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Gold: The Audacity of Hypocrisy

Cartoon: Obama in a corner

Unfortunately governments today wallow in the hypocrisy of politics, particularly when it suits them. America's foreign policy is symptomatic of this hypocrisy from branding Egypt's coup d'état as a "change in government" to the repeated bending of Mr. Obama's "line in the sand". Or then there was big brother's NSA spying on everyone including America's allies but spying was considered not as bad as Edward Snowden's crime of "leaking" the information to the media. Then there was the Internal Revenue Services' targeting of conservative groups because of their political leanings and not their tax status. Or how about the West's invasion of Iraq in pursuit of weapons of mass destruction which were found to be non-existent. That shadow loomed again as the US was about to launch air strikes against Syria, not for regime change nor to destroy their cache of chemical weapons but simply to teach that country a lesson. Obama and his team certainly lost credibility, turning a "commander-in-chief" opportunity into another unseemly political episode exposing a dysfunctional political system.

"I know that an invasion of Iraq without a clear rationale and without strong international support will only fan the flames of the Middle East, and encourage the worst, rather than best, impulses of the Arab world, and strengthen the recruitment arm of al-Qaeda. I am not opposed to all wars. I'm opposed to dumb wars. So for those of us who seek a more just and secure world for our children, let us send a clear message to the president." ~ State Senator Barack H. Obama, October 2002.

And five years after the US financial banking system meltdown, the new safeguards were watered-down with the banks becoming even bigger, making the system ripe for abuse by those same players that almost brought the system down. Or, how about the much talked about Obamacare which was introduced so that all Americans could receive medical care under the "Affordable Care Act" and for those who can't, subsidies, which included the members of Congress and their staff. What hypocrisy.


Unintended consequences

New US Dollar Bathroom Tissue

After a five year spending binge and trillions of newly created debt from rounds of quantitative easing, there is an unwanted side-effect. July's deficit was $148 billion and the Fed's balance sheet has expanded at the expense of the private sector inflating asset prices instead of the economy. As a result, Wall Street has fared better than Main Street. However, the long awaited plan to reduce the Fed's purchases of America's debt brought not relief but angst among governments, investors and now the Fed is addicted to ultra-cheap money. The Fed has bought $2.8 trillion of new debt in the past five years and over the same period, foreign investors have bought $2.3 trillion of American debt of which the Chinese own $1.3 trillion of US Treasuries. The Fed continues to buy Treasuries with dollars it mints for that purpose and to date has bought up to 70 percent of net issuances. Debt on debt is not good.

Since the collapse in 1971 of the old fixed exchange rate system under Bretton Woods, the world has been using the dollar as the international reserve currency. While each country has control over their money and interest rates, the benchmark remains the US dollar. However, in the past dozen years, the US federal monetary policy has been the world's defacto monetary policy, a form of financial protectionism. The dilemma for each country other than the United States is that a "made in Washington" policy is not necessarily, Beijing's or Brazil's policy.


Gold is a Default Currency

The US Federal Reserve has flooded the emerging markets with dollars. However, with the slowdown, many emerging countries have seen their currencies drop against the dollar, causing them to purchase their currencies in a support arrangement. Emerging markets now make up over half of the world's GDP and what they do with their currencies or the US dollar has international ramifications. For example, the coming showdown over debt could lead to a government shutdown and a collapse of the dollar when those dollars come home to roost. The big risk is that the emerging countries, in order to protect their currencies will wash their hands on America and Mr. Bernanke's successor will have to live with the consequences. After all, America is the world's largest debtor and the emerging markets are the largest creditor and in diversifying their holdings into gold for example, they are only defending their purchasing power.

China too is making a major adjustment. In warp speed fashion, it has loosened controls around the renminbi, moving the renminbi to the top 10 currencies and there is talk of backing the renminbi with a little gold. China is the world's largest gold producer and this year will prove to be the largest gold consumer, surpassing India. The financial crisis gave China a vivid lesson depending on another country for its reserve currency. The Chinese have a problem with what to do with their outsized $3.5 trillion of foreign exchange reserves. They are big holders of US Treasuries but will suffer big losses when the Fed exits the market. China has hedged their bets and diversified. It has been reported that they have been adding to their 1,000 tonnes of gold, which represents less than two percent of their reserves. Even if China were to buy the next three years of total world output they would have less 10 percent of their reserves in gold, the average of most Western central banks.

