Gold: That 70's Show
John Ing
Gold is a barometer of investor anxiety. Last year gold was the leading asset class gaining 25 percent, outperforming all the world's stock markets, major currencies and world's hedge funds. Historically gold has a negative correlation or inverse relationship to the stock market and US dollar. The US dollar index has fallen almost 17 percent against the major industrialized currencies, its biggest drop since 1987. Over the same period the Dow Jones Index fell 17 percent for the third consecutive year in a row, only the third time that this has occurred over the last hundred years. Indeed, gold is the ultimate hedge asset class.
After hitting $390 an ounce in February, gold retreated on expectations that the countdown to war was postponed. Gold was seen as a safe haven and the war premium was quickly extinguished following Blix's speech to the UN. While gold's stellar performance has been remarkable, we believe that we are only at the beginning of a multi-year bull market. The average price for gold last year was $315 an ounce and our expectation is that $375 an ounce will be the average this year. Gold's role as a store of alue is the basis for our belief that gold will trade at $510 an ounce this year.
Gold's Move Preceded Iraq
The price spikes of gold and oil over the past year has surprised most investors and the conventional wisdom is that the sharp rises are attributable to the sabre-rattling with Iraq. Some believe that a quick war with Iraq, as was the case in the Gulf War, will be a positive catalyst for the economy lifting the veil of uncertainty over the stock market. Gold and oil then would quickly lose their war premiums. Overlooked is that much of the increase preceded the Iraqi war drums. Gold has been going up for other factors and the prospect of war has only exacerbated this trend. While the intensifying geo-political tensions have influenced gold's performance, the main driver was the lack of confidence in the US dollar and the stock market. When the fog of war ends, the structural imbalances will still remain in the economy, underpinning even higher gold prices.
Another myth is that since gold shares have lagged bullion, they must have reached their peaks. Again that is wrong. Gold shares and bullion do not always go hand-in-hand. Following gold's move to $330 an ounce from the $253 an ounce low, gold shares outpaced bullion. However, when gold spiked above $330 to $390 an ounce, gold shares were laggards. Part of the reason is that the TSE gold index is heavily weighted to the big cap companies such as Barrick and Placer Dome, which are heavy hedgers. These companies were non-performers because the upside is capped whilst the unhedged mid-cap producers and the leveraged juniors have quadrupled. Pundits also argue that the huge hedge funds have shorted gold shares and put a long position on gold. And, once the war is over they will flatten that trade. We do not subscribe to this view since the reported shorts are attributable more to the arbitrage opportunities following the Kinross Gold amalgamation and/or the recent unit offerings with warrants. Our view is that a more likely influence for gold shares' non-performance was the successive rounds of offerings as investment dealers took advantage of the rising price and flooded the market with paper.
The Big Drivers For Gold
A big driver for gold's move is the positive changed supply/demand fundamentals. Last year, total global demand was 3,900 tonnes, of which jewelry accounted for almost 3,000 tonnes. Total fabrication demand was almost 3,500 tonnes against global mine output of only 2,500 tonnes. Scrap sales, central bank sales and producer hedging filled this deficit. Mine supply is expected to be down again because no new deposits have been found and it will take a few years to bring onstream those discoveries found in the eighties.
Physical Shortage of Gold
Further reinforcing gold's rally is the looming physical shortage of gold as central banks and the bullion banks attempt to recover the bullion they have lent to third parties in the form of gold loans. The mining industry has scrambled to deliver against their hedges and even bought back hedges, which serves to provide a solid base to gold's uptrend. We expect this trend to continue. The lack of contango and dehedging will force the industry to become net buyers, supporting even higher gold prices. To date, we believe the industry has bought back only about 10 percent of the estimated global hedge book.
Gold has become the default currency of the world. With the collapse of the US dollar, gold is the second largest held reserve in the world. Indeed, gold's recent strength is due to the lack of currency alternatives, not the impending Iraqi war. Of greater importance is the message that a $500 an ounce gold price will send to the world. Gold has historically served as a beacon, keeping investors protected from the financial shoals. In the nineties, that beacon dimmed as investors refused to take heed of the past and preferred to leverage up the financial system. Following the nineties' legacy of debt, gold's beacon is shining every brighter.
