New Proposals, Same Fault-lines

Washington's political gridlock and President Obama's repeated retreat from "red lines" has eroded confidence in this president raising questions about the United States. The deep polarization of parties has alienated investors and Washington's continued dithering has hobbled the world's superpower needlessly. The US spends nearly 18 percent of its GDP on health or about 100 percent more than is spent in Canada, yet the much ballyhooed Obamacare still lacks universality. So far, the potential fallout is not apparent because America is able to borrow at a record pace, piling up debt with little effect. Politicians believe that they can always borrow more despite debt rates comparable to 2008 when liabilities exceeded assets. Yet no one seems to care that the weakest economic recovery since World II was bought by a fiscal policy which doubled the national debt and was financed by an unorthodox monetary experiment of free money that expanded the monetary base by trillions.

After the debt ceiling fiasco, the sad truth is that there were only losers. Trust was lost in America's ability to restore world markets shaking confidence in its financial institutions and even the dollar's reserve status. The Republicans lost the fight to cut spending and the Democrats got a chance to fight again. Mr. Obama's negotiations and empty promises only reinforced his "dithering" and of course Obamacare has lost its way. The dollar lost one percent in a week. And despite trillions injected into the economy, there are 47 million people living on food stamps in America. And to no surprise, it appears the Fed lost courage to taper the monthly $85 billion asset purchases as the likelihood of tapering decreases due to the market's addiction to cheap money. And when tapering does arrive, we believe it will morph into another form in a rebranding exercise.

Bubble, bubble.....

Investors remained complacent until the government shutdown. Default did happen, not in missing a payment, but in the devaluation of the greenback. The US economy is in a self-inflicted zombie state heading into a downward spiral (car sales, employment rates, etc). To be sure the Fed's quantitative easing (QE), will continue well into 2014, piling debt on top of more debt, stoking hard asset bubbles reminiscent of the mortgage collapse or the dot-com bubble. Today we have a stock market bubble, bio-tech bubble, tech bullet and a debt bubble. QE has been the market's best friend.

But the central bank's balance sheet has grown to almost $4 trillion under the Fed's bond buying program designed to lower unemployment. Foreign investors hold nearly half of the Treasury's $17 trillion of debt and the return of irrational exuberance has caused foreign bondholders to buy other debt because of their overexposure to this asset class. To pay for the chronic budgetary deficits, the Federal Reserve must borrow at least $1 trillion a year to purchase newly printed paper because other nations have shunned America's debt. Dagong, the Chinese state owned credit agency downgraded the US sovereign rate to A- from A with a negative outlook, equivalent to Brazil's or Panama's rating. Significant, when consideration is given that China is America's number one creditor. America's record government debt makes it more vulnerable than ever to outside shocks. More than anything, the inability to fix America's finances was a lost opportunity to make the recovery lasting.

Rhetoric Vs. Reality

Reality is not that simple. To begin with, the Americans spent $3.6 trillion without a budget and the new bipartisan budget agreement increases spending to over $1 trillion adding to the $17 trillion which excludes $60 trillion of unfunded entitlements or even the escalating cost of Obamacare. Federal debt held by the public has increased to 70 percent of GDP this year, up from 41 percent in 2008. Without a change in policy, the Congressional Budget Office (CBO) calculates that will rise to 250 percent. The deficit is the problem. To be sure, America might have dodged a bullet by postponing the debt of reckoning but a bigger battle lies ahead.

Notwithstanding Treasury Secretary designate Yellen's dovish Keynesian rhetoric and presumed tolerance for higher inflation, the Fed's easy money policy must end one of these days. However there have been numerous false starts and interest rates are edging higher in recognition of the uncertainty created by undoing the non-conventional policies in a pain-free exit. So far however there has been more rhetoric than reality. We believe the consequences of easy money and a reliance on unorthodox policies will soon become known.

HealthCare.gov

To make matters worse, Obamacare's 10,535 page document is eight times the size of the bible covering over 110 regulations but is now mired in red tape including a problem-plagued web portal. Obama's signature bill was passed in 2010 without securing the votes by the Republicans which caused the Tea Party to shutdown government. The Tea Party should have waited. Now available in 36 states, in the first month alone, only 26,794 people managed to sign-up to the most expensive health care programme ever(on a per capita basis).

