Gold Surges on Market Uncertainty, Gold Miners Benefit

Investors are monitoring the fast approaching debt ceiling limit on federal spending. The U.S government could reach its debt limit by mid-October. The U.S Federal Reserve expects to reduce its monthly bond-buying program, but the risk of the U.S defaulting on its debt raises doubts of tapering. Gold prices have ballooned as investors placed funds into safe haven assets to protect their investments from market uncertainty. Investors may consider investing in undervalued gold mining producers as the gold market recovers.

Debt ceiling concerns
The U.S Treasury Department said it would reach its $16.7 trillion debt limit by mid-October. U.S Treasury Secretary Jacob Lew advised Capitol Hill to raise the borrowing limit before the possibility of default. If Congress does not raise the debt ceiling, investors would "become unwilling to loan the United States money, the United States could face an immediate cash shortfall," Lew said in a letter to House Speaker John Boehner. "Indeed, such a scenario could undermine financial markets and result in significant disruptions to our economy."

The Obama administration expects the U.S to have about $50 billion in cash on hand by mid-October with no capability of borrowing more funds. The administration told Congress it would not negotiate on raising the debt ceiling, while Congress demands spending cuts before it agrees to raise the $16.7 trillion limit. Internal political tension between Democrats and Republicans could trigger a sell-off in equities. This is not the first time the debt ceiling debate set off uncertainty in the financial markets.

In April 2011, former Treasury Secretary Timothy Geithner warned that the U.S would hit its debt limit by May 16, 2011. Congress agreed to raise the debt ceiling in early August 2011. Although Congress addressed the issue, Standard & Poor's downgraded the country's AAA credit rating for the first time. This event disrupted global markets. The U.S dollar faced currency debasement, the S&P 500 plummeted, and gold futures and gold-backed ETFs reached new highs for the year. If Congress fails to raise the federal debt ceiling this time around, market reactions could reflect results from two years ago, where investors pulled away from equities and jumped into physical and paper gold.

Source: CNNMoney -- The red box depicts the markets reaction to the U.S debt limit debate from May to August 2011. The dark blue line represents SPDR Gold Shares. The yellow line represents the S&P 500.

The Fed's tough decision
The U.S central bank looks to reduce its monthly purchases of $85 billion in Treasuries and mortgage-backed securities. The market believes the Fed could start tapering following the Federal Open Market Committee (FOMC) meeting this month. The Fed's decision to taper its bond buying is dependent on the growth of the U.S economy and labor market. The country's GDP growth rose to 2.5% in the second quarter, beating estimates of 1.7% growth, but conflicts in the Middle East and debates over the debt limit could lag growth in the coming months. Hedge funds and speculative investors have reacted cautiously, transferring their funds from equity markets into safe haven assets such as gold futures and gold-backed ETFs to hedge against uncertainty.

SPDR Gold Shares (NYSEMKT: GLD  ) , the world's largest gold-backed ETF, allows investors to leap into the gold market without the vagaries of the gold futures market. The ETF has seen $1.9 billion in outflows so far in the third quarter. This compares to outflows of $11.5 billion in the second quarter ended June 30, according to data compiled by IndexUniverse. The Feds decision on tapering could determine whether the outflows from gold-backed ETFs will continue or reverse.

Source: IndexUniverse--

If the Fed decides to initiate tapering the stimulus program after the FOMC meeting, physical gold and paper gold prices may fade in the short-term as the U.S dollar and investor confidence in the U.S economy strengthens. If the Fed decides not to start tapering this month, I believe gold prices could rally to $1,500 as soon as October. Higher gold prices would help gold miners recover margins lost from this year's gold slump. Now, gold miners present investors an opportunity to generate alpha from mining stocks that currently trade below their book value such as Yamana Gold (NYSE: AUY  ) and Kinross Gold (NYSE: KGC  ) .

Two gold miners to benefit from a gold rally
Yamana Gold has focused on cost containment programs this year to slash costs of operations to bolster free cash flow and margins per gold ounce. Yamana managed to save $115 million from its aggressive cost-cutting initiatives started in April. All-in sustaining costs (AISC) for the second quarter came in at $950/oz, down from $1,014/oz six months ago. The company expects higher production levels and lower AISC in the second half of 2013 that will reflect the new cost structure.

For the next six months, Yamana will have three new working mines — Ernesto/Pau-a-Pique, C1 and Pilar — which look to further boost production levels. Yamana expects gold production levels to grow 30% more than six months ago and 13% more than a year earlier. Lower costs and higher production levels will strengthen cash flows and margins for the company amid a higher gold price environment. 

Kinross Gold also has searched for solutions to curb rising operating costs to protect profits and cash flows if gold prices drop once again. Kinross reported a $2.48 billion writedown in its second quarter results because of lagging gold prices. This represents its third impairment charge in a year and half. Kinross's impairment charges now total $8 billion. 

Management reduced the company's annual capital expenditures forecast to $1.45 billion from $1.6 billion, saving $180 million from its cost restructuring initiatives. Cancellation of its upcoming semi-annual dividend payment to its shareholders will save $182 million per year. Kinross expects to produce gold at an AISC of $1,000 to $1,200/oz this year. 

Both companies recognize that cutting budgets and conserving cash will add strength to their liquidity. As mentioned in an earlier article, gold miners have been conservative with deploying their cash into new projects. Miners have avoided taking on the risk of investing in projects that may not yield sufficient cash flows or profits at current gold prices. Balance sheets have improved from preserving cash, better positioning gold miners when they seek to expand their operations in a richer gold environment.

Bottom Line
U.S policy makers have tough decisions to make that could potentially shape the global markets for the next few years. Congress's failure to raise the debt limit in a timely manner could dampen investor confidence and trigger a sell-off in equity assets. The debt ceiling debate has markets questioning if the Fed will decide to taper its monetary policy. If the Fed announces the delay of tapering at the FOMC meeting, hedge funds and speculative investors would yield profits from their safe haven assets such as gold futures and gold-backed ETFs. Gold miners Yamana and Kinross present equity investors long-term value in the event gold prices surge.

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