recovered fully from the rock- fall, which hurt production this year but the weakness is a purchase opportunity. The company has reported a change in mining will allow it to recoup the lost production next year and we believe that the rockfall is an isolated event. The LaRonde mine has good leverage to gold and zinc prices so costs should be lower next year and the company hopes to develop LaRonde II but that would require yet another shaft. We expect Agnico to produce 275,000 unhedged ounces this year and 320,000 ounces next year. Agnico plans to develop the 1.5 million ounce low grade big tonnage Goldex Mine and news is expected before yearend.

Barrick Gold Corporation (ABX)
Barrick again has lowered its production forecast for next year to 5 million ounces down from the already lowered 5.4 million ounces this year. While production will be down, costs will be higher reflecting the maturation of its gold mines at Pierina and Meikle. Also, Barrick has changed the management at the troublesome Bulyanhulu in Tanzania suggesting that Barrick has not yet turned that operation around. Barrick similarly has flattened its management team and there have been a number of high-level departures recently.

Barrick is in the midst of a transition and there may well be additional bad news in the next few quarters. On the development front, Barrick continues to push the 6.5 million ounce Alto Chicama project in Peru and is going ahead at Veladero in Argentina. Those mines should be in production in 2005-2006 but at a combined cost of almost $800 million. Over the near term, Barrick is faced with a dilemma, how to replace declining reserves. Pierina runs out of ore and Barrick has nothing in the near term to replace it. Meanwhile, Barrick's balance sheet is laden with healthy goodwill and faces a declining production profile and a stubbornly high hedge book. Barrick's premium multiple will deteriorate. Barrick converted some calls but still has about 16.1 million ounces with a "mark to market " hedge book loss in excess of $600 million. We believe that Barrick should more aggressively lower this hedge book since unlike its competitors, the company is not built for a rising gold price. Barrick still doesn't get it. Investors would like 100% of the upside and that is why Barrick's shares have lagged the others. While Barrick's shares offer stability and an A-rated balance sheet its hedge book is an albatross. Switch to Newmont.

Bema Gold Corporation (BGO)
Bema released additional holes from the Kupol project in Far East Russia almost thousand kilometers northeast of Bema's Julietta mine. The Kupol project is a joint project between Bema and the government of Chutkotka. Bema has the option to purchase a 75 percent interest from the government. Bema has drilled about 130 holes so far and has outlined a high-grade gold-silver vein system from forty holes confirming a resource approaching five million ounces. Grade remains consistent and production could start in 2007. We believe that there is strong potential for another mine, which would complement Bema's Refugio, which will be reopened next year. Buy.

Crystallex International Inc. (KRY)
Crystallex unveiled a new President, Todd Bruce and the long awaited SNC Lavalin feasibility study at the Las Cristinas project. The study calls for a 20,000 tonne per day open pit with a conventional mill producing 300,000 ounce of gold per year. The stripping ratio was 1.34:1 and the mine will have a life of thirty-four years. As such we expect the company to consider doubling the production rate since the cost estimates allow for an expansion to 40,000 tonnes per day. SNC Lavalin estimated the capital costs at $243 million with an internal rate of return estimated at 14 percent using a $325 gold price. On September 17, 2002, Crystallex and CVG signed a Mining Operation Contract for the development of Las Cristinas 4,5,6, and 7. The contract provides Crystallex the exclusive right to explore, design, exploit, process and sell gold from Las Cristinas. The previous owner Placer Dome had expected to spend $600 million but Crystallex has simplified the mine plan. We continue to recommend Crystallex for this attractive deposit since this is one of the few 10 million plus ounce deposits still in the development stage. It is our belief that Crystallex offers the cheapest ounces among the junior producers. Buy.

Eldorado Gold Corporation (ELD)
Eldorado boosted reserves at the 100 percent owned Kisladag project in western Turkey by 11 percent to over 5 million contained ounces following increased drilling. Eldorado has improved the stripping ratio and a recent study calls for annual production at 155,000 ounces a year increasing to 246,000 ounces. Production could start in 2005. Under the revised plan, the capital cost was estimated at $138 million with a robust internal rate of return of thirtyseven percent. Eldorado recently raised $75 million through the issuance of 25 million shares at $3.10. Net proceeds will be used to complete the construction of Kisladag. We continue to recommend Eldorado shares for the attractive Kisladag deposit and the steady Sao Bento mine in Brazil.

