To Infinity and Beyond

America is more bankrupt, leveraged and vulnerable than Europe. And to finance its debt, one branch of the state (Treasury) borrows money from another branch of the state (the Federal Reserve) and everybody thinks this is the norm – they call it quantitative easing (QE) as the Fed embarks on a third round which could eclipse the first one’s trillion dollar cost pushing America closer to the fiscal cliff on their mountain of debt. America’s debt as a share of GDP excluding the debt of Fannie Mae and Freddie Mac is already over 100 percent. Although the cost of servicing that debt is only 1.4 percent of GDP because of low interest rates, half of America’s debt is in foreign hands and so interest rate levels around the world are important. If America had to pay the rate of comparable sick countries, say six percent, the debt burden alone would exceed the spending on Social Security, Medicare or national defense.

Central banks around the world have also flooded an already flush financial system with more cash presumably to give their respective politicians more time to sort out our problems. The world has gone on a “liquidity binge” heading towards an economic cliff. Yet each time substantive issues are glossed over, they return to petty infighting. Real issues? Later. Simply there is a lack of leadership. And worse, the blanket monetisation of government debt debases currency, distorts capital markets and calls into question the viability of sovereign debt. As a consequence, currencies have weakened so much that a tide of offshore money seeking higher returns are taking bigger and bigger risks, similar to what happened in the Great Depression when a currency war was a prelude to hyperinflation. Too much money simply chased too few goods. Our central banks have created a new bubble. What ballasts the world’s monetary system is debt. The problem is that we simply live in a debt-laden world with fiat currencies propping up failing economies and central bankers continue to believe that the debt crisis of today can be solved with more debt. The financial system is broke.

Politicians will do whatever it takes to win elections but no one has the political will to tackle this debt and thus markets have become reliant on central banks who are left to tackle this debt problem with the lowest rates in half a century. In the United States, despite the November presidential election, there was still no talk of the latest made in US crisis, the fiscal cliff, a combination of automatic tax hikes and spending cuts that could send the economy reeling into a recession. Billions of spending cuts are needed as well as revenue increases yet we have reached this fiscal cliff because neither side wants to cut or introduce tax increases. Legislators have not even passed last year’s budget and will reach the borrowing ceiling before year-end. No debate, no discussion – not a peep. Like a game of chicken, the players are ready to call each other’s bluff.

While, there is the likelihood of an extension, postponing again national bankruptcy, this time foreign investors won’t wait for another round of folly. What everyone misses is that after a five year spending binge and an additional $5 trillion of debt, the US needs to dramatically reduce a debt load that is more than the combined debt of Europe. Emerging economic powers such as China or Brazil no longer desire to pay this bill. America is in a bind. It will find it hard to default on the $1.1 trillion of US Treasuries held by the Chinese.

QE3 ∞ to infinity and beyond

QE3, the “solution du jour” uses debt to create demand propagating the myth that money can be conjured out of thin air. The third round of quantitative easing involves the usual asset purchases aimed at driving interest rates down creating at the same time ever larger artificial markets for government bonds and all of its derivative products, but this time without an expiration date. From infinity and beyond.

But, how low can we go when interest rates are at record lows? The Fed has tried adding liquidity before and while QE2 had a short lived boost (see chart), the cries for another round of quantitative easing has pushed the US economy into uncharted waters. To be sure, the Fed’s monthly open-ended purchases of $40 billion of mortgage-backed securities ensures that interest rates will stay negative, punishing investors and savers alike. Interest rates are no

longer meaningful. What ails the US economy is cheap money and despite near zero rates, the economy remains anemic. Ironically, it was the Fed’s low interest rate policy that caused the last debt driven housing boom, and bust. Rates aren’t part of the problem and therefore can’t be part of the solution. Piling more debt on debt is not the fix.

This is also the case in Europe as Mario Draghi, the president of the European Central Bank promises the bank’s bottomless pockets will be opened indefinitely. The printing press solution was tried less than a year ago and is again found wanting. Yet today, new concerns emerged with both Spain and Greece now caught up in constitutional crises as north-south fractures open up old rifts within these member states. Today, central banks’ promises have become empty promises and while our so-called guardians of money possess unlimited powers to print money, their experimentation and track record of late has also been found wanting. The recent round of monetization of debt even violates the European Central Bank’s own constitution. And still they continue pump more money into the system in addict-like fashion. It is like a drug. More and more is needed, with less and less effect. We believe that the monetary financing of deficits will only lead to more inflation.

