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Gold: The Debt Trap

Deflation was yesterday's crisis. Economic growth is today's. What is tomorrow's? We believe that it could be America's large and growing record debt load. In a single presidential term, the US has gone from a creditor nation to the world's largest debtor. This crisis has been building but the lack of consequences has lulled markets into a sense of complacency. Far from being alarmed, many Americans believe their indebtedness is a good thing. It is not. It is a debt trap.

For sometime we expressed concern about the unprecedented global imbalances in the financial system sustained by the ever-widening deficits in America's budget and current account, with accompanying surpluses by the rest of the world. In the 1960s and 1970s, total debt (government, corporate and consumer) was 140 percent of GDP. In the 1980s fuelled by junk market debt, it jumped up to 180 percent of GDP. Today total debt stands at 300 percent. That means the debt to GDP expressed in a ratio stands at more than 3:1. History shows that no company or household can exist for too long at that rate.

The American Financial House of Cards

Excessive spending and borrowing, sustained by cheap interest rates, has kept the US economy afloat. Despite six rate hikes, real interest rates remain at their lowest in 15 years. Consumers borrowed against their inflated real estate values and the US government was able to borrow with impunity, thanks to foreigners willing to write blank checks and recycle their US dollars. US households do not save enough and those in Asia appear to save too much.

The obvious and important point is that the weak dollar was not only a sign of gross imbalances in the global economy but allowed the Americans to consume much more than it produces. With financial liberalization and the explosion of derivatives, central banks and governments no longer talk about money supply targets, but instead about providing enough credit to the system. As such, the printing press has been working 24/7 allowing fiscally reckless governments, consumers and businesses alike to go on the biggest spending binge in post World War II history.

But It Has Happened Before

America's "beggar thy neighbour" policy was last pursued in the 1930s, when countries allowed their currencies to decline in order to seek export advantages and of course lessened the money owed to debtors. The dilemma today is that much of America's growth has been built on a Ponzi-like pile of dollar indebtedness. With a current account deficit of $617 billion or almost 6 percent of gross domestic product, the US needs to attract $2 billion of overseas capital every trading day. Yet Americans are unlikely ever to produce enough investment to offset or attract this needed foreign capital.

Meanwhile, America's financial institutions are straining under the weight of this debt. Balance sheet quality has deteriorated. The deterioration is a serious threat to America's future funding ability. Fannie Mae with $1 trillion of assets, is the second largest financial company after Citicorp and among the biggest derivative players. Following an investigation of its accounting and a $9 billion downward adjustment in earnings, management was replaced but the regulators still have not been able to put Humpty Dumpty back together again. And now one of America's biggest icons, General Motors is not only facing an earnings crunch but its finance division which contributed 80 percent of its profits, faces a downgrade to "junk" status. And finally, the reformation of Social Security returns America's huge indebtness to its workers, exposing the vulnerability of its pensions liabilities - both public and private.

Smoke, Mirrors and The Deficit

Of equal concern, is that while massive borrowing fuelled America's growth, then what is left for the next four years. The Commerce Department gave us a hint, and that is more debt. Just where is the money to come from? According to the Bush people, there is still room. After all defence spending rose 27 percent in real terms under Mr. Bush, and in the first term he achieved both guns and butter at the same time. The US will spend a whopping $420 billion on defence or 5 percent more than last year. Since 2001, defence spending has grown 41 percent. The numbers are mind-boggling. Projected deficits turn into ever larger deficits.

The Administration's new $2.6 trillion budget for example, is the third record deficit in three years. The deficit will reach $427 billion excluding the escalating cost of the wars in Afghanistan and Iraq, which has already exceeded $500 billion. President Bush pledged to halve the deficit last year, but instead it went up $15 billion. Despite tough rhetoric, Bush has yet to veto a spending bill and his budget left out the future costs for the post-war military operation in Iraq and Afghanistan. It also does not even include funding for his new Social Security plan (an estimated $2 trillion over ten years). And the decision to extend the Child Tax Credit prompted the bipartisan Congressional Budget Office to forecast the cumulative deficit for the next five years will be $1.2 trillion. Bush's dilemma is that over 80 per cent of the budget goes to mandatory entitlement programs, Social Security, Medicare and Medicaid. Mr. Bush's tough proposals assume deficits forever.