Created by Ben Bernanke, quantitative easing was the unconventional monetary policy that involved the Fed purchasing bonds to subsidize interest rates at near zero levels in order to resurrect the economy from the last debt-fueled housing bubble. The unprecedented money printing was a double edged sword, helping Wall Street but yet to help Main Street - twas better to give the money directly to taxpayers, at least that would have helped Christmas sales. The problem is that the bulk of Mr. Bernanke's $3 trillion of cheap money ended up in Wall Street banks' excess reserves, allowing the Fed's surrogates to leverage even more to buy additional government debt in a Ponzi-like scheme.

Still, Europe's problems remain. Italy had another inconclusive election. The European Central Bank (ECB) cut rates to near zero because the Eurozone is mired in deflation, but is fast running out of ammunition. And France is falling into recession with a debt to GDP of 96 percent this year. Greece still has not emerged unscathed. Germany is slowing down. The ECB's asset quality review showed its banks are not as well off since the sovereign debt holdings of each bank averaged 10 percent of assets which is more than their equity capital. Like their US counterparts, the European banks have become leveraged option bets.

Singing From the Same Hymn Book

The world's central bankers are singing from the same hymn book. Quantitative easing also sparked another round in the currency war. With interest rates at near zero, Shinzo Abe of Japan recently adopted Mr. Bernanke's quantitative easing policy causing the yen to fall 17 percent against the dollar. The Eurozone also cut rates by a quarter of a point to a record low. The euro then fell nine percent. All are following America's path. Since November 2008, the beginning of Mr. Bernanke's unorthodox quantitative easing policy, the US dollar has fallen 18 percent.

To be sure a lower currency has boosted exports but also the risk of higher inflation. History shows that the creation of copious amounts of domestic currency will inflate bubbles and more bubbles, eventually ending up in hyperinflation. With quantitative easing increasing the supply of dollars, many countries have made arrangements for settling their trade balances in other currencies or swaps. The need for dollars is not rising as fast as supply and thus the dollar's value has fallen, a prelude to higher inflation. It is not so different this time.

Larger Image

America's chronic flirting with default (three times in the past year) has undermined the confidence of investors in the integrity of the capital markets. It is difficult to see how much longer US financial hegemony could exist. To be sure the recent fiscal war has cast doubts on the ultimate safety of US debt or even the dollar's reserve currency role. Kicking the can down the road only reinforced investor uncertainty. The US is in a similar situation to Europe, where nothing happens unless there is a crisis. US Treasuries are no longer risk free.

The world is more exposed, more leveraged and more risky, trapped in a cycle of rising debt and falling currencies.

Fiscal Follies

And then there are the Federal Reserve's surrogates, the big Wall Street banks who in aiding and abetting the government's financing of quantitative easing have "gamed" Fed policy in casino-like fashion. All too often there are daily scandals in the world of finance with numerous government probes from the Libor rate rigging, JP Morgan Chase's manipulation of global currency markets where some $5.3 trillion changes daily and now even the London gold fix. Ironically any independence was thwarted with JP Morgan's $13 billion shakedown for selling structured products following the government-sponsored takeover of Bear Stearns and Washington Mutual during the 2008 financial crisis. Or how about those products of state-owned Fannie Mae and Freddie that were issued and sold but found to be equally damaging. Any fines there? The real culprits were Henry Paulson, Barney Frank and Tim Geithner. It is no coincidence that the Dodd-Frank Act created to prevent the next financial crisis, only 40 percent of the rules are finalised, including the recently ratified Volcker Rule. While the industry has complained of government's ungratefulness, they have become no different than China's state-controlled entities. At least in China, they don't fire their own.

The Greenback's Shelf Life Has Expired

For centuries, gold was money. After World War II, the US dollar under the Bretton Woods Agreement was the cornerstone of the global financial system. However, in the seventies, America printed too many dollars to pay for President Johnson's war on poverty and the Vietnam War which resulted in double digit inflation that sapped America's strength as more and more of America's allies swapped their dollars for gold, depleting US reserves. America was forced to drop the gold standard not as a commodity, but as a currency, replaced by floating rates linked to the US dollar. The full faith and credit of the US was lost. Gold subsequently reached $850 an ounce. Today, Washington's fiscal follies are comparable to the seventies when there was a need to put its financial house in order.

When America spoke, the world listened, until now. America's hegemony is over. Today, the combination of an endless string of budgetary deficits, the 2008 financial crisis and two wars in the Middle East have been financed by the issuance of new debt and new money. We believe the printing of too many dollars, and letting politics subvert economics has undermined America's credibility as a prudent custodian of the world's official currency, fueling a distrust of fiat currencies. This erosion of confidence has resulted in a decline of the percentage of dollars held as a reserve asset to only 56 percent. The spectacle of Washington's disarray has strengthened the desire of America's creditors to diversify their big foreign exchange reserves, lessening their reliance on the dollar. Russia for example has taken steps to free itself from the dollar. Since 2007, Russia has tripled its gold holdings and widened the bandwidth in which it allows the ruble to fluctuate against the dollar-euro basket.