The End of the Fiat Currency Experiment

In seeking higher returns, investors are putting pressure on the safe haven currencies, sparking competitive devaluations and the spectre of the “beggar thy neighbour” currency war in the thirties when governments deliberately reduced the value of currencies to prop up their ailing economies. And like America’s lemming-like rush over the fiscal cliff, it is inevitable that Europe will face a default of one of their members which will unleash large scale bank defaults, balance of payment crises, and of course the end of Europe’s experiment with fiat currencies.

History suggests the need for a currency that everyone can trust. When Britain, faced with huge deficits proved unable to defend sterling, it went off the gold standard losing sterling’s preeminent status. Then US debt surged over 300 percent of GDP following two world wars, not dissimilar to the Greek and Italian problem today. Under the weight of too much debt, President Franklin Roosevelt went off the gold standard and even confiscated private gold holdings, in order to deal with the debt. Indeed, it was the credit creation from financing wars which produced the problems then and of course the bust in the thirties. Subsequently from the end of World War II through the early seventies, the financial system was tied to fixed exchange rates under the Bretton Wood’s Agreement. That system fell apart when America fought a war in Vietnam and financed the “Just Society” which caused the great inflation of the seventies. America again went off the gold standard in 1971 tearing up Bretton Woods, forcing the world to move to a float tied solely to the US dollar backed by the faith and full credit of the US economy.

Subsequently for almost half a century, the US dollar as the world’s reserve currency, has taken the world on a wild roller coaster ride culminating with the biggest boom ever ending in the transfer of personal debt to the big banks and with the 2008 bailouts, Wall Street’s debt to government debt. And full circle this whopping sovereign debt is being transferred where it started, the taxpayer. Investors are fickle. And their confidence and trust in the dollar has been sapped.

Gold Is the New Global Currency

To avoid such woes, the world needs a currency backed by assets, not by faith. Gold of course, reached a record high just a year ago and flirted with the old highs last month. Throughout gold has risen against all currencies, especially the dollar. Gold’s stellar performance is due more to the fact that the dollar has fallen in terms of gold. Gold’s performance is a measurement of the world’s view of the dollar value which is weakening with every printed IOU. Gold is simply an alternative investment to the dollar by central banks and savers alike. As a result, hopes have been raised for a new order with a return to a gold standard. Nostalgia buffs tell us that a gold standard simply limits the central banks’ ability to print money in unlimited quantities. True, but is it practical today?

In Gold We Trust

The idea of a gold standard is enjoying a renaissance because it takes policy away from central bankers who lately are more adept at printing money in copious quantities, than maintaining the value of their respective currencies. And that is the problem. Empty promises show empty results. We believe that a return to a gold standard is less radical than the helicopter money printing exercise of the Fed which has fueled the public’s distrust of politicians, central bankers and money. The relentless pressure from the markets leaves governments little breathing space to implement the difficult and controversial measures needed. Needed is a reliable store of value. Even the state of Utah has recognized gold and silver as official means of payment. Monetary financing of governments has to become more conservative and dependent upon reserves and their currencies must be anchored to some system which they can respect and cannot duplicate. America’s biggest creditor, China is now actively pursuing alternatives promoting the cross-border use of the renminbi in trade and investment. The People’s Bank of China once commented, “to prevent the deficiencies in the main reserve currency, there’s a need to create a new currency that’s delinked from the economies of the issue”. Next? Gold.

There is even talk of revaluing gold upward that would securitise Europe’s holdings to provide the needed financing to help out its weaker member states. There are proposals to revalue the IMF’s gold to give it more liquidity. At one time, gold even backed French bonds (the Giscards) so the usage of gold as collateral is not without precedence. In the seventies, gold was used as collateral to back loans to Italy, Portugal and Switzerland. Central banks have not been idle. According to the World Gold Council, Russia has doubled its gold reserves in the past five years making it the fifth largest holder in the world. China, Saudi Arabia and now Russia are among the top five holders, joining the United States. China is the world’s largest gold producer and is also its largest importer. Yet its gold reserves are less than 2 percent, a far cry from the 12 percent held by Eurozone members whose 10,000 tonnes of gold reserves currently back the euro. At least, some central banks are getting prepared.

In the interim, we believe that the “balkanisation” of the world’s financial system is likely with a mix of currencies tied to gold such as the East mobilizing around China and the West divided between Europe and North America. The dollar’s days are limited. The Middle East might develop a petro-currency as the recent differences between the Middle East and West might dictate an independent stance and currency by the Middle East petro-players. Gold is a global currency.

