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Gold: The Fiscal Hurricane

November 1, 2017

Mr. Trump will replace Chairperson Yellen next February. Good. The job is responsible for safeguarding the US economy and the Fed is a source of global financial stability or recently instability. Yellen viewed inflation a bit of a “mystery” citing the Fed’s understanding of inflation as “imperfect”. She said, “We recognize that something more persistent may be responsible for the current undershooting”. To us, there is no mystery. Decades of debasing their currency, has made money too cheap helping to inflate the biggest asset bubble in history from stocks to bonds to real estate to bitcoins causing economic, political and social havoc and, by extension, distorting the price of all assets and of course, risk.

Inflation Time Bomb

Yet, there is inflation, the Fed is playing semantics and sitting on an inflation time bomb. Already there are early signs of a return to “cost-push” inflation. Metal commodities have turned up, reflecting China’s insatiable appetite for resources. Open interest in futures from crude to wheat have reached record levels. Oil is flirting with $55 a barrel, a two-year high. As for food inflation? Florida was hard hit by Hurricane Irma, there are drought conditions in the Midwest and another hurricane wiped out Puerto Rico’s agriculture production, which will result in higher food prices. There’s even a butter shortage in France.

Inflation is normally too much money chasing too few goods. And significantly, after almost a decade of easy money, most of that liquidity was concentrated in the hands of too few, inflating financial assets like the stock market, real estate or classic cars which were the beneficiaries of the ultra-low interest rates. Money simply has been funneled like grain is force fed into a goose. The easy money environment also fueled the huge tech group to bubble-like valuations such that the Googles, Facebooks, Amazon and Apples are beyond political control, antitrust issues and their treasuries are larger than some countries.

But now after numerous false starts and believing that inflation is benign, the Fed has thrown its crisis-era stimulus programme into reverse, reducing purchases to shrink its mammoth $4.5 trillion balance sheet which was less than one trillion before the financial crisis. Other central banks have followed suit. The European Central Bank (ECB) will halve its asset purchase scheme. However, just as quantitative easing was a grand experiment, never has a central bank embarked on such a monumental task of unwinding. We believe we are in unchartered waters. Nonetheless it will be a “dovish” taper with the ECB refusing to set an end date to bond buying which has caused negative rates, penalizing savers with puny returns.

Even under “dovish” Yellen, the Fed has targeted gradual treasury sales of only $10 billion a month, important since there is a large gap between Fed expectations and what is priced in the market. Nonetheless, deposits will be drained from the system ushering a competition for funds – rates must increase. This time a dovish Fed might not have a choice, a new sheriff arrives in February.

Bitcoin Bandwagon?

For thousands of years, gold was considered money. Today there is another alternative and yet another sign of inflation. After a decade of extraordinary money printing and credit inflation, the recent creation of cryptocurrencies have become a new asset class, led by bitcoin as investors believe that it is the new money, rising six fold in the past 12 months. With bitcoin, there is no centralized clearing, settlement or regulatory oversight. The key to the success of any currency is its wide usage and legitimacy as a store of value. Cryptocurrencies can be used as money with relative anonymity without the need for a central authority such as a bank or government. Thus its growing usage. Until recently, central banks were not too worried about digital currencies believing that they were small since the market value was only some $200 billion. However, there are some 2,000 cryptocurrencies and the exponential growth exposes a mania that has seen a separation between price and intrinsic value. New ones are created every day since any entrepreneurial computer whiz can easily write code. We believe a war is inevitable between the central bankers and the crypto-creators, so they are now subject to regulatory risk.

The explosion in cryptocurrencies has been underpinned by the introduction of ledger blockchain technology. Blockchain technology is a network of computers and algorithms that is the backbone which allows bitcoins to be traded, verified electronically, without a central ledger. Six of the world's biggest banks have joined together to create a new form of digital cash that they hope to launch next year for clearing and settling financial transactions using blockchain technology allowing for quicker trade settlements, freeing up capital.

To date they are unregulated, which is why China closed the door. However, the Bank for International Settlements (BIS), the central bankers’ bank recently warned that they could not ignore the bitcoin boom suggesting that the central bankers themselves should issue their own digital currency as a reliable store of value.

However, the counterparty risk, once considered negligible is high and there are numerous instances where the distribution of these open-source digital currencies can be easily stolen or hacked. The Chinese banned initial coin offerings (ICO), fearing the virtual currency could provide an avenue for capital flight leading to the collapse, causing it to plunge 40 percent in three days. South Korea too banned ICOs and margin trading. But no one central bank can stop this growth.