Of concern is that America's policy of supporting bond prices and currency debasement has pushed worldwide risk correspondingly higher. In fact if the much feared tapering finally arrives, we believe it will bring turmoil to the markets sending shockwaves and money from the so-called safe haven of bonds into gold. Money has been cheapened, it has become a market commodity, much like the tulips during the Dutch tulip mania - the more printed, the less the worth. Holders of vast amounts of dollars are witnessing an erosion in confidence. Neither the euro nor renminbi are yet in a position to supplant the greenback, but Asia and many others are calling for alternatives to fiat currencies and the dollar. It is the relationship between the dollar and the reaction of some central banks that makes gold an attractive buy here. The Fed can print money but it cannot print gold. We thus believe gold's 2011 peak at $1940 an ounce will be surpassed. The bandwagon is empty.

China Is Challenging America

China's population of 1.4 billion people is four times that of the US, yet its economy is only half its size. China has become richer, faster than any country in history shifting trade from the west to the east with an insatiable appetite for resources. China trades as much with the rest of the world as the US. While the recent Third Plenum's communique lacked details, the push for market forces to play "a decisive" role in allocating resources will allow China to rebalance its warp speed growth. Its growing wealth has sharpened its appetite for power. While there is much attention on Beijing's economy or lately, the airspace over East Asia, China has also pursued a separate path in international monetary markets. The economic order has changed. We believe the disharmony with the United States risks damaging relations, especially over the dollar.

China too has been buying gold and the renminbi now is among the top ten international currencies traded. The UK recently relaxed requirements for Chinese banks to allow direct renminbi/sterling trade, making the pound the fourth currency to trade directly against the renminbi and one of over twenty four arrangements allowing central banks to swap renminbi for other currencies.

The Middle Kingdom is Golden

Inflation is currently running at three percent in China and seven percent in India. With a sinking US dollar, gold is an effective inflation hedge for these countries. We also believe the recent purchases of physical gold is a major step in the internationalization of the renminbi as it makes the renminbi more liquid as part of the goal to make the renminbi a reserve currency. Figures show that the renminbi has passed the euro as the second most traded currency for trade finance. The mobilisation of the Chinese renminbi to allow investment overseas, settle trades in Chinese currency and the development of its financial markets is an important move to make the renminbi, the anchor for China's financial system.

China is also the world's largest gold producer producing a record 440 tonnes this year and its gold producers are buying offshore production. Of interest is that the gold producers sell their production to the Peoples Bank of China (PBOC) which three years ago held 1,054 tonnes of gold. While China does not publish regular updates, it no doubt holds more since the amount is a fraction of their $3.7 trillion foreign exchange reserves, which is three times more than any other country. While most western nations hold 10 percent of their reserves in gold, China's tiny two percent is still the fifth highest holding in the world.

Meantime, China's consumption is expected to increase 29 percent and will likely import 1,100 tonnes overtaking India as the biggest consumer of gold. Both countries have centuries-old tradition of valuing gold highly. In fact, the Shanghai Gold Exchange and Hong Kong Gold Exchange reported that some 30 percent of contracts were delivered physical or a whopping 1,730 tonnes in the first eight months alone. Since its inception, the Shanghai Gold Exchange has delivered 8,655 tonnes of gold or more gold than is held at Fort Knox. This is corroborated by reports from Switzerland that the four Swiss gold refineries which refine 70 percent of the world's gold, imported 2,420 tonnes while exports totaled a record 2,184 tonnes. Much of that gold went to China via Hong Kong. There are even reports that the refiners have converted the ETFs' 400 ounce bars into 1 kg bars, shipping them to China because of a healthy bar premium.

The world's mine supply, on the other hand is only estimated at 2,400 tonnes. In essence, Chinese demand alone has taken virtually the entire western world's production. With China holding too many dollars and not enough gold there is simply not enough gold to satisfy this demand. We believe that with China's huge dollar reserves depreciating daily, their appetite for US debt has been replaced by gold purchases in a tug-a-war between China and the Western banking system's fiat paper.