The Fed Is More leveraged than Lehman Brothers

With the new round of quantitative easing in the United States together with the central banks of Japan, Europe and Switzerland loosening their monetary reins, the excess liquidity has shifted not into the world economy, but into commodities and gold. You cannot avoid the arithmetic. During the financial crisis, the CRB commodity price index rose 36 percent during the sixteen months of the first round in 2009 and 2010. During the second round in the eight months up to June 2011, the CRB rose 10 percent and in only weeks of Bernanke’s announcement of the third round of the QE trilogy, the CRB moved 2.5 percent in only one month. In essence hundreds of billions of dollars have flowed into hard assets, such as oil, soft commodities and of course gold. Forgotten in the wake of QE3, is that inflation is now back in the Fed’s toolbox.

Tellingly, Since mid-September of 2008, the Federal Reserve has expanded its balance sheet from $924 billion to a whopping $2.9 trillion with the purchases of massive amounts of US mortgage-backed securities, Wall Street’s toxic obligations and Treasuries. Non-marketable assets are a growing part of the Fed’s massive collateral portfolio. Of course, to finance those purchases, the Fed increased bank reserves, aka money printing without seeking congressional approval. Since that period, the Fed also acquired $1.16 trillion of government securities or some 77 percent of all additional debt issued by the Treasury, blurring the distinction between monetary and fiscal policy.

Is the Fed Too Big to Fail?

Ironically, while the Fed is calling for strengthened capital requirements for the largest US banks, the Fed itself is severely undercapitalized. The Fed is supposed to backstop the dollar and America’s obligations. The Fed’s assets have grown much faster than its capital. The Fed’s leverage ratio- the amount of equity capital that the Fed holds relative to its assets is a useful indicator when looking at other banks. The equity capital underlying those so-called assets has not grown, nor is backed by hard assets, just more IOUs. The truth is that the Federal Reserve now is more highly leveraged at 51 to 1, than Lehman Brothers (31X), Bear Stearns (30X), or even Fannie Mae failed which necessitated the bailouts by the Fed.

In other words, the Federal Reserve does not have enough capital against its assets, exposing it to a disaster when interest rates increase. A modest one percent increase in rates is enough to wipe out the Fed’s capital base or when the Fed unloads this massive debt portfolio, in a normal environment, higher interest rates could cause huge losses. If confidence should waiver in America’s ability to pay for their obligations, then we would have an implosion worse than the failure of Bear Stearns and Lehman Brothers. Ironically, the Achilles heel is the very balance sheet which limits the Fed’s ability to use monetary and fiscal policy no matter who is elected in November. Of course the Fed could always print more capital but a capital infusion would require an Act of Congress. Is the Fed too big to fail?

The Asians Are Coming, and They Are Looking To Buy

Gold climbed above $1,800 to reach the highest level in more than six months on expectations that the Federal Reserve would embark on a third round of quantitative easing in the wake of the eurozone problems, the slowdown in the economy and of course the upcoming elections. Since then gold has been backing and filling and we remain bullish expecting gold to reach $3,000 an ounce as currencies continue to be debased due to the global monetary expansion.

For centuries gold has been central to savers and we believe gold is now in a secular bull market supported this time by negative interest rates, a dramatic shift in supply and demand as well as our belief that gold is the antidote to our problems. Gold is the new global currency. This bull market is only just beginning – to infinity and beyond.

The Asians are coming and they are looking to buy reserves in the ground. China has $3.2 trillion of foreign exchange reserves and is beginning to flex its financial muscles. Zijin Mining Group is buying copper projects in Africa. China’s Minmetal Resources spent $1.4 billion for Anvil Mining’s copper mine in the Democratic Republic of Congo. China’s Western Mining is spending $250 million for Canadian based, InterCitic which has the Dachang mine in China. And in its biggest deal, China National Gold, the country’s largest gold producer, is proposing to pay $3.9 billion to acquire African Barrick, the largest gold producer in Tanzania. African Barrick has some 30 million ounces in the ground and its African base is an attractive asset. Chinese cash rich companies are in a perfect position to snap up mining asset around the world.

Is it all just a coincidence?

China is the world’s largest gold producer in the world, producing some 360 metric tons of gold last year and among the largest, consuming 800 tonnes. China would like to be self-sufficient but its mines have short reserve lives. The country is also seeking to build global entities, diversifying its assets beyond its borders to improve access to mining technology, particularly underground to be used in its own mines. The trend is not new. The purchases are part of a trend that has been building over the last decade and will continue over the next decade as China bulks up in terms of gold miners. Today, China’s largest companies are only about the size of the world’s midsized producers, such as Eldorado or Yamana. We expect M&A activity by Chinese companies will increase. We also believe that given the sophistication and recent deal mastery, that future deals will be bigger and bolder.

