Gold: Whoever Has the Gold, Makes The Rules

June 1, 2017

Leaked memos, recorded conversations, impeachment talk and a plunging stock market. Trump and his White House problems? No. Brazil. The Brazilian stock market took a nose dive wiping out this year’s gains on newspaper reports that Brazilian President Michel Temer, installed only last August after the impeachment of his predecessor Rouseff, is involved in a cover-up and bribery scheme. It seems that Washington is not the only swamp to drain.

Amid the controversy over yet another firing, the Washington circus is again caught up in another dysfunctional gridlock. As he careens from one controversy to another, Mr. Trump is determined on fixing America- his way. Lost in the hysteria is his economy-boosting agenda is divided along party lines. Washington is intensely polarised and the American system is undergoing yet another stress test, with echoes of Watergate. Donald Trump’s impulsiveness and distaste for orthodoxy, Congress, the media and even his own party, is at the root of this political turmoil. As a result, the Trump bump has turned into the Trump slump and while the dollar slips to six month lows, business is concerned that his plan to overhaul healthcare, the federal budget and tax code will be sidelined by his antics.

However, impeaching Donald Trump requires two things. The first, the Republican controlled House of Representatives would need to vote for impeachment by two-thirds and then the Republican controlled Senate would have to ratify impeachment by a two-third majority. Thus, impeaching Trump becomes a political, not a legal question, difficult when polls show that likely

US voters approve of his job performance (Rasmussen Reports) by a 48 percent margin. Everyone should take a deep breath – four more years.

The Trump Card

But true to his word, the Trump administration focuses on the biggest wholesale changes to the tax code since the Reagan era. While laudable and ambitious, the plan is to reduce seven tax brackets to three and slash the corporate tax rate to 15 percent from 35 percent. While the tax cuts are at the centre of his economic agenda, they require congressional cooperation, not an easy task today. Yet all this will cost trillions with the ratio of public debt to GDP already at 100 percent, set to soar again.

To be sure his cabinet has loads of business experience but their cultural DNA consists largely of financial experience and transactional relationships, particularly in distress debt rather than the operation of a big company. Some are a coterie of tycoons whose wealth came from risky bets and reward, taking advantage of the cheap prices following the global crisis of 2008. That explains the potential mess up over trade with their instinct to use brinksmanship or a zero-sum view as part of the negotiations, led by the master negotiator, Donald Trump. Give a little and instead of diplomacy, stick to generalities, obfuscate and if the deal, goes badly, just walk away. No nuance here. In Mr. Trump's first hundred days, pulling out of TPP, challenging NATO, the threat to tear up NAFTA are good examples of the cut and thrust of his “take no prisoners” negotiations. America’s enemies should be so lucky.

Honey, I Shrunk the……

Last year, the Fed financed roughly 40 percent of America’s budget deficit. The risk is that if the Fed advances plans to unwind its massive $4.5 trillion balance sheet, amassed during the crisis, the supply could destabilize the market just at the same time as Mr. Trump attempts to finance his huge deficits. Most likely the Fed will allow the securities to mature, minimizing the impact but problematic, since the Fed is the biggest buyer of its securities. There is even concern that the balance sheet which has grown fivefold since the crisis could actually be used as a piggy bank to finance Trump’s programs, simply because Americans have few savings. The crowding out effect last occurred in the 2007 – 2009 recession when the deficit last hit $1 trillion. Ironically Mr. Trump’s portfolio of spending plans is to cost over $1.1 trillion so his deficits are set to soar, and not only roar. So without the obvious tax increases, how to fund the deficits?

Worrisome is that in the face of those numbers, the “exit strategy” coincides with a deterioration in relations with America’s so-called trading allies he is bashing today, at a time when their capital is most needed to fund Trump’s programmes.

History illustrates that unfunded deficits are unsustainable and there is a cost. Timing this time is a factor since Congress must pass Trump’s reforms before next year’s mid-term congressional elections in 2018, when his party could lose seats and control of the House. Also Congress and Trump must lift or suspend the debt ceiling since the spending limit extension expires this September. As Trump’s predecessors from Reagan to Bush learned, tax cuts that are to be revenue neutral, instead blew large holes in the federal budget and always, were paid with more borrowings. The hard truth is that politicians and Mr. Trump find it easier to spend and for that reason, deficits are set to soar. The other, of course is that despite plans to lower the rates of tax, America’s tax code continues to encourage businesses and consumers to borrow, because interest remains tax-deductible.

Let’s Do The Time Warp, Again

Central banks have become the world’s largest buyer of government bonds, in an incestuous arrangement to lower rates to revive the global economy. The world’s central banks have manufactured some $20 trillion of liquidity as part of a global quantitative easing binge that caused an explosion in bank reserves which has not yet filtered into the economy in the form of increased money supply. Central banks believe they should keep their feet on the monetary pedal because core inflation, which excludes volatile energy and food remains stuck at only one percent.

