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Archive for August, 2010



   Posted by: Mr. Gold    in Uncategorized

Coming out of the recessionary cost-cutting and post-recessionary restocking, US and European stocks offered a slew of expectation-busting results in the second quarter. But the positive earnings surprises (for the former) and revenues surprises (for the latter) did little to avert the outflow of funds from the equity market. A theory of ageing baby boomers caring less about return on capital and more on capital preservation (the popular pun refers to return OF capital) is gaining traction, keeping pace with the inflow of funds into the seemingly bottomless bond market. Safe heaven bonds are selling like hot cakes and only the Japanese Ministry of Finance is allowing more products to mature than to be sold. This week again, the yields on the Japanese, German and US government bonds have dredged record depths.

The stock market apathy is now being countered by feverish M&A activity. The last two weeks have seen an unprecedented onslaught of announcements targeting a variety of companies: Potash, McAfee, NedBank, 3Par Inc, International Power, Cairn India, Dana Petroleum, New Alliance and Sphere Minerals (which controls attractive iron ore assets in Mauretania). With the exception of Kinross’s advances in West Africa (and the earlier Newcrest-Lihir tie-up), the gold mining industry has been remarkably quiet on this front. This relative inertia continues despite the much higher level of fragmentation than in the case of more M&A-prone potash or iron ore industry. Why has the gold industry been so quiet? The answer is threefold.

The first part of the answer lies in the structure of the gold mining industry. Three out of top 10 gold mining companies are domiciled in South Africa. After Pretoria’s initial green light to Anglo American, Billiton and several others to establish Plc structures in the UK, the process of internationalization of South African resource companies stalled. The last significant acquisitions made overseas by SA gold mining firms were executed in 2001. The liquidity and fungibility of their shares made it extremely difficult to compete for Australian assets and practically impossible to enter a contest for North American assets. The legislation favoring ownership by historically disadvantaged South Africans, first leaked in 2002, further depressed any interest in South African producers as potential targets of corporate activity. Several years later, the botched approach by Harmony to take out Gold Fields offered the final nail in the coffin. Short of resuscitating the idea of intra-South African consolidation (or rather asset rationalization), there is little chance of the three giants to play a decisive role in the global consolidation of the industry.

The second part of the answer has to be sought in the relative valuation of gold mining stocks. The CEO of Yamana has recently complained that the undervaluation of large mining stocks vis-à-vis their smaller competitors lies behind the slow pace of consolidation. It is true that when a tier I company does venture out, the allegations of ‘overpayment’ abound. Kinross’s CEO is still facing a tough battle with many reluctant shareholders over the purchase of Red Back. Both gentlemen have investment banking background and Yamana’s boss seems to be correct in his assessment. Currently North America’s large gold stocks trade at around 13x next year’s cash flow, 21x forward earnings, 7x EV/Ebitda and around 1.4x NAV. By comparison, the 2nd tier producers, where most growth is expected, trade at 16x cash flow, 23x PE, 9x EV/Ebitda and around 1.7x NAV. And that despite the largest companies having the free cash flow yield twice the size of the second group’s. Essentially, that would mean that large companies – many of which were built on successful acquisitions in the past – are bound to destroy value if they embark on costly acquisitions among the 2nd tier producers. But that does not rule out some activity on the part of 2nd tier producers targeting small and emerging gold miners.

Here lies the third reason behind the slow progress in consolidation. Even if we put aside the Chinese and Russian producers, the universe of potential takeout targets runs close to three digits. Monitoring this universe requires dedicated teams for both desktop overview and on-site due diligence. Many of the 2nd tier producers lack the adequate corporate structure to focus on any targets that are not known already – through geography, personal contact or other privileged leads. Investment bankers will not find a $150m-$300m deal attractive enough to dish out a detailed proposal. Essentially, the industry lacks vehicles facilitating the deal flow beyond the most obvious targets (Lihir was one of them). Canadian banks may have the best information about their actual and prospective clients, but it is the prospective acquirer which will eventually have to do all the time-consuming homework. The signature of confidentiality and standstill agreements with the target will invariably divert resources from the key development work that 2nd tier miners depend on. Those which may potentially have such resources at their disposal (ElDorado? Agnico-Eagle?) possess plenty of in-house growth projects in the near term, or are busy integrating recently acquired assets. In addition, while tier 1 companies may more easily deploy resources from other operations to increase efficiency gains from the target’s assets, smaller acquirers usually find the post-merger acquisition just as challenging as the ongoing process of monitoring the available universe of potentially attractive targets.