Noteworthy is that cryptocurrencies cannot be “shorted” which contributes to their over-valuation. Consequently, prepare for Wall Street to create funds, ETFs or futures which would allow shorting. Only then will cryptocurrencies’ store of value be tested. Gold meantime edges higher in stealth-like fashion, as the ultimate store of value. Unlike digital currencies, gold cannot be created by a click. Gold is finite, withstanding the test of time.

DOW 100,000?

This bull market has long legs, recording daily all-time highs and while bull markets normally climb walls of worry, so much ink has been predicting the demise of the market. The euphoria is also a global phenomenon, with Japan, China and Europe near highs on hopes of synchronised global economic growth, kept afloat on a tide of cheap money. Leverage continues to rise all over the world. What gives? Simply, greed. This inflated market will keep going up, until it doesn’t.

Still, markets are blithely ignoring risk. Markets could be wrong. Dangers are lurking.

Of larger concern is Mr. Trump’s aggressive mercantilism on trade and propensity to spend will make America’s budgetary deficit explode at a time when the Fed’s nine-year monetary experiment is supposed to come to an end. As ever, no one is talking or dealing with other big elephants in the room, like America’s big spending drivers, entitlements. And, awash in a sea of debt, the US financial system based on debt, keeps climbing at 100 percent of GDP. And of course, there’s Trump’s push for tax reform, a last chance for a major piece of legislation before the 2018 elections but his nine-page blueprint to overhaul the tax code, calls for steep tax cuts which will increase the red ink, boosting the deficit and national debt by almost $2 trillion. America faces a fiscal hurricane and no one is heeding the storm warnings. Gold has climbed 11 percent this year. It’s the canary in the Washington coal mine.

History shows that when central banks pull the punch bowl away, rates rise. Only then, will reality set in, as risk is measured. Ominously, ten-year Treasury yields just crossed 2.40 percent. Thus, it is our belief that the monetary mandarins push for “normalization” is a hint of what is to come. In fact, the immediate problem is not Mr. Trump but the fact is that the US needs to continue printing money to pay for some $20 trillion of debt and that every year, must issue more debt to rollover US paper and finance of course, a growing deficit. Americans have a financing dilemma. Debt on debt is not sustainable. About half of the federal government’s debt is held by foreigners and there is no certainty that they will continue with their largesse, particularly since like clockwork, the debt ceiling discussions begin again in December.

The Greenback is Past Its “Best Before” Date

This mountain of debt is America’s Achilles heel and looming higher rates, will increase the cost of the ballooning debt. America’s debt-based system is dependant upon the largesse of its foreign-based creditors. “America’s First” president should be aware that he risks biting the hand that feeds it when his next twitter tirade calls them “currency manipulators”, or threatens tariffs on German made steel imports or Japanese aluminum. Those countries hold the bulk of America’s debt. As the world’s biggest borrower and issuer of the world’s reserve currency, Trump’s unpredictable tactics has undermined the dollar and the United States will not be allowed to leverage itself further. It has happened before.

As a result of the unprecedented amounts of money printing and credit creation, the world is awash in dollars. The major worry is that America's creditors are growing weary of dollar dominance. America, in building enormous financial power since the Forties has anchored its dollar to a debt-based system. In August 1971, President Nixon ended the Bretton Woods agreement, severing the dollar’s tie to gold. Since then, gold has risen 3.7 percent annually in part because the fiat dollar allowed the Americans to rack up massive current accounts and financial deficits resulting in the largest build-up of debt in history. In the past decade alone, there have been three successive shocks; the financial crisis of 2007-2009, eurozone crisis of 2010-13 and the commodity collapse of 2014-2015. While the US dollar is the reserve currency of the world, this is a privilege that Mr. Trump seems eager to devalue. It is obvious that alternatives other than cryptocurrencies are being sought. Sanctions against Russia, Iran, and Venezuela have enabled those countries to use creative alternatives to the dollar.

After the 19th Party Congress, China, the world’s largest creditor is expected to pursue Xi Jinping’s “Chinese Dream” of restoring the Chinese nation, which will deepen economic and financial reforms, including the internationalization of the renminbi which will lessen the role of the greenback. The dollar’s hegemony is ending. In fact, the world’s largest importer of oil is expected to introduce a yuan based petrocurrency, redeemable in gold instead of dollars. China is the world’s largest producer and consumer of gold and a yuan/petro oil futures contract may be a harbinger of China’s intentions to tie its currency to gold, just as Britain did in 1821, which ensured British dominance during the rest of the 19th Century. Today, Russia takes only roubles at its seaports in a “Russia First” move and also doubled the pace of gold purchases, buying 129 tonnes this year. The Saudis are resurrecting an alternative currency to the dollar in a dedollarization move to reduce dollar hegemon.