The Long Run

Central banks hold a little more than 30,000 metric tons of gold or less than twenty percent of the above ground gold stocks. United States is the largest holder at 8,000 tonnes with the IMF, Switzerland and now the Russians hold more than a thousand tonnes of gold. China, Russia, Kyrgyzstan, and Turkey are buying gold with their excess dollars. Gold is an alternative investment to the dollar for these central banks. Change is coming. A stable international system has alluded the world since the end of the gold standard. Perhaps the solution is back to the future. Gold is the default currency.


Botching the Exit

The Fed's blinking on tapering was due to their concern over the uptick in interest rates following Mr. Bernanke's musings in June. While the markets soared on his back-peddling there are reasons to worry. The economy is still weak despite trillions of stimuli. Today even the Fed is addicted to low interest rates. And coming soon are the negotiations between the White House and Congress which could trigger a Federal shutdown next month. Ironically, none of this is going to give the economy a boost.

We believe that America botched the "exit" partly because nobody has tried it on this scale before. In fact, while long term interest rates rose, they are still negative suggesting monetary conditions are still too loose despite the rhetoric of "tapering". After three rounds of quantitative easing, itself an untested innovation, the end goal is no longer an improvement in the "labour market" but simply a "better set of data". Mr. Bernanke's red line looks like Mr. Obama's. It would be hard to trust this central banker or his successor. Instead there is going to be more volatility and a revaluation of risk. Ominously, money has already left. According to the US Treasury Department, there was a record $40.8 billion of net foreign selling of Treasuries in June, for the fifth straight month. Investor confidence is fragile. The repeated crossing of red lines has undermined America's credibility. That will be good for gold and bad for the dollar. We have a lame-duck presidency, lame-duck Fed and a lame-duck economic recovery.


Investor Confidence is Too Fragile

From Syria to Grand Bargains to" tapering", red lines are being crossed and one by one, these issues are weakening the credibility of our leaders who have lost the respect of the public and the markets. The audacity of hypocrisy. Last year the fiscal cliff was to bring fiscal credibility but policymakers ducked that chance. And now Mr. Obama's new red line of no negotiations on debt ceiling discussion is just more rhetoric than decision-making.

Most striking is that Mr. Obama's troubles have weakened investor belief that America is the source of economic growth. Put another way, the US dollar's pinnacle position has slipped as America's position as a global superpower deteriorates under Bernanke and Obama. In fact the remedy, the push for higher inflation devalues the dollar, raises the risks of high inflation and even hyperinflation.

Five years after the collapse of Lehman, the Fed's balance sheet has quadrupled to $3.7 trillion, up from $2.9 trillion a year ago and growing each month. That excess liquidity has resulted in a narrowing of corporate bond yields and sovereign credits lulling investors into complacency. However low interests rates have not worked. The cheap money did not go to build new investments or factories. Cheap money allowed corporations to buyback their own stock, pay higher dividends and of course rack up more debt. Savers indeed have been penalized while investors were forced to buy riskier and riskier investments. That same complacency exists especially among central banks who, one by one adopted America's unconventional monetary policy, the UK becoming the latest convert. The shadow banking system too has prospered as financial engineering products become new asset classes in a "loosey goosey" secondary market.

Regrettably we have wasted the past five years. Banks are bigger, debt is higher and the appetite for the trillions of the shadow banking system's derivatives is more voracious. Five years ago, the taxpayer bailed out Wall Street. Progress has been made. Instead of taxpayer bailouts, governments created a saver-bailout template. Cyprus and Poland are recent examples but the failure of a sovereign credit or one of the big banks has yet tested the new template of confiscating private wealth. Yet the market views sovereign defaults as yesteryear. Wrong. Argentina is about to default for the second time in a decade. Noteworthy is that gold remained the best performing investment since the Lehman collapse in 2008, even during the past year's correction. It will a good thing to have in the future.


