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Gold: The Race To The Bottom

March 20, 2015

Mr. Obama’s Robin Hood $4 trillion budget was dependent on $320 billion of additional taxes just to keep the deficit at $474 billon. His stubborn effort will trigger a standoff with the Republican controlled Congress and yet in his rejection of “austerity”, he proposed to spend $1 trillion more than in 2008, leaving untouched the entitlements which make up some 15 percent of GDP. Meantime he blindly ignores the ratcheting up of public debt to 75 percent of GDP, the highest since 1950.

Much is made of America’s economy becoming one of the fastest growing economies in the world. It is all relative. Debt has grown even faster. The US dollar too has soared relative to other currencies, thanks in part to a relatively better economic recovery and of course the trillions from the Fed’s bond buying program. However, the US still has 47 million people on food stamps and unemployment remains stuck at 5.5 percent. The US is just the least ugly duckling while the rest of the world copes with its own serious challenges. The US needs to grow and close the gap between the haves (who benefited from QE) and the have-nots (savers and pensioners hurt by zero interest rates). America’s growth is simply not sustainable because this debt load is heavily dependent upon the largesse of its creditors. In fact, the strong dollar makes America’s goods and services less competitive such that Obama and America’s lawmakers are threatening a trade agenda attacking the “currency manipulators” aka trade wars.

Echoes of the Past

Still an influx of global liquidity has flowed into the US reminiscent of the late nineties when money attracted by high returns, flooded into Asia with supposedly limited exchange rate risk. Soon foreign investors headed for the exits when defaults rippled from Russia to Thailand and, of course their currencies collapsed. Also, “too big-to-fail” Long Term Capital Management closed their doors. The contagion spread later in 2008 when Iceland sparked another round of defaults as its indebtedness grew to ten times the size of Iceland’s economy. The first Eurozone crisis followed, unraveling with the initial default of Greek government bonds. Months later, Cyprus’ economy collapsed in 2013 with bank depositors paying for the defaults. It never ends. The can is always kicked down the road. This long cycle

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of dysfunction in Europe and Washington still grows. Today, Greece is home to a debt crisis which is still in danger of boiling over. Venezuela is set to default and war torn Ukraine will need more cash this year. Russia too is not insulated with giant Gazprom and Rosneff needing state support. Déjà vu. And, despite heavily indebtedness, the United States remains the most vulnerable with markets remaining complacent.

Currency Wars

The European Central Bank (ECB) has belatedly followed the United States, the UK and Japan, in introducing a quantitative easing (QE) program. The ECB plans to spend more than a trillion euros leveraged by zero-cost borrowings to purchase sovereign debt in hopes to reverse deflation and an anemic economy. Europe’s sovereign bonds (Greek debt excluded) will be bought by the ECB with newly minted euros, which is a massive bet that growth will return. However, even the French will have a deficit of over 4 percent, not registering a budget surplus since 1970. Four months from now, the threat of a Grexit will be back. Twice bailed out, Greece was looking for another handout from the EU-IMF troika but the recent history is not good and hopes are simply that they can kick the problem down the road.

We believe that Europe’s move to QE has laid bare a “stealth” currency war that has seen the euro fall from $1.40 a year ago towards parity with the dollar. Central banks reduced interest rates causing their currencies to fall against the dollar, reviving worries of a “beggar thy neighbour” currency war which was part of the Great Depression. Ironically, what was good for the goose, is not good for the gander as the Americans complained about the ECB’s move to QE.

Return to Deflation

The whiff of deflation is everywhere. The arrival of deflation where a dollar today buys more than a year ago has caused panic amid falling benchmarks such as energy and interest rates. Virtually, every central bank resorted to ever more unorthodox means to repair their economies are now in a fight to stave off deflation, creating speculative mountains of cash, causing nervousness over steadily falling prices. German stocks have benefited from the ECB’s largesse. Cash is no longer king, or at least, it doesn’t earn anything anymore. Sweden has followed the downward march of yields with the krona falling to a six year low against the dollar. Nineteen central banks have set a labyrinth of negative interest rates. Somehow investors are willing to take less to park their money in sovereign debt, paying for the privilege of parking their money.