Central banks have become net buyers of gold. Everyone it seems is looking for alternatives to the dollar, fearing the day it will be unreliable as a store of value. The greenback is past its “best before date”.

Gold, The Antidote To Our Problems

Meantime, geopolitical fires are burning. While the world’s largest economy is mired in a dysfunctional swamp, China, sitting with $3 trillion of reserves is challenging the West’s dominance of the global financial system. The global economy is too leveraged with debt to GDP at 300 percent. At the same time, divisions within Europe are mounting again. The negatives in Europe are myriad. First Brexit. Now Spain is undergoing its own Brexit with Catalonia, its richest and populous region, declaring independence. The hardline stance by Prime Minister Rajoy has seen the Catalan rebellion escalate in a game of chicken threatening to impair Spain's debt rating and exit from the European Union. Populism also raised its head after Merkel's expected election but, unexpected was the gains made by the far-right AFD, breaking up Merkel's "Grand Coalition”, threatening EU stability. The danger is not the far right, but like the United States, Germany too will turn inward and withdraw from a responsible global role. And of course there is the fallout from North Korea's missile launches which was an excuse for Japan Prime Minister Shinzo Abe to score a solid victory in national elections. Political risk has increased everywhere.

Consequently, given the record debt levels and the global central bankers’ experimental move to “normalization”, we believe that the world’s biggest debt boom will end in the biggest bust.

The underlying fear is that America might enter another era like the Seventies, when soaring inflation and interest rates rose to levels that only the heroic efforts of Paul Volcker was able to turn the inflation tide around with double digit rates. Today, the second biggest fear is that in an attempt to pull the punch bowl away, the unwinding of quantitative easing is fraught with risk and unintended consequences. In mid-2013 then Fed Chair Bernanke’s hint of selling assets bought under QE I, caused an overnight market panic and a spike in global yields. Today, the Bank of Japan owns 75 percent of Japan’s ETFs. The Swiss National Bank owns $80 billion of US stocks. Central banks would be selling back to the market a time when interest rates are edging higher resulting in potentially huge book losses on their bloated balance sheets. Or, they could allow the securities to mature which would not make much of a dent since it would take eight years alone just to offload its mortgage-backed securities. The process is unpredictable. Gold is an alternative investment to the dollar for these central banks, and a hedge against the uncertainties.


Investors always seem to drive with a view of the rearview mirror, expecting prosperity to continue and thus do not feel the need for gold. Commodities themselves have emerged as a distinct asset class with billions of dollars poured into exchange-traded funds (ETFs). Physical commodities have been replaced by derivatives which Wall Street can create easily with a single computer click. We think the market has not discounted the risk that the central bank's reduction in stimulus will cause rates to go up and markets to correct. Even gold shares are finally beginning to move, after establishing huge bases and are in our opinion, poised to breakout from their trading range -future ten baggers are ahead.

Today, gold is simply back in fashion because of its traditional status as a safe haven, and although the saber rattling with North Korea has certainly helped its value, the biggest driver is the depreciating greenback as central banks diversify away from dollar securities. While supplies of the metal are no longer growing, peak gold arrived, becoming more expensive to mine gold since reserves are deeper in the ground. Gold is a finite currency and its value against fiat currencies like the dollar, sterling or euro have risen. In today's ultra-low rates, gold's yield matters little. Most important is that gold's recent rise shows investors are nervous. That is an important message for central banks who are unwinding their portfolios. While gold flirted with $1,300 level recently, we believe that $2,200 is still in sight within the next 18 months, particularly when so much fear stalks the world.

Many gold miners have undergone an identity crisis. After becoming more disciplined, redressing their balance sheets bloated from ill-gotten acquisitions in the decade long bull market, the miners have emerged with less debt, fewer high cost mines and for some, new management. Yet the miners do not know whether they are growth stories, value players or manufacturers of wealth. Properly chastened, many are gun shy in making acquisitions but are in much better shape than they were.Some are spending billions, just to standstill. Others are mired in the heavy lifting of debt reduction. Few, however are really growth vehicles, difficult since gold is a depleting resource and reserves are the lifeblood for the industry.