The occasionally optimistic pronouncements about the overdue nature of gold mining consolidation are destined to remain just that – optimistic. The fragmentation of gold’s primary supply is a combination of historical legacy and the comparatively high-value, yet low tonnage nature of the majority of the relatively isolated deposits with few operational synergies. This does not mean that interesting targets are not there – in West Africa, in the Andes, in North America’s northeast or in Southwestern Pacific. But the process will be as slow as it has been in the past – regardless of the bouts of M&A fever in other sectors.

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   Posted by: Mr. Gold    in Uncategorized

Last week we reflected on what lessons, if any, the Japanese experience with deflation carries for gold investors elsewhere. A tentative conclusion was that the value of Japanese Yen mattered probably more for Japanese gold investors than the domestic decline in prices. And while the recurrent deflation has certainly influenced the wide-spread preference for long-term holdings of JGBs, the evidence for gold has to be sought in more selective statistics of bar hoarding, coin purchases and gold accumulation plans. A look into these historical data reveals just how astute the daily readers of Nikkei Shimbun are…

Let us step back to the onset of the first yen-carry trade, in 1996. After a record year for gold investment in Japan (1995 was punctuated by the Kobe earthquake and 18-year low prices in JPY terms) the investment demand nearly halved to 57t. The following two years saw a combination of profit taking and bursts of demand towards the end of each calendar year. In 1999, the Yen strengthened and deflation began, but overseas gold also hit a low of $275/oz. Investment demand in Japan picked up 16%, but this was a short-lived phenomenon, despite deepening deflation and further strength in the Yen.

Carry trades resumed in 2001. Between terrorism, Argentina’s default, Enron and a collapse of Daiei supermarket chain, Japanese investors increased somewhat the purchase of gold for investment purposes (this was the time when yellow jewelry barely sold in Japan). In early 2002 – against the background of weakening Yen and stronger gold prices, Mrs Watanabe rushed to purchase gold to protect the household against reduced government insurance for time deposits. Investment in gold hit 95t – an amount never registered again. At that time, bullion would change hands at around Y1400/g.

The subsequent three years of deflation saw a recovering economy, buoyed by exports and aggressive (and ultimately futile) attempts to weaken the Yen. Interest in gold depended on a variety of factors, ranging from the health of the banking sector, the performance of the local stock market and the JPY exchange rates.

The shock came in 2006, after the deflationary period was over. The carry-trade driven depreciation of the Yen sent the prices fast above Y1500/g and Mrs Watanabe began to take profits. That year, the Japanese disinvested a net amount of nearly 43t. With equally weak Yen the year later – and gold continuing to gain strength (crossing Y2600/g), 2007 saw a further 32% growth in net disinvestment. This process continued until JPY reversed the course in the wake of Lehman’s collapse towards the end of 2008. The return of deflation and a stronger Yen (a veritable ‘Hauch des Lebens’ for the otherwise embattled uncovered interest rate parity) coincided in 2009 with further dishoarding, albeit at a much slower pace.

This short summary of the recent history in Japanese gold investment reveals Mrs Watanabe’s uncanny sensitivity to the fluctuations of real values (rather than nominal prices). It is all the more surprising because it is, a priori, impossible to gauge the exchange rate reaction to changes in monetary aggregates. For example, a reduction in money supply should, ceteris paribus, lead to an increase in nominal exchange rates – and (depending on interest rates) a possible increase in real exchange rates. However, as the velocity of money is reduced, deflation sets in, and deflation means a decrease in real exchange rates.

Despite the multifactor complexity of these phenomena, the wisdom of (ageing) Japanese crowds got it right. Naturally, the gold investment demand exhibited a very high (negative) correlation to gold prices expressed in Japanese Yen (based on annual average prices). No surprises here. However, given gold’s relentless gains during the last decade, the nominal exchange rate (JPY/USD as a proxy) offers little guidance (barely 34% correlation to gold prices in Japanese Yen). The value of the Japanese Yen vs USD does not correlate with the gold investment demand in Japan at all.

It is by looking at JP Morgan’s broad Yen index (real effective exchange rate), that an astonishing picture unfolds. First, gold confirms its role as a “reality” check on the actual value of the currency (an argument made on these pages previously). JP Morgan’s JPY index and gold in JPY correlate at 55%. And Mrs Watanabe beats even that. Her gold purchases since 1996 correlated at 63% with the real effective value of the Japanese currency!

More granular data (e.g. on a quarterly basis) would be necessary to refute alternative hypotheses. Yet even at this high-level, the short review illustrates how attuned Japanese investors are to the real purchasing power of their currency. Rather than offloading gold at the first sight of positive real interest rates, they continued to hoard the metal and then sold a third of these holdings once the economy crept out of deflation. Remarkably, latent inflation fears never dented their resolve.