We believe there will be a new kid on the block and this time it is to be the renminbi based on a basket of currencies pegged to gold. Deja vu. In fact, similar to a basket of currencies like the IMF's SDR or Special Drawing Rights which already exists today but is limited in circulation. On the other hand, gold is very liquid becoming the default currency for some countries with some 175 million ounces, worth $220 billion, changing hands daily - certainly better than Bitcoin with only $19 billion in circulation. Gold is a hedge against the chance that the world's central banks will botch an exit advertised as pain-free, It will be an alternative investment to the dollar for many of these central banks, if the exit is not.

Recommendations

We believe the tip of the iceberg may be gold itself. There is a divergence between the availability of physical gold and paper gold with deliverable Comex inventories dropping from three million ounces to 700,000 ounces. The plunge in the gold price was caused by extraordinary large sell orders dumped on a coordinated basis at least a half dozen times. The dramatic drop in delivered gold has caused more than 800 tonnes of redemption from the gold ETFs, resulting in a dramatic shift with physical gold ending up in Chinese vaults. The gold cupboards of the West are empty and markets are vulnerable to a huge short covering rally.

Gold climbed a whopping 550 percent in a twelve year run from the August 1999 low at $253 an ounce to the peak at $1,941 in September 2011 spurred by the financial crisis and quantitative easing. Since the peak, gold has fallen 37 percent or 26 percent this year, retesting the lows. Gold trading was interrupted half a dozen times as large futures contracts were dumped on the market raising questions that these leveraged bets were really manipulation. The trading action, however has caused a shortage of physical bullion. Inventory stockpiles on Comex are at record lows such that paper claims per ounce of registered gold are at a whopping 70 times. There is simply not enough gold to satisfy these claims. As such we continue to believe $2,000 an ounce is only an interim objective and gold's twelve year bull run is not over. This year is the pause that refreshes.

Yet gold production will be slightly higher this year due to the commissioning of mines started during the hey days of yesteryear like Detour Gold, Barrick's Pueblo Viejo and Osisko in Quebec. However falling prices, declining grades and a capital restrictive environment has resulted in the shelving of multi-billion sinkholes like Kinross' Tasiast or Barrick's Pascua Lama. Disasters de jour like Colossus or San Gold have hurt investors reminding them that not all gold deposits are alike. Gold producers are echoing the mantra of profitability instead of growth at any cost and the industry is finally restructuring and undergoing needed change. Over twenty CEOs have been replaced and the executive washrooms were shutdown.

The gold miners' third quarter results showed the benefits of a combination of a reduction in capital spending, disciplined cost controls and an emphasis on balance sheet liquidity. We believe the industry will consolidate further with an emphasis on the acquisition of those companies with world class deposits instead of the development of marginal deposits dependent upon higher prices and big dollars. The low hanging multi-million ounce deposits have been picked.

Growth in mine supply is thus challenging. The huge capital cost and operating cost inflation together with increasing nationalism has made a shortage of world class deposits. High grade deposits have become increasingly rare. The average grade today is only a gram per tonne, so we believe the in-situ resource of the producers will become increasingly more valuable. Today the in-situ reserves of the gold miners are valued by the market at only $215 an ounce market cap per once or half of a year ago. Too cheap and as such we believe many will be privatized, instead of going bankrupt. Reserves are just too valuable.

We believe that premium valuations will go to those producers with above average grade deposits. Rather than the mega transactions of the past, we expect more bolt-on acquisitions like B2B Gold and Volta or Eldorado and Glory. As such, we like Barrick among the seniors. Agnico Eagle, New Gold and Eldorado are among our favourite intermediate players. We also would take advantage of the more junior plays such as St. Andrews Goldfields, Detour Gold and McEwen Mining which are favoured as simple options on the gold price.

Agnico-Eagle Mines

Agnico reported a strong third quarter due largely to the changes made late last year. Higher grades at Meadowbank and Kittila helped results and there was a solid contribution from La India and flagship LaRonde together with an initial contribution from Goldex. It is our view that Agnico has one of the better management teams led by Sean Boyd and Agnico has been successful in developing early stage projects. In fact, Agnico has become the "go to name" company amongst the juniors and now has a portfolio of juniors of which one or two are potential producers. Agnico also has an enviable unbroken dividend record of 31 years great balance sheet and we continue to consider Agnico a Strong Buy.

Barrick Gold Corp.

Barrick is the world's largest gold producer but its shares were cut in half due to the decline in gold, management missteps and a stretched balance sheet. However, newly minted President Jamie Sokalsky produced a strong third quarter beating analysts' projections due to a dramatic reduction in costs and headcount as well as the divestment of noncore assets. Importantly the company will save $1 billion by mothballing Pascua Lama which was going to be the world's most expensive gold mine. With $5 billion sunk already, Barrick's decision was necessary and most importantly, the gold reserves have not disappeared, which might be useful when gold is over $2,000 an ounce.