Deficits Do Matter
There are a number reasons to take heed of the brightening picture for gold. Since the dollar's turning point in July 2001 (before Iraq became headlines) it has fallen 17 percent. The cause of the US dollar decline is clear. Today, the US dollar is fundamentally overvalued and over-owned. Americans have again become the world's largest debtor and foreign investors are pulling out of the US. It must borrow about $200 million from the rest of the world each day just to cover the savings gap. The Americans must absorb almost $2 billion of overseas capital to finance the shortfall. Alternatively, the Fed must print as many dollars as is required to pay for the twin deficits - fiscal and balance of payments. The price of debt has not gone unnoticed. Deficits do matter. Fed Chairman, Alan Greenspan warned, "once debt to GDP begins to rise, there's just no self-correcting mechanism, the debt just continues to rise." Greenspan further cautioned, "short of a major miracle in immigration, economic growth cannot be safely counted upon to eliminate deficits and that difficult choices that will be required to restore fiscal discipline." In the past four years, America's current account deficit soared from $128 billion to over $435 billion and will be a whopping $600 billion this year or 6 percent of GDP.
New Decade Of Red Ink
And then there is the other deficit, the budget deficit. President Bush has taken a $200 billion budgetary surplus and turned that into a projected record $300 billion deficit in 2003, exceeding the last record budget deficit of $290 billion in 1992. President Bush is attempting to fight a war and keep the economy strong without raising taxes. It can't be done. Vietnam was the last bitter lesson where policymakers learned that they could not have both "guns and butter" at the same time. History shows that inflation always follows wars that are not paid for. Duct tape is of little use here. With the Fed reducing interest rates eleven times to near zero, the Bush administration resorted to other weapons in its arsenal, unveiling a $2.2 trillion budget with deficits into the next decade. The
funding of the US economy comes just when the absence of savings and growing government deficits requires a desperate need for external financing. Using Washington's numbers, the tide of red ink already represents 3 percent of GDP, a level last seen in the late 1980s when the US faced a current account deficit representing 3.5 percent of GDP. Then, the US dollar lost almost half of its value.
Guns And Butter Must Be Financed
Like Lyndon Johnson, President Bush has optimistically called for a 100-hour perfect war with Iraq. Politicians are always optimistic about both the amount of time and the cost of waging wars. The Gulf War was not a seven-day war, but lasted a month and half and was financed by the Saudis and Kuwaitis. The Vietnam War was supposed to last only a few months but dragged on for twelve years and cost ninety percent more than forecasted. The Korean War lasted three years and of course WWII lasted almost six years. Little is said of the cost of the Iraqi War, whose aftermath or reconstruction cost is estimated to be between $50 billion to $300 billion. Even less is said on how and who is to pay for this war.
Déjà vu - That Seventies Thing
In the fifties and early sixties, inflation was dormant. But by the late sixties because of the war and government reflation, inflation picked up. In the seventies, the commercial paper market quadrupled in size in only four years. Money was cheap despite increasing inflation. Credit card borrowing ballooned as well and credit card debt soared to record levels. With the explosion in debt came the over-issuance of money and the inevitable explosion in inflation. The ensuing high interest rates did not even slow the real estate market, it mortgaged it. Indeed it was the explosion of loans that played a major role in the strong recovery from the '73-'75 recession. Between 1968 and 1981 the stock market moved sideways giving rise to "stagflation". However when inflation soared, interest rates went up because America had too much debt and not enough gold. The US dollar collapsed.
During the seventies, the flawed economic policies led to a 70 percent fall in the dollar. President Nixon severed the gold link in 1971 and the gold standard discipline disappeared with it. The US dollar became worth exactly what America said it was worth - not very much it seems. Then in 1979, Jimmy Carter appointed Paul Volcker to stop inflation with higher interest rates, curtailing credit. The prime rate was at 15¼ percent and treasury bills yielded 12 percent. At the beginning of the seventies, gold was $50 an ounce. At the end of the decade the US dollar sank further and gold spiked up to $850 an ounce in January 1980 as investors sought protection from further debasement of the greenback.