Recently, noted investor John Paulson proposed a coalition of gold investors in order to gain a more activist voice in the affairs of the miners. The proposal was sparked by some $100 billion of writeoffs, hefty executive pay packages and plunging share prices. Now that the horse has left the barn, Paulson and other co-conspirators who earlier participated in the rounds and rounds of share issuances that financed these ill-conceived acquisitions, are now experiencing buyer's remorse. Ironically, after his successes in sub-prime mortgages, Paulson helped fuel gold’s bull rally by setting up a fund in January 2010, almost a year before gold peaked. The fund went up 35 percent in its first year but the poor choice of investments of leveraged players like NovaGold or high cost mines like lamgold, hurt performance, despite amajority of the funds invested in the exchange traded bullion SPDR Gold ETF. His fund lost 65 percent in January 2013. Seven years later, Novagold is still not in production. The story could have been different. Mr. Paulsonmissedthe Pretiums,Agnico Eagles or FrancoNevadas and many others.

Still Paulson's criticism is justified but old news, since the industry has learned its lesson. Investors already have a say, they can vote for or against management at annual meetings, they can boycott share issuances and frankly, they could become better gold investors by backing better management and buying those superior deposits with reserve potential and not just the latest “story".

As an example, big cap producers are up 10 percent this year. New discoveries are dwindling and peak gold has arrived so mergers with an emphasis on reserves will become more attractive. Producers must replace depleting reserves. We continue to like Barrick because they have the largest reserves in the world, and could easily maintain production of five million ounces plus every year, for the next 15 years. We like Agnico Eagle for its superior management and acquisition record. B2Gold is an intermediate gold producer with a growth profile that also has grown through acquisitions. McEwen Gold, a company we recently helped finance, is also favoured and has grown through astute acquisitions. Not all players in the industry should be painted with the Paulson brush.


Agnico Eagle Mines Inc.

Agnico just celebrated their 60th anniversary with a strong third quarter. Production was up and the company increased the dividend by 10 percent. Amazingly long life flagship LaRonde recorded another strong quarter and will produce 315,000 ounces this year. LaRonde is more than 3 km underground. Kittila in Finland also recorded a strong quarter. Agnico increased its production guidance. Meantime Nunavut projects, Meliadine continues on schedule and on budget with engineering 89 percent completed. We like Agnico for their rising production profile, astute management and collection of assets. Agnico will likely produce close to 1.7 million ounces at a cash cost of under $600 an ounce. Agnico will spend about $900 million at Meliadine and $330 million at Amaruq, which is wrapping up and going to be yet another core producer. We like the shares here, and believe Agnico’s market cap will soon surpass Goldcorp’s.

B2Gold Corp

B2Gold produced first gold from the Fekola mine in Mali. The production came on schedule and the commissioning of the mill is ongoing with commercial production expected before year-end. With Fekola, B2Gold’s profile is one of the fastest-growing intermediate goal producers in the world. The new mine plan for Fekola is based on increased throughput which will extend mine life improving to 400,000 to 410,000 ounces next year at an operating cost of less than $400 an ounce. In the third quarter,B2Gold production was ahead of schedule due in part to Okjikotos’ output and a strong quarter from Masbate. Meantime in Nicaragua, La Libertad and El Limon results were weaker due to permit delays, but the problems are temporary. Next year, B2Gold will produce almost 1 million ounces at an all in cost of about $950 an ounce. We like the shares here for its exposure to West Africa.

Barrick Gold Corp.

Barrick had an expected “off” quarter, with production lower by 100,000 ounces or so due to the loss of output from 63.9 percent owned Acacia. However, production rebounded at Velardero in Argentina, which produced almost 90,000 ounces. Production of 1.2 million ounces in the third quarter was in line with our forecast with free cash flow at $225 million. Barrick paid down $1.5 billion of debt this year as part of a multiyear strategy to reduce debt to $5 billion by the end of 2018, using cash flow and divestitures. At the end of the third quarter, Barrick had $2 billion of cash and a $4 billion undrawn credit facility. Barrick's main production comes from core mines, Cortez and Goldstrike in Nevada, Pueblo Viejo in Dominican Republic and Lagunas Norte in Argentina. Future output will come from Turquoise Ridge in Nevada. Kalgoorlie which is 50 percent owned with Newmont is still for sale. Barrick is the world's largest gold producer with 12 operating mines with in-situ reserves in excess of 85 million ounces.