Washington - Ignorance is Bliss

What makes this particularly troubling is that Washington does not see this as a crisis nor does it feel that immediate attention is needed. History shows that deficits are far from benign. Deficits raise the cost of capital, squeeze financial markets and eventually undermine a country's currency. Although there was a dead cat bounce to a three month high, the greenback is still off 6 percent since October. In the last three years, the greenback has fallen 35 percent against the euro and 24 percent against the Japanese yen (the value of the US dollar peaked about the time that Bush came into office). Calling the glass half full, Treasury Secretary Snow and others view that the influx of foreign buying to finance the string of deficits as a reflection of strength of the American economy, not a weakness. The broad consensus is that deficits do not seem to matter. Inflation? Rate hikes? No big deal to US policymakers.

Inflation Is Back

So why hasn't there been a bigger impact on the economy? The bond market has pretty much dismissed these threats. If investors looked at commodities, they would see record prices. We have just survived $55 a barrel oil, but there is no certainty that was the peak.

Today gold is at $435 an ounce, after posting a sixteen-year high last December. Commodities are telling us that all is not right. Despite the ratcheting up in rates, financial markets have stayed calm, due in part to the view that inflation is not a problem. For example, the Consumer Price Index rose 2.2 percent last year, but this was understated because it excludes food and energy - both of which we need to live. The index is really a laggard index and not a leading indicator. More accurate is the solid uptrend in commodities, which are priced in dollars.

In our opinion, easy money and too much debt has fuelled a big secular upturn with too many excess dollars chasing hard assets like energy and real estate. Inflation is next.

The pricing of oil in euros or China's request for copper priced in yuan may trigger the long awaited collapse of the dollar. It took 100 years for the British pound to lose its reserve status. Thirty four years later, the dollar's reign as the world's reserve currency is at an end now that the Americans have debased their currency.

Our doubts are wedded in America's over-reliance and dependence on central bank purchases to fund its twin deficits. How long will the rest of the world finance America's profligacy? The world is witnessing a game of chicken with America, Europe and Asia. This is unsustainable. The recent decline in the dollar has resulted in huge losses for the world's central bankers holding large dollar reserves. But Americans should take note. Not only are central bankers shunning the dollar but its equity market as well. One of China's biggest foreign exchange banks is hoping to list its shares in Hong Kong instead of New York.. Air China recently went public on the London Stock Exchange for the same reason. China now attracts more foreign investment than does the US.

Exodus From Dollars

Foreign central banks have been big buyers of US debt to help keep their currencies weak against the greenback. The dollar decline was blunted in part due to the need for dollars by foreigners who consumed fuel, foodstuff and airplanes. However, their appetite for dollars appears to be waning. The Treasury Department reported that foreigners bought less than 30 percent of the $24 billion of two year notes at the most recent auction. And foreign purchases plumetted 75 percent to $8.4 billion in November. Financial markets reversed when the Bank of Korea said it plans to diversify its $200 billion of reserves (the fourth largest buyer of US treasuries) into currencies other than US treasuries. In addition, a survey of central bankers recently showed that two thirds would like to keep a proportion of dollars to other currencies unchanged this year. By implication, one third of those polled indicated their desire to shift their reserves out of US dollars to increase their reserves in euros. Noteworthy was that neither Japan (with reserves of $845 billion) nor China ( reserves of $610 billion), who hold 40 percent of the world's reserves were included in this survey.

China's tail will wag the dog

Meanwhile China continues to grow, reporting fourth quarter growth at 9.5 percent versus consensus of 8.9 percent. China has overtaken the United States and has become the world's number one consumer (grain, meat, coal, iron and steel). It is also the world's largest cell phone producer. Inflation? It declined to 2.4 percent in December from 5.3 percent from earlier in the year. But is the Chinese economy on a surge again or is it slowing down? In China things are never that simple - it is a country of contradictions. The growth was powered by the consumer and private enterprises who filled the vacuum left by the slower state-owned enterprises. Exports have grown at 33 percent while retail sales grew at 15 percent. And a sign of what this means for 1.3 billion Chinese, per capita income of rural residents rose 6.8 percent, the strongest growth in seven years. The growth was even faster for those who live in the urban areas which make up over a third of the Chinese population.

So while the Americans are running huge deficits, the Asians are piling up huge surpluses. The annual deficit with China set a record of $152 billion, which is the largest deficit ever with a single country. Today, Asia has more than $2.8 trillion in foreign exchange reserves, of which a large part is in dollars. However, Asian central banks have diversified their reserves, investing in euros, Canadian dollars and gold. While the Western world is bellyaching about unpegging the yuan, few realize that the Americans are impotent in telling their banker how to conduct it's affairs. The Americans don't realize it yet, but they have already lost the war with China. The decline of the dollar's reserve status and America's need for funding will prove to be "interesting times" - "interesting" as in the Chinese curse (may you be born in interesting times).

A Bought Deal For Gold?