That Sucking Sound Is Coming From China
The market may have discounted war, but it hasn't discounted the massive dollar debasement that lies ahead as Bush attempts to reflate his way out of the debt morass. We detect a seachange from financial assets to hard assets. In addition, our view is that the upswing in commodities is not due this time to the missing anchovies but is attributable to China sucking in the world's resources and acting as the locomotive of the world. China now accounts for nearly five percent of the world exports, seven times that of India. Indeed, China last year received more foreign direct investment than every other country including the United States. Flush with the largest foreign currency reserves in the world, China has embarked on diversifying its reserves from the dollar by purchasing euros and, in December purchased 100 tonnes of gold to hold 500 tonnes. China's gold reserves are now about 2%, which is increasing every month, which compares to an 11.2% world average. Gold is going to be a good thing to have.
Twin Deficits Fuel The Dollar's Decline
Gold has finally emerged as a tangible asset in lieu of other paper investments. Hard assets are in as Wall Street loses its appetite for financial assets. The protracted countdown to war with Iraq only increases the economic and geopolitical uncertainties. Meanwhile, like the seventies, the CRB Index hit a five-year high indicating that inflation warning signals are flashing. The US dollar bubble has burst amid worries over the prospect of the debasement of the US currency, leaving little incentive for foreign investors to continue to finance President Bush's growing global aspirations. We believe that the need to finance the twin deficits will tax the government's borrowing needs and lead to higher inflation. History shows that the darker side of a weaker dollar, however is more inflation, higher interest rates and a severe economic downturn. Gold is an excellent alternative investment.
Summary And Investment Conclusion
In our opinion, gold has completed the second leg and now requires a consolidation after breaking through the twenty-three year downtrend at $330 an ounce. Once gold breaks through the $375-$390 an ounce resistance area, we believe that gold's next target is $510 an ounce this year. More important we are only at the beginning of gold's multi-year bull market.
We believe that investors have a second chance to establish positions in gold shares. Once bullion consolidates the recent move, we expect that bullion will move to a higher trading range. This will move prices of gold stocks substantially higher. Our picks continue to be focused on the mid-cap producers with rising production profiles. We continue to rate Kinross Gold, Goldcorp, Agnico-Eagle, and Meridian as attractive buys. We continue to recommend to swapping out of Placer Dome into Newmont who has superior growth potential and virtually unhedged policy and superior management.
We continue to believe that we are in the early cycle of a gold bull market. We think that there will be another major move in the gold price. Once investors become convinced that gold will not pullback, gold stocks will outperform. Bull markets climb walls of worry and we see nothing different this time. Our enthusiasm for gold stocks is due to the fact that the bandwagon is still relatively empty. Not everyone is convinced of our view; inflows to precious metals have been limited, activity has been centered with the momentum and hedge fund players. Second, most of the producers have done their financings and there likely will not be another round of financings, capping performance as they did in the last go around. Because of gold shares inherent leverage, we continue to expect that the best times lie ahead. Indeed, a review of our Top Ten junior producers show that the stocks on average gained over 90 percent. As for the downside risk, we continue to emphasize producers and near producers rather than just the pure exploration vehicles. At this time, it is too early to gravitate down the food chain by purchasing exploration or grassroots players though selective exploration companies look attractive. We expect the major producers who are short of reserves will rather spend their money by gobbling up smaller tidbit-sized companies. In the exploration sector, normally the winners are those companies that finally discover the deposits of the future, but for that we need risk money and it appears to be early days yet.
John R. Ing
416-947-6040
5 March 2003
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
Maison Placements Canada
The information contained herein has been obtained from sources, which we believe reliable but we cannot
guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.
Email this Article to a Friend 
Printer Friendly Version