A year ago, we reviewed the top dozen producers in the world and compared them to the two top Chinese producers. Since then, the Chinese producers have bulked up and it is noticeable that the western producers remain stagnant which is an opportunity for the Chinese. Indeed, the market cap per ounce of in-situ reserves has declined 25 percent from $463 an ounce to $347 an ounce while the gold price has gone up. Of interest is that the top twelve companies control more than 90 percent of the world’s in-situ reserves.

We believe the owners of those gold deposits represent the only source of new supplies of gold. Thus, given the geo-political uncertainties and cheap gold shares, we believe that these producers are well placed and it makes sense for Chinese investors to take a position in some or all of the key players, giving them a strategic access to a valuable and scarce commodity in the ground. Barrick, for example has 140 million ounces in reserves and is the largest producer in world. Barrick will remain front and center but could use Chinese help to expand and develop its vast reserves in the ground.

Indeed, looking at prices paid for reserves, there is an opportunity for Chinese companies given the fact that market cap per reserves in the ground is now at $347 an ounce or 20 percent of today’s gold price. We believe that reserves can be bought for as little as $100 an ounce. If one adds the $600 cost per ounce, gold mining acquisitions could be extremely profitable, even today. Consequently we believe the cheap valuation of the western companies will not last, particularly given that Chinese companies can avail themselves of lower cost financing and market access. Indeed from a longer term standpoint, we can see that the capital of the East will be used to finance western capital intensive projects, where cheap financing will lower overall costs.

Recommendation

The gold mining industry remains in a funk, despite gold’s flirtation with last years’ peak at $1,900 an ounce. The lower share prices are due to investor disenchantment with huge cost overruns, rising energy prices, acute labour shortages and threats of nationalization and/or increased taxes in many so-called safe mining jurisdictions. Two mining executives were fired leaving investors to wonder who is next. In the past, mining companies would hedge their production to maintain their healthy margins, however with the rising gold price, miners were burnt by their hedges and no one today would dare hedge the upside.

Absolute growth became impossible. The real problem is that there is a shortage of world class deposits. In the past ten years, most mines have been of the open-pit category and today deposits are deeper and thus costs are rising. In addition, grades have declined and thus the known cash expenses, such as depreciation, depletion, and amortization are finally catching up. Margins also narrowed. Gold stocks simply became lousy investments.

In addition, gold exchange traded funds (ETFs) have siphoned off many investors from investing in the mining companies. Simply the mining industry has impaled themselves on their own sword, so to speak, since the mining industry’s World Gold Council was the chief architect of ETFs. Nonetheless, ETFs now hold more than one year’s production, which is a formidable amount. We believe however that the gold companies can differentiate themselves through increasing their dividend and share buybacks which increases the leverage to the gold price.

A worrying trend is the political shifts in some mining areas and a pick-up in resource nationalization in Mongolia, Peru, Argentina and Indonesian. The price of gold has been affected by the widespread strikes following the shooting of workers at Lonmin’s platinum mine in South Africapton and more importantly the government’s response is a reminder of the fragile nature of world’s second largest gold producer in the world. The recent wildcat labour strikes and demands for pay increases are having an impact on South Africa’s supply in the worst crisis since the end of apartheid.

Gold Stocks Have Never Been So Cheap

Higher taxes in Australia, heightened political and social unrest in Peru, and Chilean tax hikes has hurt mining in those areas. Australia’s gold production increased in the second quarter, but overall output has fallen five percent in the first half. That the government wants an increased take is perhaps coincidence however mining executives are looking at all costs as well as at the cost they must pay to governments. Australia is soon to become a “have not” country and South Africa is looking more and more like Zimbabwe. Bottom-line? Less gold is coming to the market.

Our bullish case for gold stocks has been based upon the cheap valuation of in-situ reserves. The margin between today’s gold price and shrinking in-ground reserves has never been so cheap. Eventually we believe that the market will follow the Chinese and wake up and discover gold companies’ undervaluation of those reserves. With central banks and retail investors buying gold there is just less and less physical gold being brought to the market. So while the all-in-cost may approach $1,000 an ounce, the reality is that the gold mining industry is the largest and only uncommitted gold source and we would argue those estimated 22,000 tonnes of in-ground reserves are the key reason why gold stocks should be bought today.

We see a continuation of the M&A activity except many of the transactions will be of the “tuck in” variety rather than the big block buster deal. The bigger seniors may even shrink themselves spinning off mines like Barrick’s push out of African Barrick. The neglected or weaker candidates may well have to shop themselves around or take new lessons in the “care and feeding” of shareholders. We thus believe that the senior producers will likely boost dividends or shrink their capitalization through share buybacks. Gold miners have now got “religion” and cash flow performance has become more important than growth in ounces. We thus recommend low cost intermediate producers and near development juniors.

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