Gold weakened on concerns that the International Monetary Fund would sell some of its vast gold reserves to help pay third world debt. The IMF owns 10 percent of the world's reserves after the US and Germany, which is equivalent to one year's demand. The proposal, floated by UK Chancellor Brown has no hope of succeeding since it requires 85 percent of member nations support. The Americans alone control 17 percent and are opposed to gold sales which would need congressional approval. The IMF is scraping the bottom and with the gold sales trial balloon quickly deflating, European finance ministers proposed a tax on air travel to help pay for debt relief. This too will fail.

Ironically, we believe that gold sales by the IMF or central banks would actually be positive. China and Japan currently the largest holders of dollars have less than 2 percent of their foreign reserves in gold, compared with 15 percent for the European community. The IMF sales would be a way for them to boost their holdings instead of going into the open market which would send gold even higher. Is a bought deal around the corner?

History has a tendency of repeating itself. America's dependence on foreign savings is nothing new, however combined deficits running at an annual rate of almost 10 percent of GDP, is new. The level of foreign holdings of US assets and thus the Americans are vulnerable to a scaling back. In September 1995, the Plaza Accord stemmed the dollar decline but not until it had dropped 70 percent. And a couple of years later, the Louvre Accord failed to stabilize the dollar. Market forces once unleashed are very difficult to put back in the bottle again. Gold is a good thing to have as the dollar collapses further.

Gold's Industry Consolidation-Musical Chairs

A twenty year bear market, declining production, and regulatory red tape caused a rash of retirement in the executive suites. Bob Buchan of Kinross, Jay Taylor of Placer Dome and Rob McEwen are trading jobs. In addition, the decline in production and reserves has also prompted a game of musical chairs, as wannabe majors consolidate and merge with their counterparts in an attempt to bulk up to attract institutional investors. It is cheaper for many to buy reserves on Bay Street rather than explore. Goldcorp sealed a $2 billion deal to buy Wheaton River Minerals creating the newest 1 million ounce producer. In South Africa, major gold producers, Gold Fields and Harmony are stuck in a time vortex as Gold Fields fends off a proposed merger with Harmony.

South African production has fallen to its lowest levels in 34 years. South Africa should produce only 376 tonnes of gold this year. The rand has doubled and pushed up costs. In addition, the South African miners recently reached a 7 percent wage increase in July which follows a 10 percent increase in 2003. Gold Fields and Harmony Gold, which make up almost 50 percent of the Johannesburg Index have been locked in a $7 billion battle that has seen both companies lose billions in market capitalization. The South African industry is in its worst condition in over fifty years.

Mega-Mergers Are Impossible Today

Goldcorp shareholders have approved the acquisition of Wheaton River and now a new round of mergers could begin. To date, the big dollar mergers were among the majors as they attempted to bulk up. Harmony's bid for Gold Fields was not only a desire to increase reserves but also diversify from South Africa. Among the seniors there are only a handful of juggernauts. Newmont for example was created from an acquisition of Franco- Nevada and Normandy. Ironically, such a merger would not likely receive the go ahead today because of a tougher SEC regulatory environment. Kinross for example is having to go back and rebook the largely book-keeping goodwill of its acquisition of Echo Bay and TVX a few years ago. The issue of valuation of reserves and goodwill is so subjective in today's heightened regulatory environment that big mergers are virtually impossible today.

Thus the stage is now set for the next round of mergers among the mid to small cap producers in the quest for scale to attract institutional support and of course, growth in ounces. Among the potential acquisition candidates are Eldorado, Bema and Crystallex which have big deposits to finance, and bring to the market. Glamis, now smitten, is likely on the prowl and is rumoured to be looking at Minefinders or Crystallex. Ironically, the newly formed Goldcorp is also rumoured to be looking at Crystallex. The second tier group of miners are poised for further consolidation into a few big players. For investors, the long awaited consolidation presents an arbitrage opportunity for some winners but also many losers. In the quest to bulk up, management point to largely stillborn projects as having new life under the umbrella of a larger entity (Newmont's Phoenix is a good example). The dilemma for the industry however is that reserves are quickly depleting and without new discoveries, the industry has found it cheaper to mine Bay Street for reserves than to spend cash flow on exploration.

Best Bets Are Exploration Companies

And as a possible explanation for the non-performance of the group, many companies last year took advantage of the spike up in gold and raised hundreds of millions of dollars. The industry had become a serial fund raiser, filling corporate treasuries but also flooding the market with paper. It appears that at long last much of this paper has finally been digested and thus the shares can begin to act better. While filling the corporate treasuries, lost on many investors is that no new ounces were found. And that is the point, the underwriters were the prime beneficiaries, not the investors.