Watanabe-san! Atama ga sagarimasu!

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   Posted by: Mr. Gold    in Uncategorized

The spectre is haunting America. The spectre of deflation.

With no apologies to 19th century’s dialectical materialism, I have chosen the quote to describe the increasingly uneasy feeling US monetary authorities express regarding the mid-term prospects of America’s economy. With the vocally dissenting exception of Kansas City’s Thomas Hoenig, the Fed has once again expressed this week its relative malaise vis-à-vis the slowing growth. Bernanke & Co also showed how limited the DIY toolbox is to counter the Japanese scenario. The markets reacted accordingly.

Yet the oft-quoted “Japanese scenario”, or “defure jidai” (era of deflation) is poorly understood. There is now considerable interest in the mechanism of Japan’s recurrent deflation and gold investors should heed some of these lessons as well.

First, it is important to stress that Japan has not been mired in deflation without interruption for two decades since the collapse of the property bubble. Rather, there have been two distinct periods of deflation – the first one during 1999-2005 (following the banking crisis of 1997-98) and the second one in 2009-10 (triggered by the global recession).

Secondly, deflation alters investors’ behavior. Deflation is particularly damaging to debtors, who, in the context of falling real incomes and prices, must make interest and amortization payments in nominal amounts. No wonder that Japan’s corporations focused on debt minimization rather than profit maximization. Private investment stalled and marginal efficiency of capital collapsed. But the debt repayment obsession continued even at near 0% rates during the periods of positive CPI, as in the mid-1990s. Japanese investment behavior durably changed because investors believed that the pre-1989 asset prices were “wrong”.

It is impossible to understand what role gold has played in such an environment without tracking the performance of the Japanese Yen. The Japanese love story with gold was a short but boisterous affair. Despite the country’s efforts to diversify energy imports after 1973, the second oil shock triggered a major panic in Japan. In January of 1980, gold hit JPY6495/g. By the time deflation set in nineteen years later, the combination of a strong Yen and uncoordinated sales from central banks brought the prices to JPY917/g. For a deflation-gripped Japanese household, whose cash tomorrow was worth more than cash today, gold offered just another route from riches back to rags.

It’s from this low point that a more interesting story unfolds. Between 1996-98, during the first spell of carry trades (when the Yen lost 25% of its value), gold remained flat at around JPY1400/g. The second period of carry trades – between 2001-08 – saw the reversal of fortunes. Now the Yen barely diverged from the mean of 114 to the dollar, while gold gained 230% in Yen terms. Despite spells of interest registered by Tanaka Kikinzoku, most gold buying during this period occurred overseas. The most recent period of a stronger Yen has seen much more modest gains of about 4.6%. Remarkably, Japan – with little domestic gold mining – has now become a gold exporter! In other words, the first bout of deflation in Japan was accompanied by gold’s gains, while the second one has so far sent mixed messages – in line with gold’s significant volatility in JPY terms.

In fact, the fluctuations of the Yen exchange rates matter more for a deflation-bruised Japanese investor than the relative value of assets and liabilities exacerbated by the recurrent liquidity trap. The reason behind the limits of the Japanese experience lies in the asymmetry of the global exchange rates. The Yen is a structurally strong currency. The Hondas and Toyotas sell for dollars and euros (ah, yes, and the renminbi), which then have to exchanged into the Yen – boosting the demand for the Japanese currency. US and European corporations do not have the equivalent need to sell Yen proceeds from the current account (i.e. trade account and proceeds from overseas investments). Instead, the solutions to weaken the Yen were periodically sought in the capital account. Although Mr “Yen” Sakakibara’s efforts to weaken the currency were first spurned by Larry Summers, Japan’s ultra-low interest rates offered the global markets a cheap way to finance investments elsewhere. These carry trades were there to stay until all hell broke loose in 2008. But as 2009 showed us, the low US Libor reduced the attractiveness of the Yen as a funding currency. At the same time, the demographically challenged Japanese corporations have now moved to build and control vast swathes of Chinese industrial capacity, thus reducing the dependence on the weak Yen. All this will limit Japanese appetite for gold, even if the current rebound in industrial production does not immediately warrant a durable escape from deflation.