Nonetheless, we would argue that there has been an inflation in asset prices, not in services. The lack of headline inflation is because trillions of printed money, remains on the balance sheets of the central bankers’ surrogates, in the form of higher reserves as a knee jerk reaction to the 2008 financial crisis. That cheap money has driven up a series of risky credit bubbles in stock markets, real estate, and even art ($110 million for a black skull) last seen before the financial crisis of 2008. Simply borrowers are artificially subsidised and every bubble-like asset class has become dependant upon this addiction to cheap money, driving down risk premiums.

Today, the average age of the baby boomers is about 62 and rather than a surge in consumer spending, boomers instead are saving for their retirement. Consequently, lagging retail sales, car purchases and mall vacancies are not surprising. For the past couple decades, consumer spending made up about two-thirds of the economy as those boomers bought cars and houses. Worrisome is that retail accounts for about a tenth of US jobs and since the beginning of this year, the US retail sector has lost some 89,000 jobs – more than America’s total employment in either coal or steel. In addition, the much bally-hooed manufacturing sector which actually employs less than 9 percent of America’s workers, represents some 12 percent of GDP, but receives about 100 percent of Mr. Trump’s “America First” obsession.

Unfortunately, he, our politicians and central bankers are still stuck in a Rocky Horror show time warp and their ready-made solutions are for another dose of money and credit creation which is not surprisingly, ineffective. And now, President Trump is looking for expensive tax cuts to make America great again. What ageing boomers really need is better healthcare, more retirement savings and not more debt. With subprime auto loans and credit card debt at record levels, boomers are encouraged to pile on yet more debt, initially for schools, houses and today for more of the same consumption with borrowing costs so cheap. Let’s do the time warp, again.

The Consequence Of Fiscal Irresponsibility

We believe the dollar standard is the Achilles heel to America’s greatness. The US government has incurred a record amount of debt for more than half a century and is a beneficiary of the dollar dominance. The Federal Reserve has become the world’s central bank. Also American imports caused a tide of dollars to go overseas. And then, quantitative easing resulted in another flood of dollars. We believe Trump’s threats to fix the soaring current account deficit will only exacerbate the problem. Already, German chancellor Merkel has warned about relying on US economic hegemony. She is right.

The White House may be in turmoil today but that also undermines America’s profligacy and power. America is the world’s biggest borrower. Since yearend the dollar has fallen 5 percent dropping to pre-election levels as the Trump administration suffers legislative and legal setbacks. The dollar has recently met competition as America’s trading partners seek to end their monetary hegemony and vulnerability to the whims of a president.

Gold Is Alternative Money For The World’s Central Bankers

Lately, the US dollar has swooned, bitcoin has soared and gold has reversed as a consequence of global quantitative easing. If central bankers can seemingly print money with impunity, the value of money eventually erodes. After all, the only thing underpinning this fiat currency is the faith and credit of the US government and that faith is testing its limits. Under the classic gold standard, countries accumulated gold in order to conduct their business and backed their respective currencies with gold. Exchange rates were fixed against gold just as they are fixed against the dollar today. Then countries could not print their way nor pay their bills with paper obligations to conduct business. The strongest currencies reflected the strongest economies.

Today, the main argument against reverting to a gold standard is because there's not enough gold in their world, which overlooks the fact that most central banks already hold gold in their reserves. The European Central Bank (ECB) for example was set up with contributions of gold from its member countries. Ironically. America today is the largest holder at 8,100 tonnes but is also the world's largest debtor. Canada unfortunately sold its gold and their cupboard is bare.

Nonetheless, in the past few years, some nineteen central banks continue to be net buyers of gold. Russia has made monthly purchases. China regularly accumulates gold, and officially holds over 2,000 tonnes making it the fifth largest holder in the world, up from only 600 tonnes a few years ago. We believe China’s purchases are a hedge against their huge $3 trillion dollar of reserves and is a step towards the realignment of the global monetary order which will see a gold backed renminbi.

One Belt, One Road, One Ambition

China is rebuilding the Silk Road that underpinned its golden age over a thousand years ago. The scheme is to bring about a new “golden age” of globalisation as President Xi Jinping recreates the Silk Road in a trillion-dollar massive infrastructure initiative to strengthen trade links between China, Russia, and Europe. China’s new Silk Road involves huge investments in infrastructure, energy and includes building deep water ports in Pakistan, new rail links, new maritime routes, and highways along the trade corridors to Europe. China’s One Belt, One Road will be financed by various state run banking entities cementing China’s trade, development and influence. Meantime, its private sector companies such as HNA are making ambitious bets acquiring an almost 10% stake in Deutsche Bank.