Debt Ceiling- Deja Vu

"The fact that we are here today to debate raising America's debt limit is a sign of leadership failure. It is a sign that the US Government cannot pay its own bills. It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government's reckless fiscal policies. Increasing America's debt weakens us domestically and internationally. Leadership means that, "the buck stops here.' Instead, Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren. America has a debt problem and a failure of leadership. Americans deserve better." ~ Senator Barack H. Obama, March 2006

In October, the Obama-Congress games begin for the third attempt to lift the debt ceiling. The last debt ceiling debate led to market turmoil and a S&P downgrading of the US credit rating. We recall the last set of negotiations was postponed by sequestration and the Treasury dipping into Fannie Mae's piggy bank. Nevertheless, debt keeps growing as the deficit gets bigger. We believe that in playing a game of chicken with America's credit rating, the US risks default. By the middle of October, if Washington fails to raise the debt ceiling, Social Security benefits and pension obligations alone are more than the $50 billion currently on hand. Meanwhile, the Republicans are arguing for a repeal of Obamacare as their price to cooperate.

"The biggest risk we can take is to try the same old politics with the same-old players and expect a different result". ~ Presidential Nominee, Barack H.Obama, Democratic National Convention 2008

Asset Performance since Lehmans

In fact, just this month in a Business Roundtable speech, President Obama said, "raising the debt ceiling which has been done over a hundred times, does not increase our debt, it does not somehow promote profligacy". Say what? If the debt ceiling has been raised hundred times, because of the need for more borrowing, one can conclude there is a hundred percent correlation between higher debt and a higher debt ceiling. What hypocrisy.

America's credit rating is at risk and any slippage would be the proverbial straw that broke the camel's back, causing the US dollar to return to a normalized level from the lofty heights driven by Bernanke's quantitative easing. A drop in the dollar will of course accelerate inflation, causing a further spiral of the greenback. The prospect that the American government would renege on its bonds is low, although a technical default is a possibility just like Mr. Obama's red line is more of a curve. America's debt to GDP has grown.

In less than five years, the national debt has increased 100 percent from 31 percent of GDP to over 75 percent. We view the complacent view that America could always borrow forever as unsustainable. Nobody questions America's ability to pay its bills, but its willingness to do so. Congress does not seem overly concerned. Sequestration replaced spending cuts while the size of government gets bigger. There are few levers left that Obama can pull. Gold will be a good thing to have as Americans face the new reality.


Gold's Bull Market Intact

Much has been written about the dramatic decline in COMEX's dealer gold to an all-time low of 672,000 ounces from a high of 3 million ounces in December 2012. The drawdown comes at a time of suspiciously large coordinated paper sales by the bullion banks and commodity hedge funds such that the resultant low inventories on Comex and LBMA raises the risk of a default. Simply, a large pick-up in demand could dangerously swamp the leveraged short derivative positions on Comex.

Meantime, demand has expanded as supply from the ETFs became available. Holdings in bullion backed exchange-traded products dropped below 2,000 tonnes after peaking at 2,700 tonnes at the end of 2012. Some of that supply was sopped up by the central banks like Russia, South Korea and Kyrgyzstan who have bought 400 tonnes this year as a hedge against a falling greenback. Fabricated demand has matched mine supply which peaked at 2,900 tonnes.

Of interest is that Chinese and India demand have taken up 80 percent of available mine output this year. China's purchases are running at 1,000 tonnes of gold, surpassing India, last year's leading buyer of gold. Despite the Chinese being the world's largest producer at 340 tonnes, they have become the world's largest consumer of gold. Chinese premiums for physical gold are running at $20 an ounce premium. Gold is in backwardation with the near month trading at a premium to later periods. In sum, we believe the huge pick-up in demand has caused a dramatic drawdown of supplies exacerbated in part by the price drop, fears of confiscation, hedge buying and expectations of a gargantuan short squeeze. Even that bullion bank, JP Morgan has gone from net short to net long.

Our view is that with limited supplies of physical gold and a decline in mine output, there is simply not enough gold to satisfy demand. Already central banks' purchases have caused tightness in the gold market. America's flood of dollars will only fuel higher gold prices. Gold will continue to rise as long as the US budget is in deficit, Washington remains dysfunctional and Barack Obama is in the White House. We thus believe this bull market is only half over.