We believe the industry should allocate more money for grass roots exploration. The rapid fire deals of the past few weeks have left arbitrage investors and shareholders looking for the next candidates. And among the industry's game of musical chairs, we believe that even fewer will be left standing. Kinross has grown through acquisitions and has been able to benefit from the rising gold market. The recently acquired Paracutu in Brazil may be that answer, but with Bob Buchan stepping down, the company will be rudderless for the next little while. Kinross will likely be among one of those looking for a chair. The midcap companies are taking the logical step, and that is to consolidate.

To better compete with these mid-caps, the junior explorers are left out in the cold. The gold correction has caused their shares to be badly mauled as investors became disenchanted with either the lack of exploration news or nervous over a potential collapse of the gold price. As such, many of these stocks are trading half of what they were trading a while ago and are quite attractive. We believe that the exploration group will be the next big winners once gold breaks out above the $450 an ounce resistance area. As such we think it opportune to purchase a basket of exploration stocks with a one year view. We would include Aurizon, Apollo, Claude Resources, Campbell Resources, Richmont, St. Andrew and White Knight Resources in that basket.

Agnico-Eagle Mines Ltd.
Agnico-Eagle's LaRonde mine is producing gold at almost zero cost due to sky-high zinc and silver prices. Agnico has boosted output at LaRonde for more than three consecutive quarters to more than 8,000 tonnes per day from 1500 tonnes from a few years ago. Despite producing slightly less gold at 272,000 ounces last year, the company is ahead of budget due to higher zinc and silver prices. Agnico's operational problems are history. The company recently extended its $100 million acquisition facility for a three year period. With over $120 million in the bank and $80 plus million of annual cash flow, Agnico- Eagle has the financial wherewithal to finance two potential mines in its own backyard.

For example, Lapa is a potential 125,000 ounce annual producer for eight years at an estimated cash cost of $175 per ounce. The underground mine is an excellent high grade mine and could cost $80 million. At Goldex, a low grade, big reserve deposit there are plans to complete a bulk sample by the end of the second quarter. Goldex could produce 160,000 ounces a year at a cash cost of $120 million. Goldex is only located three miles west of Val D'or and thus is close to existing infrastructure. Finally Agnico-Eagle also has the deeper LaRonde II deposit. We continue to recommend the shares for its management, underground mining capability, balance sheet and potential to boost production and reserves.

Barrick Gold Corp.
Barrick reported strong results due largely to tax recoveries. For the full year, the company produced 5 million ounces and expects to boost this by 10 percent this year as Tulawaka in Tanzania comes onstream. Barrick has over $1.4 billion of cash, which is needed since the company has huge capital requirements over the next three years. In a strange move, the company took half of its hedges and allocated them to Pasqua Lama to make it easier to finance the billion dollar plus price tag. By moving over half of their hedges, Barrick has tied up over 35 percent of Pasqua Lama's reserves in long term hedges which are currently underwater by almost a billion dollars - we are not sure how that makes Pasqua Lama easier to finance? Nonetheless, Barrick reduced its hedges last year by 2 million ounces to a total of 13.5 million ounces, which is still too high since the mark to market of those hedges is almost $2 billion. Barrick should be more aggressive in reducing those hedges which would make the financing of its development projects simpler.

Looking ahead, the Veladaro project is a key project since 230,000 odd ounces are slated. In Alta Chicama in Peru, Barrick expects 260,000 ounces of production. The company has ambitiously built up its strategic relationships in Russia, through partnerships with Highland Gold and Celtic. All the above are positive but what Barrick needs are lower hedges and maybe an acquisition that would boost its production profile in the near term. We prefer unhedged Newmont at this time.

Cambior Inc.
Cambior reported a whopping loss of $73.8 million or $0.30 a share due to the writedown of the Doyon mine in Quebec. Doyon is a major disappointment and the mid-sized company now must go back to basics. Meanwhile newly commissioned Rosebel in Suriname was successfully brought into production on time and on budget as Cambior's main cash producer replacing Omai. Cambior produced almost 700,000 ounces at a cash cost of $244 per ounce last year. Cambior also acquired the balance of the Niobec mine, leaving it with cash of about $55 million. Cambior is expected to produce 620,000 ounces at an estimated cash cost of $250 per ounce. The decline in output is due the shutdown of the Omai Mine in Guyana.

Cambior has become a serial fund raiser with over 250 million shares outstanding. The company raised $110 million in equity to finance the acquisition of the 55.3 percent stake in Poderosa in Peru. The deal fell apart over title questions. Cambior raised almost 30 million units at $3.75, which resulted in a major dilution of shares and Cambior has not been able to replace the Poderosa acquisition.