In fact, much of the talk of deflation was due to the halving of oil prices. Oil prices have actually fallen six times in the past three years. In the late seventies, we recall when a $10 a barrel oil price almost morphed into near hyperinflation levels. Today, while savers and retirees have been punished, medical services, smartphones, stock prices and classic car prices have experienced the opposite – price inflation. Walmart recently increased wages in a prelude to a wave of increases. Taxes too and of course debt, have not fallen but increased. Inflation is back, we just don’t recognize its pervasiveness.

The central point is that the fall in prices are a reflection of the imbalances in the system. In the Thirties, the “beggar thy neighbour” deflation was caused largely by the contraction of money supply and credit. Deflation then was a negative year to year change in CPI. Today, nowhere have we seen this. Monetary policy continues to be expansive around the world, and while there have been threats of cutbacks, the monetary base elsewhere and at home has not been constrained. Real interest rates are negative, limiting the choices for central banks. And that is the point. We are experiencing disinflation as part of an inflationary cycle that ebbs and flows. Disinflation in fact is a prelude to inflation when the imbalances become extreme.

Part of the problem is that while the market is focussed on deflation, it provides an excuse for even looser policies, which will exacerbate the inflationary consequences to come. The other problem is that negative interest rates remove the most obvious shock absorber for policymakers leaving them without a policy cushion for increasing liquidity. The monetary playbook is empty, thus the move to currency wars. The boo-birds, bond investors and Mr. Krugman are just crying for even lower interest rates and bigger profits.

Balance Sheets on Steroids

Central banks printed money in massive amounts to buy “assets” of everything from low yielding treasuries to mortgages to equities boosting their balance sheets on steroids. Balance sheets matter. That at least is one of the biggest lessons of the last financial crisis. We also know that the Swiss do not play games with money. Switzerland shed its peg to the euro because the Swiss National Bank’s balance sheet choking with euros, equivalent to 86 percent of Switzerland’s GDP, reached its limit. The Fed’s balance sheet too has grown to the largest ever at a staggering $5 trillion, equivalent to 25 percent of America’s GDP. Noteworthy is that the equity capital of the central banks is only one twentieth their exposure such that central banks have become the world’s largest hedge funds with worse leverage than the hedge funds which collapsed in 2008. Of course, central banks can’t fail – they can always print enough to cover their liabilities or can they? Central banks simply have become part of the problem. The world is now awash with more debt than the last crippling financial crisis. When rates rise, the existential faith in central bank’s largesse will be tested. We think investors should be prepared for a meaningful rise in market volatility. Gold will be a good thing to have.

Of course, we are told that this printed money can always be sterilized before it reaches the economy. To date, this massive money printing exercise has benefited the big banks’ who after a near death experience in 2008 are holding trillions of reserves stuffed with ultra-safe debt driving down yields even further. Some banks are stockpiling cash suggesting the economy is not as robust despite the political rhetoric. Others have huge reserves stashed with central banks. Small wonder that this cheap money has not filtered down into the world’s largest economy plagued by anemic growth and increased volatility. Indeed, central banks having bought up sizeable amounts of their own government debt are now stymied doing little for the all-important private sector. Then there is the complacent view that because America pays its bills with its own currency, its large and growing debt does not faze the markets who prefer to celebrate daily highs rather than be concerned about the dollar’s lack of value. There seems to be no limits to the aggregate debt that global markets can absorb but this growth is illusory. Money printing is not yet inflationary only because money remains on the balance sheets of the rich banking sector. This is to change. When interest rates and long term yields reverse – as they surely will, money will demand even higher and safer returns. And the dollar on borrowed time will fall as investors reverse the world’s biggest “carry trade”.

