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GOLD: The Goldfather

By John R. Ing
President and CEO,
Maison Placements Canada Inc.

Francis Ford Coppola’s 1972 iconic classic “The Godfather” focused on American politics, American crime and the American dream. The Don’s classic line, “I’m gonna make him an offer he can’t refuse”, best described the family’s power, money and influence. Today life is imitating art.

President Trump recently expressed an interest to buy Greenland, the size of Louisiana purchased in 1803 from France for a paltry fifteen million dollars. In true Trumpian fashion, the president floated his idea to purchase Greenland and rather than make an offer they can’t refuse, he likely wanted the Danes to pay for it too. The Danes predictably, rejected his offer. After all, the Danes are among the happiest people in the world, enjoying long lives and ranking ninth in per capita income, just behind the United States. Yet, Mr. Trump might not be interested in just happiness.

Greenland is estimated to hold 38.5 million tons of rare earth oxides or a third of the world’s total reserves of 120 million tons. Today, China is the biggest producer of rare earths, needed in high-tech applications for electric vehicles, wind turbines and of course, military technology. Could Mr. Trump simply be looking for other ways than happiness to isolate China? And with US angst over China continuing to manifest itself from trade to Silicon Valley to Wall Street, maybe, Mr. Trump, “the Goldfather” should remember that other great line uttered by Don Vito Corleone, “a friend should always underestimate your virtues and an enemy your faults”.

The Thucydides Trap

Trade has long anchored the relationship between China and the United States but Mr. Trump is trying to unwind the two intimately entwined economies in his US/China conflict. Tariffs now cover two thirds of the trade between the two countries. The US-China tariff tit-for-tat has cast a pall over the global economy and financial markets. Conflicting signals from the US president also worried investors. So far, America has lost foreign markets, participated in a tit-for-tat retaliation with virtually all of its trading partners, boosting consumer prices. Also, the painstaking pace of the US/China negotiations have kept investors on the sidelines as global trade volumes collapse. Trade wars are pushing the world economy to the brink. How is that winning?

The unresolved trade wars harken back to the days when President Hoover openly embraced trade protectionism to get the economy going but his Smoot-Hawley tariffs exacerbated the worst depression ever. Subsequently for over half a century, tariffs around the world have come down, boosting the world economy and helping China emerge as a superpower. But now, Trump’s tariffs have reversed this downward trend, increasing tariffs by some 20 percent which predictably dampened growth as Trump embraces the protectionism that doomed Herbert Hoover nearly a century ago.

Significantly, we believe the trade conflict is part of a bigger US strategy over trade, the internet and values to contain China’s growth. However, that risks the United States falling into the “Thucydides Trap”, when a rising power threatens to displace an established power; 12 of 16 instances ended in war. Of concern is that the threat of blacklisting Chinese investments is akin to shooting themselves in the foot since the biggest casualties will be America's multinational companies who have seen their markets disappear, American pension funds’ returns and of course, America's consumers who have discovered that tariffs, like taxes are borne by them.

Trades Wars, Currency Wars and Financial Wars

Mr. Trump views the markets as a proxy for his actions and each time he lifts the hopes of a trade agreement, the market rallies but falls when no progress materializes. And subsequently, trust in his government and tweets suffers, at home and abroad, undermining faith in the United States and its currency. And while the President tells voters that there has to be a cost to fix the US economy, that cost is borne by the very voters he is hoping to help him return in 2020. Likely then is that the much ballyhooed mini-deal is more of a truce and the partial deal is only a reprieve. Uncertainties and a final agreement remains, particularly since the 15 month China-US conflict has morphed into a tech, currency and financial war.

Even so, President Trump has taken aim at Europe and China accusing them of playing “currency games", threatening all with a currency war and bullying his own Fed, to push the dollar down. Round one started when China temporarily allowed the renminbi to fall, breaking the “seven to the dollar” benchmark, for the first time since 2008. The Chinese have become the largest creditor, with the largest foreign exchange reserves in the world and the United States by comparison, the world’s largest debtor. With less ammunition, the White House’s trade war threatens to hit capital markets because any selling of dollars would be limited since the US only has $146 billion in the Treasury Exchange Stabilization Fund, too small to do much in a multi-trillion dollar currency market.