Meantime, Barrick has negotiated a deal with the Government of Tanzania. The framework agreement involves the payment of $300 million and handing over 16 percent of Acacia’s three mines to the government to give them 50 percent ownership. It is unknown what Barrick will receive in return, but we can assume that all approvals, environmental and government go-aheads would be granted before the deal is signed and the likelihood of future payments from cash flows. While the terms are steep, the alternative would have been a stalemate and possible closure of this moneymaker. We continue to like Barrick shares as a core holding.

Centerra Gold Corp.

Centerra resolved its dispute with the Kyrgyz Republic at the Kumtor gold mine in the country's east end. Centerra has agreed to a one-time $57 million payment to the government and accelerated reclamation payments to the government. Meantime the Kyrgyz Republic will grant all permits to resolve the stalemate. Kumtor is a cash machine which could produce 550,000 ounces with all in costs of under $800 an ounces. Centerra spent $1.1 billion to purchase Thompson Creek Metals for its Mount Milligan copper mine in British Columbia, which sent a message to the Kyrgyz government that it was not placing all its bets in the Kyrgyz Republic. Mount Milligan is a long life copper/gold operation but still is not producing positive cash, needing to boost throughput. Centerra’s Oksut gold project in Turkey will produce 110,000 ounces in late 2018.

Eldorado Gold Corp.

Eldorado had another disappointing quarter, losing $4 million and reduced its guidance for Kisladag in Turkey, its flagship mine. Apparently, recoveries have dropped dramatically from 60 percent to 40 percent due in part metallurgical issues. Eldorado will now conduct work including looking at additional crushing and the addition of high pressure grinding crushers (HPG) which can crush to a finer level in order to improve leaching. Eldorado is a mid-tier producer producing gold in Turkey and Greece but has been plagued with problems. Kisladag is a low-grade, bulk tonnage, open pit mine that uses heap leach for gold recovery. Grade is low and thus the mine has to produce a lot of tonnage but the metallurgical issues is a problem. As for Greece, Eldorado earlier threatened to close its Halkidiki asset, but on a positive note, has reached an agreement with Greece on most of its permits allowing it to go ahead (including Skouries’ permit). Time will tell if Greece’s bureaucrats are serious. Eldorado also recently closed its Integra acquisition, a longer term development Quebec play in need of permits. While the stock is cheap here, near term problems at Kisladag and ongoing Greek negotiations overhang the shares. However, downside is limited here and the balance sheet is solid.

Goldcorp Inc.

This senior producer will produce 2.5 million ounces this year but will have difficulty maintaining output while saddled with monster capex just to maintain production. Operational execution plagues the company as well as past value destroying M&A. Goldcorp’s problems with flagship Penasquito in Mexico continues although the pyrite leach project is ahead of schedule but an increase in production is not likely until next year. Meantime Goldcorp’s prefeasibility study on the Century project in Ontario will cost a billion dollars for 350,000 ounces of production. Five million ounces of indicated resources are on the sidelines until this mine plan is executed. Former flagship Red Lake in Ontario was another disappointment producing only 40,000 ounces at a high $1,400 cost. Eleonore was better and Cerro Negro grade improved. Goldcorp is a senior gold producer but is plagued by lack of focus and too many capital commitments. Switch into Agnico-Eagle.

Kinross Gold Corp.

Kinross's released the Tasiast phase 2 project in Mauritania which calls for spending almost a billion dollars to maintain production with almost $400 million in capitalized stripping alone. As expected Kinross is planning to increase mine throughput to 30,000 tonnes per day from 12,000 tonnes per day, add a power plan and replace two existing ball mills with a much larger one. We believe a lot of money is being spent to stand still. Meantime Round Mountain phase W in Nevada has a sub 15 percent rate of return but only extends, this short life mine slightly at a cost of almost half a billion dollars. The production profile however is up and down and although Kinross’ balance sheet is in good shape at $2.5 billion, these two projects alone are capex top heavy. We prefer B2Gold here.

New Gold Inc.

New Gold Inc. finally commissioned the major project Rainy River in Ontario in mid-October. Average throughput has been 20,000 tonnes per day, which is slightly less than design capacity of 21,000 tonnes per day. To date revenues and grade have been as planned. The first gold pour at Rainy River is good news but the company has a stretched balance sheet from placing Rainy River into production. New Gold is a Canadian gold producer with four operating mines in Australia, Mexico, California and BC.

John R. Ing

[email protected]

The first use of gold as money occurred around 700 B.C., when Lydian merchants (western Turkey) produced the first coins
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