It’s Everyone, Every Currency, Every Central Bank For Itself

The problem is that the sums are so huge that hyperinflation is now a very real possibility. We believe that the imploding Middle East, a cold war with Russia and cracks within the Eurozone are sideshows to the largest money making exercise in history. All this looks like a formula for a repeat of the Dirty Thirties with “beggar thy neighbour “ competitive devaluations, unstable social strife and falling interest rates. While central bankers are keeping their feet on the money accelerator, backed by those politicians who are addicted to low interest rates, the dilemma is that no one wants to take the punch bowl away. While America has stopped its asset purchases, dovish Fed Chairman Yellen’s rhetoric has been one of delay and bluff in a reluctance to take the necessary steps. It’s everyone, every central bank and every currency for itself.

The bond vigilantes are playing chicken with the Fed on interest rates, however the eventual unwinding will cause the Fed and other central banks to liquidate those leveraged balance sheets that are in fact larger than the market itself. And, those sales will drain rather than add liquidity resulting in an increase in the much feared volatility and of course, a move to liquid and ”hard” assets. This change is ultimately inflationary and as volatility picks up, interest rates too will edge even higher. Indeed, when the Fed finally raises rates from near zero to a likely 0.25 percent, markets might go apoplectic. However, to put the manoeuvre into perspective, between 1954 and 2007 the average yield was 2.5 percent, not 0.25 percent. Having exhausted a toolbox of easy money and deficit spending, as mentioned earlier, central banks have now resorted to currency wars. However, faced with excessive debt and the declining credit quality of consumers and governments, these defacto devaluations put increasing pressure on the American big multi-nationals such that a coalition is building to push America to join this race to the bottom. The choices are narrowing. Deflation, default, devaluation or more inflation. This unwinding will be dangerous. Gold anyone?

Gold Is the Ultimate Store Of Value

We believe the inflection point will be reached when overseas creditors realize that they are to be repaid in depreciated US dollars which are being produced on a massive scale. Gold historically has been a reliable store of value that is superior to fiat currencies. Were gold a currency last year, it would have been the second best performer of all currencies, after the US dollar. Our view is that gold has even deeper appeal. It is a hedge against the escalating currency war. In fact, gold’s recent rally in January is an early warning of a potential crisis over the loss of confidence in fiat currencies, especially the cheapened US dollar.

Importantly, gold miners have some 20,000 tonnes of unallocated gold in the ground while central banks’ hold some 30,000 tonnes of gold which has been loaned many times after backing the billions of complex derivatives. Today there is an actual physical supply deficit in the gold markets. The century-old gold fixing was recently abandoned recently, coinciding with reports that the US Department of Justice (DOJ) and the Commodity Futures Trading Commission (CFTC) are investigating the ten major bullion banks for price rigging the “fixing “. The investigation will tighten an already tight market. The valuation of the “in-situ” gold miners reserves are at the lowest ever. Gold miners are a good thing to have.

Sure, gold lacks yield but so does the dollar today. Since 1971, when gold’s link to the dollar was severed, gold has outpaced consumer prices, stock markets and debt. Simply it is an alternative currency. Gold is money. Central banks can always create new money with the click of a mouse but the total supply of gold is finite. Thus, while our central bankers are busy creating money, other central banks led by Russia and the Chinese are buying gold. Nineteen banks bought gold last year, at the highest price in 50 years. And now, the continuation of quantitative easing in Europe only reinforces that paper money continues to be debased. Gold $2,000?


Meantime China, the world’s second largest economy has built up an enormous mountain of foreign exchange reserves at $5 trillion of which a good part comprises US government securities. Although, China has diversified by buying European assets and granting huge loans to emerging countries, China alone has purchased as much gold as all the central banks purchased last year or equivalent to half of gold produced last year. We believe Chinese demand will buoy future gold prices. China is the world’s largest producer and consumer of gold. At the same time, the yuan has been one of the top performing currencies. However, China too has weakened the yuan by three percent against the dollar, joining the stealth currency war, leaving only the United States alone.