Despite few cards to play, Mr. Trump’s pattern of bluffing has now been widely called out by America’s trading partners and his policy of threatening the Federal Reserve, actually strengthened the dollar. In reality, needed is an accord such as the 1985 Paris agreement when President Reagan enlisted the G5 group of countries to coordinate a weakened dollar. However, President Trump’s “America First” policy of trade wars and bullying of allies leaves “America First” in isolation. He should remember, that other classic Godfather line, “revenge is a dish best served cold.”

President Franklin Roosevelt declared in his 1933 inauguration address, "We have nothing to fear about a recession right now, except for the fear of recession". President Roosevelt's words, said in the midst of the Great Depression, reveals just how long it takes to recognize how bad things are. The US Institute for Supply Management Index (ISM) shocked the street with a report that manufacturing data fell sharply to the lowest in a decade. The Fed's Beige Book too showed the US economy slowing down. Still the market and politicians believe there is no recession, yet, there is a recession, not in the economy, but in corporate profits. The cost of President Trump’s “easy to win” trade war mounts.

However, the orgy of spending under Trump and entitlement spending has resulted in a fiscal deficit of 4.5 percent of gross domestic product lifting the government debt to GDP to 100 percent. And now with the sugar high from the tax cuts in the past, central banks led by the Fed are pushing interest rates lower. US Treasuries, once the risk-free pillar of modern finance, now threaten negative yield territory, leading to risks of inevitable chain reactions and time bombs.

Negative Interest Rates, Yield Negative Returns Once upon a time, saving for a rainy day meant setting aside money so that bills could be paid if one loses a job or needed for retirement. Money was even kept in mattresses because banks were considered unsafe. Today it is different. After experimenting with three rounds of quantitative easing, central banks have bought up most of the available bonds with newly printed money. Central banks from Europe and Japan have embarked on their next big experiment, negative interest rates as more than 30 central banks around the world cut interest rates this year. Negative interest rates distort markets. Swiss bankers, UBS and Credit Suisse introduced negative rates on large deposits where their wealthy clients must pay for the privilege of leaving their funds with the bank. In fact, desperate for yield, investors are buying 30-year bonds, despite the prospect of losing money at the end of term.

One concern is that the negative yields are climbing at the rate of some $3 trillion a month, growing to $17 trillion, an historic high, and soon to be joined by the United States. The rich are getting poorer. Holders of bonds today, if held to maturity are guaranteed to lose money. Another worry is that pension funds who depend on interest returns are aghast as central banks threaten to lower interest rates even more. So what to do? If you are going to be charged to keep money in the bank, investors will buy other assets to preserve capital. To be sure, aging populations and negative yields will collide as capital allocation is distorted as debt becomes too unmanageable. Over the short term, money has been chasing overvalued stocks with a view that return on capital is better than nothing. Sometimes nothing is better than losing.

To be sure the distortion of negative yields across the globe also hurt the central banks whose portfolios hold part of the one third of global bonds that carry negative yields. More significant is that negative yields also undermine the pension funds, banks and other savers who are the very cornerstone of the capital markets and cannot exist with negative IOUs. And Wall Street has yet to figure out how to price risk on the trillions of dollars of esoteric financial instruments because negative yields do not work in their mathematical models. The financial system has thus become not only overly exposed but also unsustainable as weaker companies, unprofitable or leveraged players pile up more “interest free” debt. Debt cannot keep rising while interest rates keep falling. Eventually, central banks will reach a negative rate floor when cash in the system runs out or when depositors withdraw funds as they decline to pay fees to lend to those institutions. Ironically, negative interest rates have done little to boost economic growth. Central banks have become irrelevant.

Of more concern is that there is simply no reason to keep money in the bank. Taken to the absurdity, the deposit base of banks will inevitably shrink as depositors stuff their savings into mattresses or alternatives, which reduces the banks’ original mandate, that is to make loans. Without capital for loans, loans aren't made. But more important, negative interest rates reduces confidence in fiat currencies. History shows that when money ceases to be a store of value, investors simply find other ways to protect themselves.

Debt Does Matter

Investors and central bankers are puzzled that despite abandoning monetary orthodoxy and rounds and rounds of quantitative easing, we have declining interest rates, and inflation is nowhere to be seen. The problem is that many overlook that there is inflation, in stock prices, classic cars, precious metals, and the bond market. Money markets are behaving differently and the risk of inflation as well as central bank solvency has increased with the repo market in disarray as a sudden spike in interest rates for repurchase agreements, set the capital markets spinning.