Recommendations

Mining companies, on the other hand are still mired in weak industry conditions. To be sure, much of the industry's problems are self-inflicted. Mega deals brought mega-problems and mega-write-offs. The ten biggest gold producers led by Barrick spent more than $100 billion on acquisitions and building new mines over the past two decades. The mining industry is trying to get costs under control however since 1998, gold grades of the world's top ten producers have plummeted from 4.6 g/ton to only 1.1 g/ton today. In fact in the past 15 years, 40 percent of the industry's discoveries have an average grade of 0.7 g/t which is why the industry has a cost problem today. Too many dollars simply went chased too few ounces.

It has been estimated that the industry has taken more than $26 billion of writedowns so far this year and those mining executives that survived the axe, are pledging the mantra of profitability ahead of growth. We believe future transactions will be based more on the acquisition of cheap ounces. The real challenge is for the thousands of juniors whose treasuries are depleted is to stay alive for the next upturn because the equity window is closed . Price Waterhouse reported that M&A activity is down 31 percent from the boom times period last year. However much that is on the market today are the lower quality assets exemplified by the modest $300 million that Barrick had to take for its Australian mines. Chinese buyers have been wiser which explains why they balked at African Barrick's price tag.

The top twelve companies control more than 90 percent of the global in-situ reserves. We believe these gold deposits are the only new sources of supply of gold. We believe those companies are well-placed. The average market capitalization per ounce of reserves in the ground are $215 an ounce or less than 16 percent of today's gold price and half of a year ago. If one adds cash costs, these miners are indeed excellent targets.

The gold mining industry is finally going through change. Profitability instead of growth will place a premium on those companies with low cost, economic grades and solid balance sheets. Given the increasing cost to replace production, the industry has not replaced mine production and we expect the industry instead to harvest those cheapest ounces in their own backyard. We continue to like those that are liquid, possess both growing growth profiles and undervalued ounces like Agnico-Eagle, NewGold and Eldorado. The junior developers/producers are also cheap from a risk reward point of view, providing both brownfield and greenfield potential. We remain convinced that the large greenshoe belt in Ontario and Quebec still hosts more than the 100 million ounces extracted to date and producers like Detour and St. Andrews Goldfields or Virginia Mines, a royalty player, are favoured. In Mexico with a growing mining industry there are McEwan Mining and Excellon, a high-grade silver producer.


Companies

Agnico-Eagle Mines Ltd.

Agnico-Eagle has five mines in Northwestern Quebec, Nunavut, Finland and Mexico. The flagship mine at LaRonde operates at 7,300 tpd. Growth will come from the reopening of Goldex, production from La India and growing contribution from Pinos Altos in Mexico. Agnico is mining nearby satellite deposits and processing the ore at Goldex's facility. La India will contribute 90,000 ounces at cash costs of $500 an ounce. Operationally, Agnico finally has its mine (including Meadowbank) running like a clock. Agnico remains a low cost producer with a growth profile. Buy.

Barrick Gold Corp

Barrick continues under pressure as its shareholders clamor for change. Two Fish Management, a US hedge fund, was critical of the company, putting forward changes to the board of directors and a change at the top. Faced with rising costs, project delays, Barrick has written off $12 billion this year and its founder Peter Munk, must feel that this year has been his "annus horribulus". Nonetheless, the US hedge fund made some solid points, including pruning Barrick's high cost operation and indebtedness. Already Barrick has sold three mines in Australia for a mere $300 million, but rids itself of high cost and short reserve life mines. Barrick gets 60 percent production from only five mines and thus still has 24 other mines left to look at. Fundamentally, Barrick needs to make changes. Barrick's generously compensated board of directors has no technical people and the board has become too Peter-centric. We believe change will come, and that Barrick shares are undervalued. Ironically, Barrick has some 140 million ounces in the ground, valued at less than $150 per ounce, which is the lowest we have seen in decades. Barrick also has some world-class mines which have long life resources. Barrick's problems are resolvable and the push for profitability is a plus. To reduce its leverage, Barrick could set up a royalty trust and dump higher cost assets like African Barrick and the PNG assets. At the very least, Barrick's weak share price together with a critical shareholder base makes Barrick a prime takeover target. We believe that possibility will push the shares up and the shares are a good trading buy here.

Centerra Gold Inc.