Today the world's largest gold producer is trading under eight times expected earnings and is attractive even for the value players. Additionally, while Barrick's $3 billion equity offering met with a mixed reception, the proceeds were applied towards reducing debt and improving the balance sheet. Importantly there was changes at the Board level. Founder Peter Munk's successor John Thornton with a bulging rolodex, after one year in training will become Chairman and will pursue a more strategic international orientation. We believe that the corporate governance issues were more of a red herring and that much of the changes including the addition of Ned Goodman will dispel the governance issues. In addition, the world's largest gold miner might also bring in new partners to develop its vast assets. Barrick has flexibility. After all, even without Pascua Lama, Barrick has more than 120 million ounces in the ground. We believe that the bad news has been discounted, and any good news will cause a welcome bounce and the risk/reward is attractive here. We maintain our Strong Buy for Barrick.

Eldorado Gold Corp.

Eldorado has five development projects in Greece with core operations in Turkey and China. Eldorado's results have weakened partly because of teething problems and concerns that the Greek development would monopolize management time. Greece is important but local and permitting issues have delayed projects. Eldorado continues to build up flagship Kisladag in Turkey which had a strong quarter, with a 12 million ounce resource. Eldorado is a low cost producer with a strong balance sheet with $600 million of cash. We continue to like the shares here and still consider Eldorado a Strong Buy.

Goldcorp Inc.

Goldcorp reported results were in line with expectations with higher production of 651,000 ounces due to the contribution from newly commissioned 40 percent owned Pueblo Viejo in the Dominican Republic. Like others, Goldcorp emphasized cost reduction and importantly continued development at Eleonore in Quebec and Cochenour in Ontario. Meanwhile at flagship Red Lake mine in Ontario, gold production was 97,000 ounces. Red Lake produces almost 500,000 ounces on an annual basis. Drilling on the NXT zone continues and good news is coming from the new 47 level exploration drift. However problem-prone Penasquito's mine in Mexico is still operating at less than capacity with water availability remaining a problem. Costing billions. Penasquito is turning into Goldcorp's Pascua Lama. At current levels, we prefer Barrick because Goldcorp's problems are deep rooted and we believe are not yet discounted in the share price. We maintain a Sell on Goldcorp shares.

IAMGold

IAMGold had another disappointing third quarter but maintained its guidance for the year. However, all-in costs jumped 20 percent to $1,200 an ounce as IAMGold's margins narrowed. IAMGold's announcement that the Westwood mine in Quebec would be pushed back due to a rock burst until late next year caused another drop in the shares. We believe that the deferral is disappointing. The Essakane Gold Mine in Burkino Faso build-out is continuing and will make a contribution next year. In short, we do not see much on the horizon for IAMGold, and believe that Cote Lake project's capital cost in Ontario is too high and therefore a likely sinkhole candidate. We still view IAMGold's share a Sell.

New Gold Inc.

New Gold has mines in Canada, United States, Mexico, Australia and in Chile. Both Mesquite in California and Cerro San Pedro are open pits which are big contributors to cash flow. Peak Mine's output in Australia is higher and the copper by-products have kept underground costs low but the project requires healthy sustaining capital. New Gold's output will improve due in part to New Afton, which had a strong quarter. The mine's throughput is 12,000 tonnes a day and could be expanded to 14,000 tpd. New Gold has an excellent pipeline in Blackwater, El Morro but recently acquired Rainy River could cost $800 million to build. An updated feasibility is expected shortly. We like New Gold's pipeline here as well as its focus on low cost growth. We now consider New Gold's shares as a Buy.

Yamana Gold

Yamana had a strong quarter with a reduction in all-in costs while cash flow increased 20 percent. Yamana's El Penon flagship in Chile produced 123,000 ounces up four percent from a year earlier. In Brazil, costs shrank but Jacobina remains a problem due to insufficient underground development work. Yamana has ramped up C1 Santa Luz, Pilar, and Ernesto but permitting has caused delays in the current quarter. The Ernesto/Pau-a-Pique mine strategy was changed and thus commercial production will be delayed into 2014. Yamana has cash and available credit of $1 billion and is well financed. Yamana needs another flagship like El Penon but today has been unsuccessful. At current levels we prefer Eldorado Gold. We maintain a Sell on Yamana's shares.

Larger Image