We believe that the markets should be looking for stagflation, as a result of the huge increase in debt. Traditional economic theory is that debt monetization is a phenomenon when governments issue debt to finance spending and the central bank itself buys that debt in secondary markets, thus increasing money supply. Yet central banks are not targeting money supply but instead inflation and unemployment, which are laggard statistics and noteworthy is that unemployment is at the lowest level in 50 years, considered full employment today. We believe that the debt monetization has come at a cost of higher debt loads. Most sovereign debt are yielding negative returns with a shift from “risk-free” returns to “return-free” risk. But, in today's environment of declining interest rates, what remains constant is that the interest payments, are taking an increasingly larger percentage of government revenues. Those fixed interest payments on debt are deflationary and one of the reasons why there is less money going into the system which ironically was one of the factors, that exacerbated the Great Depression. Debt does matter.

Repo Market Mess,
A Repeat of 2008?

And today, a decade after the last financial crisis, Wall Street is again facing a liquidity crisis as the Fed was forced to inject funds into the overnight repo market. The Fed pumped almost $300 billion into the US financial system because the system literally ran out of cash. To steady the short term money markets, the overnight borrowing rate surged more than 10 percent, up from 2 percent and upsized to $200 billion of cash for the last day of September, reflecting the tightness of the US money market. The Fed then extended purchases of Treasuries in a second attempt to avert another lending squeeze. Many viewed the repo rescue as a technical hiccup in the market’s plumbing. Wrong.

We believe the squeeze and emergency funding was a natural consequence and systemic problem of the unwinding of six years of quantitative easing, and as a result the Fed has lost its monetary grip, leading to fears that they are no longer in control of short term borrowing rates and are resorting to a soft QE4 to fix the problem.

Others believe there is a larger unknown counterparty risk, particularly since the five largest US banks hold more than 90 percent of total reserves. Ironically, left unsaid is that the shortage of cash is no surprise in an environment of negative interest rates, and a familiar scene for emerging countries like Argentina where patterns of running out of cash is an all too regular event. Gold is a good thing to have as the so-called collateral chain tightens. After all, the repo market was at the epicentre of the last global financial crisis. Déjá vu.

In the Beginning, There was Gold

That is not all. The market’s daily record highs sometimes feel like a mirage. The trade wars and negative interest rates have forced investors to risk returns even though shares are overvalued. But trees don’t grow to the sky and the market is showing signs of old age. Daily highs in the Toronto market come from only a core group of stocks, while the broader sector such as the energy or financial stocks are stuck in the doldrums. Similarly, in the United States, the big technology stocks pushed the Dow to ever higher highs but the lack of breadth is concerning. More troublesome is that in the quest to boost returns in a zero rate environment, investors have sunk trillions of dollars into the largely unregulated private and venture capital markets with the big Wall Street banks stoking the bubble, fueling even higher valuations in a Ponzi-type valuation scheme.

The illusion of prosperity is best reflected by the collapse of unicorn WeWork which postponed its IPO offering, causing a backlash against big tech stocks. WeWork failed to secure the analysis of the public markets when its corporate governance and leadership concerns were disclosed. Although Wall Street’s big investment banks had valued WeWork at $65 billion, the IPO price at $47 billion was quickly discounted to $15 billion, when the deal was shelved. Scrutiny was also on the big venture capital fund, SoftBank Group who invested almost $10 billion in WeWork and like the big Wall Street banks had much to gain by the going public route.

However it is not that WeWork failed because of its CEO’s foibles, but it was a flawed “growth at all cost” business model of never making any money. Of concern is that with rental commitments of $47 billion, WeWork has become the largest landlord in the world and will spend $9 billion this year, despite having cash of $6 billion It appears that SoftBank and WeWork did not hear the music stop. Caveat Emptor.

Gold Is a Better Store of Value Than the Dollar

We believe that America’s new isolation, together with the trade hostilities will usher in a cycle of competitive devaluations, stock market crashes and volatility, strikingly similar to the onset of the Great Depression in the Thirties. Governments then boosted trade barriers and rounds of protectionism caused the reneging of monetary commitments. What ended the Great Depression was a new monetary order in Bretton Woods, which lasted a quarter of a century, until replaced by a fiat currency, the US dollar and eventually, dollar hegemony. China and Russia are moving out of dollar denominated asset and buying up enormous stores of gold instead. China added almost 100 tonnes of gold to its reserves over the past 10 months. Today America has been running large, chronic deficits, spending more than they are producing, piling up the largest debt in peacetime. Like before this is unsustainable.