As such, with only Rosebel and 50 percent owned Sleeping Giant, we would switch Cambior into Kinross or Crystallex at current levels.

Crystallex International Corp.
Crystallex shares picked up in part due to speculation that it is the next big takeover candidate. Crystallex is undervalued and has been making progress in bringing the big Las Cristinas concession into production. Despite boosting reserves beyond the 10.2 million ounces, completing an infill drilling program and ordering more than $90 million of equipment, the company still has not broken ground. Crystallex is in need of the important environmental permit which was supposed to come in November of last year, then December, than January, and now hopefully before the spring. A shake-up of the Venezuelan cabinet, resulted in a new environment minister, who is reviewing Crystallex's application. In addition, the old Energy & Mining Ministry was divided into two and the Basic Industry and Mining Ministry is now properly responsible for the gold miners.

We believe that these moves are positive and expect that in the usual Latin American fashion, the permitting issue will take a little more time. There does not appear however to be any deal breaking problems, so the delay, while an irritant, will not impact the timetable. As such we continue to recommend Crystallex as an attractive tidbit for one of those intermediates looking to bulk up. We recommend the shares here.

Goldcorp Inc.
At long last Goldcorp and Wheaton River Minerals Ltd. have merged with Goldcorp taking up over 70 percent of Wheaton River shares. The hotly contested merger created a million ounce producer with a market capitalization of $5 billion. The new Goldcorp has assets in Canada, U.S., Mexico and Argentina and should generate earnings of $240 million or more. Of more significance, the new Goldcorp provides a platform from which future acquisitions can be launched. We believe that a 500,000 ounce acquisition is in the cards and that the tandem of Telfer and McEwen are poised to elevate the new Goldcorp into the senior category. However over the near term there has been a lot of paper created and we think that it will take six months or so to digest this paper. As such the company may be dead money for a while and thus Agnico-Eagle or Meridian shares may be better performers. Over the longer term, we would hold the new and improved Goldcorp with its excellent platform and bright future as a senior in the making.

IAMGold Corp.
IAMGold shares have recovered after being the bride left at the alter. The company has non-operating mines in Mali and Ghana and a strong balance sheet. Despite paying out more to the lawyers than from mining gold, the company is poised to produce over 450,000 ounces this year. IAMGold has reserves and resource of almost 5 million ounces and thus is expected to be an excellent tidbit for one of the majors. With a terrific balance sheet, owner mining at the Tarkwa mine and the expansion at Sadiola, together with the royalty stream from the Diavik diamond property in the Northwest Territories, IAMGold is good value situation here.

Kinross Gold Corp.
Kinross has grown through acquisitions. An SEC review of the accounting treatment over the TVX - Echo Bay merger in 2002 has caused the company to get stuck in a regulatory cobweb that will see up to $918 million of goodwill reclassified. The problem is book keeping but would likely involve the restatement of Kinross' financials. When the regulators stopped pooling they made the accounting treatment of goodwill much more complicated and annual tests, allocation to business entities have become central. As such Kinross has retained Standard & Poors to give a third party opinion as to the treatment of goodwill. Meanwhile production at Refugio is delayed and Kinross has another tax dispute with the Russians over the expansion at Kubaka, which runs out of ore in couple of year. Kubaka is currently processing material from Birkachan but the Tsokol deposit remains untouched until there is a tax agreement with the authorities.

On the positive front, Kinross has acquired the other half of Paracuta in Brazil, which adds about 1.5 million ounces to Kinross' production profile over the next fifteen years. Kinross acquired the balance of Paracuta from Rio Tinto for cash and paid less than $200 per ounce. It is our understanding that Paracuta has promising upside and now that the operation is under one umbrella, Paracuta could be Kinross' next big mine. However the exploitation of these will be left to ne*w management since Bob Buchan who was responsible for building Kinross is leaving, effective April 1, 2005. In passing the torch to presumably younger hands, Kinross has a solid base of core assets, a stable of exploration projects and remains an attractive tidbit for one of the majors. Kinross has virtually no hedges, a clean balance sheet, attractive upside and the company is well levered to gold price. We recommend the shares here.

Miramar Mining Corporation
Miramar Mining has been a disappointment in large part to the slow development at Hope Bay. While drilling news has been positive, investors have become disenchanted with the slow development and permitting issues at Hope Bay located in Canada's far north. Miramar recently sold what was perceived to be its second leg in the sale of its option on the Back River project which included the Goose and George Lake deposits. Miramar received $10 million from Dundee Precious Metals, which is turning itself a operating company. While the shares have been beaten up, we believe there are other alternatives preferable at this time.

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