Deflation happens when saved money is not (productively) invested. Low interest rates in a weak economy, lack of credit growth, excess corporate savings, overcapacity – all these themes echo from Marunouchi to Wall Street. Yet, it is impossible to gauge whether the usually optimistic American extroverts will ever consider the pre-2007 house prices “wrong”. In the meantime, what matters more is the relative performance of the currencies. The currencies benefiting from risk aversion (the Yen, the Swissie) and from Asian growth engine (again the Yen, the Taiwanese dollar, the Won, the Aussie) are not friends of local gold investors, especially in a deflationary setting. On the other hand, the US dollar and the Euro are structurally weak, even though the dollar’s vast fixed income market will periodically make it the destination of risk-fleeing capital. European and American investors have thus little choice but continue to add to their gold holdings to offset the competitive erosion of their currencies’ value. For as long as the continued pressure on the labor markets does not derail the global trade, this recurrent weakness of Euro and Dollar should help counter the deflationary pressure.

Finally, it is worth remembering that investment in economically inert gold is, ceteris paribus, deflationary. Luckily, with barely $350bn of equity gold available worldwide and about a $1 trillion in private vaults, the global deflationary risk of flight into gold is a doomsday scenario better shelved with the Mayan calendars.

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   Posted by: Mr. Gold    in Uncategorized

If you trade copper, aluminum or tin, or Australian iron ore equities, then every muttering of a Chinese official may make or break your day. You follow religiously the spread between Shanghai and LME prices and plough through the construction numbers in Anhui. But now the country that gave us a suite of graceful oxymorons – from “agrarian communism” to capitalism without capital markets – is encroaching on the sanity of gold investors as well.

How should it be otherwise? When you already own eight apartments in Wenzhou, three ambitious mistresses and a gleaming black Buick with a chauffeur, what else is there to impress your peers than a solid gold toilet, in the aptly gaudy style known from Hong Kong exhibits or the recent Shanghai Expo. For the rest of us math majors, the equation goes: “more solid gold toilets – better for the gold market”. Then multiply it by 1.3bn and you attain nirvana.

The attractiveness of gold toilets has as much to do with the delicate tastes of the ‘xinfu’ (nouveaux riches), as it has with the paucity of gold investment products in China. Not surprisingly, this week’s announcement about the widening of gold trading in China has created quite a stir, helping gold test the elusive $1200/oz level again.

China’s reform of the internal gold market has been painstakingly slow. Although the government monopoly was broken in 2001 and Shanghai Gold Exchange opened a year later, for the first four years SGE served exclusively the jewelry market. Only in 2006 were individual investors put on a “trial method” to trade 100kg bars. It took two more years for CSRC to treat favorably the application to open up the futures market. Nearly 7m gold futures were traded on Shanghai Gold Exchange in 2009. This has been a helpful development for Chinese gold producers, who are not allowed to export gold mined in China. Yet some of the gold mined in China finds its way through bank swaps into Hong Kong market. The announced launch of Hong Kong Mercantile Exchange and its gold futures contract represents a (healthy) competitive threat to SGE. SGE could counter this partly by allowing in foreign participants on the exchange, but any such allusions are, for the time being, a matter of bureaucrats’ “opinion”, not policy.

Meanwhile, in the absence of ETF products, most individuals on the mainland rely on popular coins (golden pandas and Olympic coins) and bars. In fact, China is now the world’s fourth largest market in terms of coin and bar hoarding.

The PBOC’s announcement called for better financing services to facilitate Chinese banks’ hedging overseas. It is impossible to divorce such statements from the problem of the closed China’s capital account and the tortoise-like internationalization of the renminbi. PBOC faces an unsolvable dilemma. Further boost to renminbi’s global role would mean progressive loss of control over its value. On the other hand, readiness for such a move would require a comprehensive plan over how to grow the economy of a post-mercantilist China. There does not seem to be such a plan at the moment. As a result, only 1% of China’s international trade is settled in renminbi and only 4 (four !) renminbi bonds have been issued by non-residents. Open cross-border trading of gold is as distant a future for Chinese investors as is renminbi’s full convertibility.

For all this skepticism, the decision to modernize China’s gold investment market should be applauded. Investment demand represents 18% of overall gold offtake in China and the potential for growth remains significant. Neighboring countries such as Korea and Taiwan have a per capita consumption nearly four times the Chinese level. This contrast is comparable to the overall differences in terms of GDP per capita. Should China continue to grow faster than the rest of East Asia, its gold demand will grow accordingly.

But even if ETFs and other investment products outweigh the importance of golden toilets, China will, in foreseeable future, remain predominantly a gold jewelry market. Whereas the global jewelry consumption now accounts for roughly half of the total demand, Chinese appetite for jewelry ensures that as much as 78% of all gold sold appears in ornamental form.

This brings us back to one of the key considerations of a self-respecting gold investor. China’s jewelry market exhibits a strong seasonality of its own, with most purchases made in September, November and January. In the near term, the recognition of the impact of these flows holds much more importance than any exegesis of PBOC’s mutterings.

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