The US dollar acts as the primary currency for the global community and serves as the global safehaven for international investors and official reserves. However, US financial markets are vulnerable and the epicentre of the next crisis as the United States is heavily dependent on foreign capital to finance its huge and growing deficits. In other words any reduction in foreign flows could cause Treasuries to lose value and the Fed would have to fill the financing gap. This eventuality resembles what is happening in Venezuela, Turkey, Iraq or Zimbabwe where increasing the money supply to finance consumption or pay the national debt, resulted in the debasement of currency.

So too, American profligacy and monetary hegemony has undercut faith in the dollar. America cannot have a strong economy, conduct a trade war and a weak dollar all at the same time. Gold is an alternative store of value to the dollar and until there is a replacement, it is a traditional haven asset against the debasement of currencies, giving financial protection during financial crises.

Mr. Trump is
Good for Gold

Gold recently traded at 6 1/2 year highs as investors sunk almost $4 billion in September in global ETFs to 2,808 tonnes, the highest ever, amid fears of a recession, exacerbated by President Trump’s protracted tariff war as well as the onset of negative interest rates leaving investors nowhere to hide. Gold is a beneficiary of the central banks’ driven policies of negative yields. Further underpinning gold is America’s profligacy and record debt level which is not only unsustainable but undermines confidence in the US economy and its currency. One can detect the decline in confidence in every part of the world. What damages trust in the US, damages the world. Investors today are left with whom or what can they trust.

Last year 22 central banks bought the most gold in half a century ending four decades of demonetisation. So far this year 14 central banks bolstered their gold reserves with total gold holdings back to early 1950 levels, with gold distribution shifting from the west to the east. Investors suspect that the American people will elect an inflationary president next year. No candidate, including Mr. Trump stands for sound money. Meantime, there are supply problems as miners deal with declining reserves, grade and increased costs. China is the largest gold producer in the world and like other major central bankers is buying gold such that China is currently the sixth largest holder, after Russia. There is not enough gold to meet demand. In June, gold broke out from a five-year trading range beginning its new bull market. Gold is up 15 percent year to date. With so much fear stalking the world, we believe gold will post new cyclical highs, exceeding the last peak of $1,921, reached in 2011.

Mr. Trump is good for gold. In the Godfather, Don Vito Corleone said, “Lawyers can steal more money with a briefcase than a thousand men with guns and masks”. Today, this "Goldfather” might have substituted politicians for lawyers. Gold is a good thing to have.

Mining Company Recommendations

Mining companies will have a mixed quarter as some producers managed to lower debt, others reduced production costs in an attempt to boost margins but few replaced ounces. Most gold producers however continue to rein in costs and focus on spending in order to protect their balance sheets. Cash flow is king as most of the gold miners have lowered “all in costs” (AISC) below $1,000 an ounce, which potentially allow dividend policies that would give shareholders a return and enhance shareholder value. Still, reserve replacement is a problem for the industry, which will end the year with a declining reserve picture, as the miners find it increasingly expensive to replace production. Nonetheless, growth-oriented Agnico Eagle Mines and B2 Gold bucked the trend with growing production profiles next year. While market fundamentals have improved, exploration players continue to find projects difficult to finance resulting in a dearth of discoveries.

We continue to recommend Barrick Gold and Agnico Eagle among the senior producers. We also like B2 Gold and would avoid debt heavy Yamana and New Gold. IAMGOLD is still pursuing asset optimization but we did not think the Chinese players would spend $2 billion to buy a producer that loses money. We would also look at the junior developers that have completed feasibility studies and need only capital to finance their developments.

Agnico Eagle Mines Ltd. (AEM) – had a good quarter and expects record production this year due to the ramp up of Meliadine in Nunavut, which achieved commercial production ahead of schedule and Amaruq in the current quarter. Most of the heavy lifting and expenditures have been done and Agnico will harvest its new production from the Meadowbank complex where total expenditure costs will come in at $830 million, below $900 million forecasted. At Kittila in Finland, good grades at the Rimpi zone will extend the high-grade mineralisation. Agnico successfully replaced reserves last year with 22 million ounces at an average grade of 2.70 g/t. As of June, Agnico had strong liquidity of $126 million and a $1.2 billion undrawn line. We like Agnico Eagle for its growing production profile, low costs, and pipeline of projects.