We believe China has taken these important steps to reduce the dollar’s hegemony. In contrast, China has strengthened its domestic currency role as a trading currency with swaps for oil with Russia and bilateral trade deals in Africa and Latin America. Deliveries from the Shanghai Gold Exchange (SGE) were a whopping 2,000 tonnes in contrast to Comex’s paltry 50 tonnes last year. Volumes surged 43 percent reflecting strong demand. China remains the world’s largest consumer of gold and its largest producer but that production remains within China’s borders because demand exceeds supply. While hedge funds in the west have been dumping gold, China has been purchasing massive amounts, as gold moves from the west to the east. It is believed that soon, China will have more gold than the Americans. Remember the golden rule, whoever has the gold, makes the rules.

The Eye Of The Storm

Overlooked is that historically low rates have lowered the discount that investors put on future cash flows which in turn, debases returns and risk. The VIX index often called the “fear index” measures the implied volatility of the market, recently reached the lowest level in more than 25 years. Is this the eye of the hurricane or the continuation of an ageing bull market which has bred a complacency that has ignored Trump’s tweets, Middle East uncertainties or even a Brexit? We believe the bastardization of our capital markets by algo and high frequency trading is behind the dampened activity. Our belief is that credit markets are simply addicted to low rates becoming overly complacent to both geopolitical and financial risks. Many are surprised that faith in the status quo remains which is as big a risk as the low rates themselves. This is not healthy, normal and unsustainable.

Another reason for the lack of volatility is the development of derivatives that were supposed to hedge risk which caused an explosion in algorithmic trading following the collapse of 2008. In fact, the value of the VIX relates to the cost of insuring against price changes via the derivative market. The price is set by supply and demand.

Today, the number of market indices now exceeds the number of US stocks. As opposed to popular indices, like the Dow Jones or Standard & Poors (S&P 500), the new indices are based on baskets of investment tactics or strategies which are tracked by derivatives or structured products. Rather than pay the hefty fees of an actively managed fund, a fund manager today can easily buy an ETF and, to make matters worse, Wall Street created a derivative on the indices (bull or bear) which tracks the ETF, itself a derivative. To no surprise then, Harvard University Endowment’s largest holding is a high-yield bond ETF. Many have forgotten Warren Buffett warnings over derivatives who called them “financial weapons of mass destruction” in 2003. In not following his own advice, it cost him almost $200 million to close his derivative position last year.

Trump Is Good For Gold

We believe that Trump’s deficits, the decline in civility and the lack of funding will fuel rates and that in turn will increase risk, causing a global demand for safe assets. Financial crises ten year ago still casts long shadows. The biggest question remains how to pay for America’s debts? Debasement led to the worst financial crisis since the 1930s. The problem is that there are too many different instruments that are the equivalent of money. While, monetary policy rather than fiscal policy has helped the recovery, the exponential build-up of debt is unsustainable. Consequently, we believe that gold is the ultimate hedge against the risk that the government's fiscal plans will run against the funding problems mentioned earlier. Unlike the “weapons of mass financial destruction”, there is no counterparty risk with gold.

In sum, gold will continue to rise as long as the US budget remains in deficit, the US trade account is in deficit and Donald Trump is in the White House. Trust in Trump has disappeared both at home and now abroad. Ironically, Mr. Trump will be very reliable as an agent of dollar devaluation, which is good for gold.

Gold’s new bull market has just begun.

Recommendation

After five years of belt-tightening, the gold miners have started to loosen their purse strings making new acquisitions, joint ventures or dusting off old plans. In response to a second year of declining production, some miners have acquired stakes in development projects. Newmont recently acquired an almost 20 percent stake in Continental Gold’s Buritica deposit in Columbia. Eldorado grabbed Integra Gold for its resurrected Lamaque play in Quebec which gives it a better geographic spread. Although, in both cases the acquisitions were bite sized, the companies had to pay up and

neither project will be in production until early 2020. Meantime Goldcorp spent nearly $1 billion to develop the huge Cerro Casale project in Chile. Goldcorp acquired a 25 percent stake in Cerro Casale from Barrick and another 25 percent stake from Kinross which gives it a big slice of the Maricuna gold belt. However the project will still require sizable dollars to put in production and despite Cerro Casales being a huge 23 million ounce deposit with a long life, the price tag is in the billions and at least six years away from production. Technical and water issues remain.

Within the group we like Barrick and Agnico Eagle among the seniors, B2Gold among the intermediates and McEwen Mining among the growing junior space. A realignment of the junior ETF GDXJ ironically favouring more established players, presents an opportunity to begin to invest in more junior exploration players. We favour and helped finance Dr. Keith Barron’s Aurania which has the largest land position in Ecuador with which he hopes to discover another monster Fruta del Norte, that Lundin Gold will bring into production late 2019.