We also believe it’s inevitable for Beijing to create a super state owned gold company along the lines of the $26 billion marriage of high speed rail China CNR and CSR. National planners are already discussing the creation of a super oil company by combining CNPC, parent of listed PetroChina and refiner Sinopec. The merger would create an entity the size of Exxon Mobil in terms of revenues. To be sure the future of China lies in a major international push for globalization and thus the creation of supersized international entities better facilitates an international expansion. We believe that a major step would be to merge the three or four Chinese gold companies under the China National Gold umbrella which would create an entity rivaling the size of the Western World’s larger gold entities. While smaller than the Barrick or Goldcorp, such an entity would create a platform to expand internationally.

After another quarter of writedowns, the gold stocks’ performance had mixed results in the latest quarter. Most companies met their guidance but the key takeaway was that costs are more or less under control. Still many companies remain in the survival mode with costs still stubbornly too high. Everywhere, grade has declined. Replacement of mineable reserves remains a major issue which is why Centerra’s joint venture with Premier and Goldcorp paying a whopping $500 million for Probe near Chapleau is a shocker. Both companies paid move than $150 an ounce for properties without a feasibility study or even a PEA. It was also a disappointing quarter for Yamana, IAMGold, Eldorado and Goldcorp. Barrick however surprised the Street and is slowly gaining investor confidence, endorsing a “back to basics” strategy.

B2Gold Corp

B2Gold has three operating mines, two in Nicaragua and one in the Philippines, together with a portfolio of strong development candidates. Results for the year reflected a contribution from Masbate in the Philippines which came on stream late last year but was still written down. The key will be production from Otjikoto, which poured its first gold bar in December and set to produce 150,000 ounces at a low cash cost of $500 per ounce this year. B2Gold has also updated the Fekola resource and a feasibility study is expected in the second quarter which is designed to be B2Gold’s next producer sometime in 2017. While B2Gold has a good balance sheet, capex at Otjikoto and the update at Fekola will stretch its balance sheet over the near term. Nonetheless, we like the shares down here.

Barrick Gold Corp.

Barrick surprised the street with a strong quarter and a “back to basics” strategy. For the full year, Barrick posted earnings of $0.68 on revenues of $10.2 billion. Still Barrick took a $1.7 billion impairment on Lumwana and Pascua Lama which was expected. Importantly gold reserves stand at a whopping 93 million ounces, which is Barrick’s major asset and the largest among the gold producers. Barrick intends to cut $3 billion from its debt to $7 billion by the end of the year through asset sales together with joint ventures optimizing Barrick’s vast portfolio. Cowal and Porgera will be sold before the summer. Barrick is one of the first mining companies to reduce its bloated overhead which is something that other gold producers should try and emulate. Barrick’s Nevada based Cortez and Goldstrike remains major core producers. We like the shares here and the adoption of a lean mode downloading decisions to the mine levels, allows Barrick’s core assets to enjoy one of the industry’s highest margins. Buy.

Eldorado Gold Corporation

Despite Eldorado reporting record gold output of 789,000 ounces at a cash cost $500 per ounces, results were disappointing. There remains a significant cloud over Skouries in Greece, and again the government has thrown another curve which could potentially stop production. Greece accounts for almost half of the NAV of Eldorado and a major contribution from Skouries was expected so delays will have an impact over the near term. However, the SAG and ball mills are installed. Eldorado has been frustrated in exploiting its $2 billion plus European Goldfield acquisition but we find it difficult to believe the Greek government will say no to a $1 billion plus investment. Meantime, Eldorado’s Chinese mines are performing well, however Eastern Dragon is still waiting for a permit. On the positive side, Eldorado’s flagship in Turkey, Kisladag and Efemcukaru performed well in the quarter. A feasibility study at Certej should be completed in the second quarter. For 2015, Efemcukuru is expected to produce almost 100,000 ounces and Kisladag will produce 240,000 odd ounces. We would take advantage of the weakness in Eldorado in the belief that the Greek government will eventually give the go-ahead. Eldorado has a strong balance sheet with almost $900 million in total liquidity plus 26 million ounces in proven and probable reserves.

Goldcorp Inc.