Barrick Gold Corporation (ABX) – Barrick results continue to show improvement, allowing the company to pay down debt. Barrick produced a five-year plan for mammoth Nevada Gold Mines with an emphasis on production, synergies and reserve replacement. The joint venture has 10 underground mines, a dozen open pit mines with 48 million ounces of reserves and 10 processing facilities. Barrick recently released drill results extending the Four Mile discovery as part of the three tier one assets it owns. Gold Rush is included in the Nevada joint venture, which produced 4.1 million ounces last year. Barrick also acquired the remaining Acacia Mining minority position, which should accelerate an agreement with the Tanzanian government to end the two-year standoff. Nonetheless, we like Barrick here for its array of tier one assets, experienced management and large reserve position.

Detour Gold Corporation (DGC) continues its cost-cutting optimization with an emphasis on expanding margins. The miner is mining less but increased mill rates to optimize output, needed for a low-grade operation. Detour has improved operations but will unveil a new mine plan. The company refinanced its debt, extended term and reduced interest payments. Detour should produce 585,000 ounces this year at AISC of $1,200 an ounce, stressing the need for grade control and reducing cost. Nonetheless we prefer B2 Gold here for lower costs and rising production profile.

IAMGOLD Corporation (IMG) is a mid-tier player that has been stymied by worker problems at flagship Rosebel Gold Mine in Suriname, which resulted in the stoppage of mining operations. Operations have been on and off following the death of a unauthorized miner. Rosebel is key since the interruptions at Rosebel mill affects processing of nearby Saramacca ore. Meantime Westwood in Quebec is still underperforming and a disappointment. We believe that the takeover talks with the Chinese failed because any suitor would not pay $2 billion plus for a company that can’t make money. Sell.

Kinross Gold Corporation (K) – Kinross surprised the street by expanding their footprint in Russia. Kinross acquired 100% of Chulbatkan development in Russia’s Far East for $283 million over two years comprising 40 percent cash and 60 percent Kinross’ shares. Kinross’ due diligence suggests that there is a large resource of 4 million ounces and good grades for an open pit heap leaching operation. The Russian mine has a six-year mine life and could produce 1.8 million ounces. While the Kupol-Dvoinoye operation continues to perform well, Kinross’ Russian exposure has been a price depressant. Also, the Tasiast 24K expansion project continues with Kinross starting the first phase but a deal with the government is needed. Kinross has a good pipeline of projects but should focus more on its Nevada assets such as Phase W or the Vantage Project at Bald Mountain than La Coipa and the Lobo Marte projects which are too big and capital intensive. We prefer Agnico Eagle or B2 Gold.

Kirkland Lake Gold Ltd. (KL) – Kirkland Lake, an intermediate player with five underground mines and three mills in Canada and Australia, reported record production at 248,400 ounces. Kirkland had a strong quarter with low cash costs and huge margins due to high-grade Fosterville in Australia. Macassa Mine made a strong contribution at almost 63,000 ounces as it mines higher-grade stopes but the Holt Complex’s higher costs hurt margins. Macassa has four drill rigs turning with high grade results to the northeast. Nonetheless, Kirkland has a strong balance sheet with $615 million and an all in cost less than $700 an ounce. We believe Kirkland should use its richly valued paper to acquire a mid- sized player to remedy Kirkland’s relatively short mine life.

Newmont Goldcorp Corporation (NGT) – Newly minted President and Chief Executive Officer, Tom Palmer has his hands full and has given a more realistic guidance outlook due to the need to integrate, reduce costs and optimize the Goldcorp acquisition. Costs were hit by an illegal labour dispute at Penasquito and while the blockade was lifted, results will be adversely impacted. We believe that digesting Goldcorp will take a couple years and there is a likelihood of further asset sales. Newmont has 14 operating mines and 2 non-operating JVs with 90 percent of output in the Americas and Australia. Newmont reported that its Ahafo mill expansion in Ghana processed first ore, which will extend mine life to 2029. We prefer Barrick here because it will take a couple years to digest Goldcorp.

Editor’s Note: This is an edited version of Gold: The GoldFather by John Ing, President & CEO of Maison Placements Canada Inc. Mr. Ing has over 45 years of experience as a portfolio manager, mining analyst and investment banker.

Maison Placements Canada Inc. is an institutional investment boutique that provides financial services to corporate, government, institutional, and individual investors. The firm offers securities underwriting, distribution, and execution services. Additionally, it provides investment banking services including mergers, acquisitions, and divestures; equity financing; financial and corporate restructuring; valuations; fairness and regulatory opinions; and management advisory.

For more information on Maison Placements Canada, visit www.maisonplacements.com.

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