Agnico Eagle Mines Limited

Agnico Eagle reported excellent results and increased their full year guidance to 1.57 million ounces with a 2 million ounce target by 2020 from the LaRonde Complex, Canadian Malartic, Meliadine and Amaruq (Meadowbank). The company has grown its eight mines organically as well as growing opportunistic acquisitions like Kittlila and Meadowbank. Amaruq itself will extend the life of its Nunavut operations. Agnico’s cash position remains strong and sustaining capital this year is only about $850 million. Reserves increased last year to almost 20 million ounces. We like the shares for its rising reserve and production profile. Agnico has paid a dividend every year since 1983.

B2Gold Corp.

B2Gold delivered excellent results from its four producing mines, two in Nicaragua, one in the Philippines and one in Namibia. Construction at Fekola is one quarter ahead of schedule and will be the third largest producer in Africa. With an October start, Fekola in Mali is fully funded and will contribute free cash flow next year enabling the funding of the Kiaka project in Burkina Faso, one of the largest undeveloped gold resource in West Africa. To date the Masbate Mine in the Philippines and the Otjikoto mine in Namibia performed well. We like B2Gold for its execution and above average growth profile which will see B2Gold produce some 950,000 ounces next year.

Barrick Gold Corp.

The world’s largest producer is stymied by a Tanzanian ban on concentrate exports following the release of a report investigating gold exports which impacted. Barrick’s 64 percent owned Acacia. The miner thus stored a month’s production in 277 containers. The lost output however only accounts for roughly 10 percent of Barrick’s annual production of 5,400,000 ounces and the company has not adjusted guidance. We believe that since the two mines are important to the Tanzanian economy and the mine minster was axed following the report, the disruption is not expected to last. We would take advantage of Barrick’s share weakness and purchases are recommended.

Centerra Gold Inc.

Centerra shares are cheap here despite hopes for a rerating on turning around the Mount Milligan acquisition in BC. Centerra’s improved results from the Kumtor mine in the Kyrgyz Republic produced a strong quarter producing 127,000 ounces at a very low cost. Grade improved. The company has $277 million of restricted cash at Kumtor which is in dispute with the government. Importantly negotiations continue and all permits have been granted on an annual basis.

Nonetheless government negotiations are difficult such that Centerra’s recent acquisition of Mount Milligan, geographically diversified the company's assets. However, Mount Milligan’s mill throughput was below plan and grades were also poor. Centerra is an intermediate gold producer with a low cost asset base. Oksut in Turkey should be started this year. Cash and cash equivalents declined to $357 million including restricted cash.

Eldorado Gold Corp.

Eldorado expanded to Canada acquiring Integra Gold in Quebec for a whopping $600 million. Integra is a junior, developing Lamaque and the $590 million acquisition was paid in cash and shares. Eldorado had available liquidity of $1.1 billion so the acquisition was easily handled. Lamaque was a key part of the old Sigma assets. Recent drilling has increased the resource. Although, there are no reserves yet, grades have been better than 9 gpt. Integra had a prefeasibility study with a four-year payback but Eldorado's people will have to go in and refine that. Eldorado recently shelved plans to expand its Turkey operations, so this deal offers Eldorado a third leg, after Greece and Turkey. We like Eldorado here.

Detour Gold Corporation

Detour had a disappointing quarter reflecting the difficulty of making money at its flagship Detour Lake open pit mine, the largest gold mine in Canada. The company is attempting to secure a $400 million debt facility to refinance $300 million of obligations this year. Detour Gold has shelved West Detour Lake’s development plans which flattens their production profile. We believe without clarity on the second phase, together with a tight balance sheet, the company's prospects are constrained near term. Nonetheless Detour has a long mine life with reserves of over 16 million ounces and is a good option on higher gold prices. Hold.

Kinross Gold Corp.

Kinross had a good quarter with a solid contribution from Bald Mountain and Round Mountain in Nevada. The Tasiast mine in Mauritania produced 64,000 ounces but the company seems to be trading dollars here until the Tasiast Phase 1 expansion is complete. Major cash contributor Paracatu in Brazil had a weak quarter producing about 108,000 ounces. Kinross has steadily improved each of their operations in the US, Brazil, Russia and West Africa. Kinross will produce 2.6 million ounces this year at a cash cost of about $700 per ounce. Pro forma after the sale of the 25 percent interest in Cerro Casales project, cash and equivalents leaves Kinross a healthy cash balance $819 million. With available credit, total liquidity is $2.3 billion adequate to fund Kinross’ emphasis on organic growth. Kupol in Russia remains a geographic risk however. We prefer Agnico-Eagle here.

John R. Ing

jing@maisonplacements.com

78 percent of the yearly gold supply--is made into jewelry.