Goldcorp Inc. (G)
Goldcorp has one of the strongest balance sheets in the gold industry with over $200 million in cash, gold bullion of $85 million and marketable securities of $60 million. Goldcorp has more gold today than the Bank of Canada and continues to build up its gold holdings, believing that gold is money. The Red Lake gold mine in northern Ontario is the largest in Canada and continues to generate surprises and should produce 530,000 unhedged ounces up from 510,000 ounces at a cash cost of $65.00 per ounce. The company reported a high-grade intersection at the high-grade zone (HGZ) yielding 2.11 ounces per tonne over forty-eight feet at a depth of around 7,250 feet. Delineation drilling confirms that this zone gets richer at depth and the area could host another one million ounces of reserves due to excellent grade and continuity. Goldcorp is sinking a new $80 million shaft to access this ore. The sinking of this shaft to a depth 7,100 feet will be able to lift 4,000 tonnes per day. Completion of this expansion is slated for the second half of 2006 and Goldcorp is planning to produce 700,000 ounces plus after the completion of its expansion project. We continue to recommend the shares not only for the rock solid balance sheet, no debt, and the Red Lake facility but also for management's aggressive funding of mining exploration. Goldcorp now has a $60 million mining portfolio, which serves as a window or "skunkworks " to the exploration scene, which allows it to capitalize on any opportunities. Buy.

High River Gold Mines (HRG)
High River has a fifty-two percent stake in publicly listed Buryatzoloto in Russia. The company also owns a fifty percent stake in the New Britannia mine in Manitoba. High River should produce 120,000 ounces this year, but costs were impacted by a stronger Canadian dollar and lower grades at New Britannia. High River plans to expand Buryatzoloto and develop Berezitoboye with Buryatzoloto. Buryatzoloto has two mines, the Zun Holba and Irokinda in Russia. High River has been one of the few success stories operating in Russia and a new power line allowed a reduction in costs. We expect High River to increase its holding in New Britannia as well as expand in Canada through its stake in Detour Lake. Buy.

Kinross Gold Corp (K)
Newmont sold two thirds or 28 million shares of Kinross giving it a ten-bagger over its original investment. The 4.9 percent balance will be held until 2004 due to taxes. Kinross preempted the Newmont sale with a 20 million share offering at $9.26 per share, which allowed Kinross to strengthen its balance sheet. Kinross is the world's seventh largest gold producer with less than $34 million in debt and $170 million of cash. It is poised to make another round of acquisitions. Kinross will produce 1.7 million ounces this year at a cash cost of $215 an ounce. Kinross' major mines include 100 percent owned Fort Knox in Alaska, 50 percent owned Round Moutain in Nevada and 98.1 percent owned Kubaka in Russia. Kinross will mine the Tsokol vein and the Birkanchan deposit will extend the life at Kubaka in Russia by a few years. We continue to recommend Kinross due to its leverage to the gold price and the fact that the company has been aggressive in building assets. Kinross has suspended operations at its high cost Lupin mine but plans to reopen fifty percent owned Refugio next year. Kinross also will grow organically with production plans for Kettle River in Washington, Aquarius in Ontario and expansion plans at Round Mountain and Fort Knox. Kinross' management is progressive, ambitious and are most likely to optimize these assets in a higher gold environment. Buy.

Wheaton River Minerals Mines (WRM)
Wheaton continues to grow as this company is being built as a paper vehicle for today's gold market. Wheaton paid a whopping premium to Miranda Mining for the Los Filos gold deposit in Mexico. Los Filos does not yet have a feasibility study but the 2 million ounce resource deposit was on the auction block for some time. Wheaton not only acquired Los Filos but also picked up Teck's neighbouring El Limon gold deposit. Wheaton has provided a lot work for the investment dealers having acquired Rio Tinto's twenty-five percent stake in the Alumbrera gold/copper mine in Argentina for $210 million. Wheaton hopes to add another 12.5 percent interest in Alumbrera in the third quarter from BHP. Wheaton's share issuance of course has skyrocketed as it has used its shares as currency to make these acquisitions. Wheaton has also arranged for its second $100 million equity financing in month. While the company looks good on paper, it remains to be seen if they could turn the street's expectations into profits. For example, the stake in Alumbrera provides an equity stake but not real cash flow, Wheaton will need some producing assets to generate cash flow to support its ambitious plans. At current prices there are better situations elsewhere, such as Northgate, Eldorado or Crystallex.

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