Goldcorp reported a disappointing quarter too and took a whopping $2.3 billion impairment charge for the Cerro Negro mine in Argentina despite record output of 890,000 ounces. Earnings missed estimate, however all-in costs for the quarter were slightly over $1,000 an ounce and all-in costs for the year were under $949. At Penasquito, fourth quarter production was 141,000 ounces which was an improvement for the problem plagued operation. The pickup was due to higher grades, but all-in costs remain at $1,472 an ounce. Goldcorp’s flagship Red Lake operation output was at 130,000 ounces with all-in costs at $934 an ounce. Red Lake should produce about 400,000 ounces this year. At newly opened Eleonore mine in Quebec which poured its first gold in October, there were few teething problems and the mine should contribute about 300,000 ounces. At Cerro Negro in Argentina, commercial production was declared at the beginning of the year and production is expected to at 450,000 ounces, coming from both stockpiles and the underground development. Overall, Goldcorp should produce about 3.5 million ounces with an all-in costs of under $1,000 per ounce. Reserves declined this year by 10 percent to 50 million ounces which is why Goldcorp paid a whopping $500 million for Probe even though the project lacks a PEA. We prefer Barrick here.


IAMGold reduced its reserves by 15 percent to 9 million ounces. Essakane remains the big cash contributor after the sale of cash cow Niobec. However output was down at Rosebel and Essakane. While IAMGold has a good balance sheet, a short mine life at Rosebel and lack of cash generator Niobec makes IAMGold heavily dependent on Essakane. Sadiola and Yatela are in harvesting mode and with a mediocre outlook, the shares should be a source of cash here. Cote Lake will be a non-starter due to the over-valuation price paid and lack of continuity. A big writedown is expected here.

Kinross Gold Corporation

Kinross has a strong balance sheet and wisely shelved plans to proceed with the Tasiast mill expansion. Kinross’ dilemma is that a major part of its asset remains in Russia, with Kupol and Dvoinaye a major contributor. Kinross should produce 2.5 million ounces this year down from 2.7 million ounces. Capex was reduced to about $725 million dollar with all-in cost of $1,050 an ounce. While they have $1 billion in cash, shelving of Tasiast means that Kinross has very little on the horizon. Kinross has $2.4 billion in liquidity and net debt of $1.2 billion. The company has issued a prefeasibility study at La Coipa but we believe the project needs higher prices. Kinross had a record quarter production at Paracatu in Brazil which has been a steady contributor. Kupol and Dvoinaye were strong performers but concerns about Russia is a cloud over Kinross’ stock price. We would avoid the shares here.

New Gold Inc.

New Gold took a $300 million impairment charge for Blackwater in BC which was no surprise. New Gold operates in stable jurisdictions, Canada, US, Mexico and Chile. Long life Blackwater and Rainy River are both located in Canada but the multi-billion capital costs make higher prices a necessity. New Afton’s mill expansion will be completed by midyear. New Gold has cash and equivalents of $371 million and facility of $240 million. However, its major exposure to copper has hurt results in the quarter. New Gold has almost 18 million ounces of gold reserves and 82 million ounces of silver in the ground.

Yamana Gold Inc.

Yamana reported a loss in the quarter, after writing down mines in Brazil and Chile. New created Brio Gold was spun off containing Fazendo Brasiliero, Pilar and CI Santa Luz in hopes that it could be sold. We believe they are optimistic. Yamana should produce 1.3 million ounces gold equivalent ounces this year but hopefully at a profit. Yamana has posted reserves of 19.6 million ounces, but we are concerned that not all of those reserves are mineable. Yamana’s acquisition of 50 percent of Canadian Malartic is doing well, but the company finally issued shares to pay down debt incurred for the acquisition. The dilution hurt the shares which are off 50 percent since the acquisition. At flagship El Penon in Chile, the company focused on converting resources to reserves. At Chapada in Brazil, we believe the low grade make development costs important. Yamana reduced its dividend as expected. We would avoid the shares here.


John R. Ing


U.S. ranks third in world gold production with 240 tons per year
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