Centerra has an agreement that has yet to be ratified with the Kyrgyz Republic government which will see Centerra vending Kumtor into a joint venture with the Kyrgyz government whereby each will own fifty percent with Centerra being the operator. The agreement removes a major uncertainty but shows how in salami-like fashion, the Kyrgyz have successfully increased their stake. We believe the deal is expensive for Centerra but necessary to get a go-ahead. Centerra has a great balance sheet and would be better served to diversify geographically and pursue those other assets that are on the auction block now that its peers are pruning their portfolios.

Eldorado Gold Corp.

Eldorado's deferment of Greek expansion and Kisladag expansion bodes well for Eldorado which is an intermediate gold producer with the flagship Kisladag mine in Turkey, Greece and China where it is the largest foreign producer. Eldorado has five mines and six development projects under its belt. Management is experienced with a healthy balance sheet and low cost operations, Eldorado is a buy here.

Goldcorp Inc.

Goldcorp's third quarter should be flat following a disappointing second quarter. Goldcorp's flagship Penasquito in Mexico remains a problem. The mine has never operated at its design throughput of 130,000 t/d. Nonetheless, Goldcorp expects total cash costs between $1,000 to $1,100 per ounce on an all-in sustaining cost basis. Production in the second quarter increased to 646,000 ounces reflecting the contribution from 40 percent stake in Pueblo Viejo. In the second quarter Goldcorp took a massive $1.96 billion write-down on Penasquito, yet we believe that further writedowns are necessary. Penasquito is Goldcorp's Pascua Lama which is still on Goldcorp's books at an inflated value. Goldcorp's maintained its guidance for production at 2.55 to 2.8 million ounces this year. To date, Goldcorp has pared its spending including exploration and G&A. Near term, after shelving of El Morro, Goldcorp will bring on Eleonore in Quebec but some slippage is expected. Goldcorp also plans to use Cochenoor ore at its Red Lake facility. As for Cerro Negro, increased taxes in the Argentine province of Santa Cruz caused a deferment resulting in Goldcorp suspending exploration. Goldcorp maybe Canada's second biggest gold producer but Penasquito's problems and rising costs make the stock prime for a disappointment.

IAMGold Corp.

IAMGold has not performed largely due to increasing costs. The closure of Yatela, which has cash costs over $2,200, makes the Sadiola mine in Mali doubtful. IAMGold's problem is that they have little on the horizon and Cote Lake is non-starter because of the huge capital costs. However, IAMGold has a strong balance sheet and solid base at Essakane in Burkino Faso as well as Rosebel in Suriname. Westwood (refurbished Doyon) will be commissioned next month and could produce 130,000 ounces next year. Nonetheless, there are better situations elsewhere.

Kinross Gold Corp.

Kinross' Russian assets will perform better the next quarter due to increased production. Kinross took a $720 million charge for Fruta Del Norte in Ecuador because Kinross could not the get the long awaited go ahead to put that property into production. The key however is the controversial Tasiast mine in Mauritania which costs Tye Burt his job after a $3 billion writedown. While Canada's third largest producer has other irons in the fire, the resolution of Tasiast will dictate Kinross' future performance.

Table of Gold Companies
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Analyst Disclosure
Company Name Trading Symbol *Exchange Disclosure code Rating
Barrick GoldCorp ABX T 1 5
Centamin CEE T 1 3
Centerra Gold CG T 1 3
Detour Gold DGC T 1 4
Eldorado Gold Corp ELD T 1 5
Excellon EXN T 1,5 n/a
Disclosure Key: 1=The Analyst, Associate or member of their household owns the securities of the subject issuer. 2=Maison Placements Canada Inc. and/or affiliated companies beneficially own more than 1% of any class of common equity of the issuers. 3=<Employee name> who is an officer or director of Maison Placements Canada Inc. or it's affiliated companies serves as a director or advisory Board Member of the issuer. 4=In the previous 12 months a Maison Analyst received compensation from the subject company. 5=Maison Placements Canada Inc. has managed co-managed or participated in an offering of securities by the issuer in the past 12 months. 6=Maison Placements Canada Inc. has received compensation for investment banking and related services from the issuer in the past 12 months. 7=Maison is making a market in an equity or equity related security of the subject issuer. 8=The analyst has recently paid a visit to review the material operations of the issuer. 9=The analyst has received payment or reimbursement from the issuer regarding a recent visit. T-Toronto; V-TSX Venture; NQ-NASDAQ; NY-New York Stock Exchange

 

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