Sprott Asset Management USA, Inc. 2017 Outlook

Strategy Report

During 2016, gold markets shook off three consecutive years of price weakness. Spot gold posted an 8.56%

annual increase, rising from $1,061.42 to $1,152.27. Gold equities were among the best performing global

assets, with the Sprott Gold Miners ETF (SGDM) rising 48.15% and the Sprott Junior Gold Miners ETF (SGDJ)

surging 64.99%. By way of context, the S&P 500 Index posted 2016 total return of 11.95%, with roughly 40%

of the gain occurring in the seven weeks following the U.S. presidential election. Despite strong relative

performance during 2016, various gold sentiment measures registered year-end readings among the lowest in

three decades. In mid-December, the Bernstein Daily Sentiment Index actually tolled its lowest 21-day moving

average for bullish gold sentiment since inception of the index in 1987.

What accounts for the dispersion between gold’s 2016 market-leading performance and year-end bearish

sentiment? As is frequently the case in the gold sector, short-term sentiment is generally more reflective of

recent price action than underlying fundamentals. After consolidating sharp first-half gains during the third

quarter (in constructive sideways fashion), gold and gold equities suffered meaningful corrections in Q4. We

attribute gold’s fourth quarter weakness to a combination of three factors, each of which we view as temporary.

First, the Fed’s second rate hike in the current tightening “cycle” has unleashed a new round of forecasts for

multiple rate increases in each of the next several years. Of course, this will be the eighth straight year of

consensus confidence in Fed tightening, a record so far unblemished by success. Second, the Trump victory has

unleashed powerful expression of latent longing for normalcy in business and economic conditions. While we

are sympathetic to the frustrations of consumers and business leaders from the distortions of eight years of QE

and ZIRP, we suspect recent sentiment highs will soon be tested by harsh realities of excessive debt levels and

legacy malinvestment. And third, gold’s inability to sustain sharp first-half gains has reignited debate as to

whether 2016 strength was merely a bear-market rally. In our view, fourth quarter weakness amounted to fairly

textbook retesting of gold’s January 2016 breakout from a three-year downtrend.

If our analysis is correct, the investment opportunities afforded by gold’s fourth quarter correction are

compelling, and, in our view, likely to prove short-lived. We recognize that bullion’s inherent volatility makes

an investment in gold notoriously difficult to “time.” When gold is appreciating rapidly, it is natural for

investors to feel an entry point may have been missed. Conversely, because gold corrections can be sharp and

swift, investors can find buying dips a bit daunting. Finally, during occasional instances when gold trades flat

for an extended period, investment urgency can be lost. In our experience, the most logical juncture for a

significant commitment to gold is immediately following a bull-market correction. As long as underlying

fundamentals remain intact, such corrections can help harness gold’s volatility within favorable risk/reward

parameters, especially over the short run.

At Sprott, we do not view ourselves as gold bugs. To us, a gold bug is a congenital pessimist who sees risk

behind every corner and who has become closed-minded to the possibility that good things can occur in the

world, even in uncertain times. We recognize that gold’s relative investment merits can shift over time. Still,

we believe strongly that careful and honest appraisal of economic, financial and monetary variables can identify

certain periods during which gold serves an invaluable role as portfolio-diversifying asset. In this report, we

hope to establish beyond reasonable doubt that the current investment landscape is among the most supportive

of the gold investment thesis we have ever witnessed. We have organized our report in three sections. In the

first two sections, we present brief reviews of our investment case for gold and 2016 developments in gold

markets (frequent readers may skip). In the body of our report, we present our outlook for gold’s prospects in

2017 and beyond.

Gold Investment Thesis

In our fifteen years following gold markets, we have learned gold is an asset without peer in terms of the sheer

number of investment cues governing its day-to-day trading. Some perceive gold as an inflation hedge, others

as a deflation hedge. Many view gold as the ultimate “risk off” asset, and just as many view gold as a suitable

“risk on” trade. During times of financial-market stress, some view gold as an appropriate resting place for

accumulated wealth, but others still favor the U.S. dollar’s safe-harbor profile (which can pressure gold prices

through the dollar’s traditionally inverse relationship).

We find it puzzling that, in an environment of compressed returns in traditional asset classes, institutional

investors continue to eschew gold’s market-leading returns. As shown in Figure 1, below, gold has generated

annual returns, denominated in the world’s prominent fiat currencies, which are more consistently positive than

any major global asset of which we are aware. After twelve consecutive years of advance and a 515.38% gain

through 2012, gold corrected 36.65% through 2015. Gold appears to have resumed its upward bias during 2016,

rising 29.59% to an intraday high of $1,375.45 on 7/6/16, before closing the year with an 8.56% gain. Gold’s

compound annual return during the past 16 years now stands at 9.44%, roughly 75% higher than the 5.37%

compounded total-return of the S&P 500 Index. There have been decades such as the 1980’s and 1990’s during

which relevant market fundamentals did not logically support a portfolio allocation to gold. And then there have

been periods such as the past 16 years during which gold has provided unparalleled protection of portfolio

purchasing power parity.

Figure 1: Annual Performance of Spot Gold in Nine Global Currencies (2001-2016) [Bloomberg]

Since 2000, gold has logged strong positive performance in individual years marked by a wide array of financial

market conditions. Along the way, every popular variable to which some portion of consensus attributes strong

gold correlation has oscillated repeatedly, yet gold has advanced in the vast majority of years. We believe

gold’s dogged performance belies an investment theme more overarching in scope than kneejerk motivations

commonly attributed to gold investors in the financial press. Our unifying theme for gold’s advance since 2000

rests on our perceptions of an ongoing migration, at the margin, of a modest portion of accumulated global

wealth from traditional asset classes to a resting place safely outside the vagaries of an increasingly stretched

financial system. In most years since 2000, capital migration from the financial asset pile (roughly $290 trillion

today) to the available gold stock (roughly $2.5 trillion) may have averaged, say, one-tenth-of-one-percent. In

years such as 2007 and 2010, the rate of capital migration may have accelerated somewhat, and in years such as

2013 and 2015, the rate of migration may have reversed in favor of financial assets.

Year US Dollar Euro Yuan Rupee Yen Pound CAD AUD CHF Average

2001 2.46% 8.13% 2.45% 5.90% 17.62% 5.25% 8.65% 11.80% 5.32% 7.51%

2002 24.78% 5.76% 24.78% 24.08% 12.64% 12.67% 23.48% 13.85% 3.87% 16.21%

2003 19.37% -0.21% 19.36% 13.52% 8.04% 7.80% -1.81% -11.22% 7.32% 6.91%

2004 5.54% -2.19% 5.54% 0.54% 0.66% -1.76% -2.19% 1.40% -3.10% 0.49%

2005 17.92% 35.09% 14.98% 22.23% 35.70% 31.44% 14.06% 25.84% 35.97% 25.91%

2006 23.16% 10.51% 19.11% 21.00% 24.32% 8.17% 23.46% 14.61% 14.24% 17.62%

2007 30.98% 18.46% 22.46% 16.64% 22.96% 29.28% 11.40% 17.77% 21.96% 21.32%

2008 5.78% 10.55% -1.07% 30.62% -14.10% 43.89% 29.91% 31.59% -4.90% 14.70%

2009 24.37% 21.09% 24.40% 18.88% 27.38% 12.25% 7.90% -2.39% 20.40% 17.14%

2010 29.52% 38.88% 25.02% 24.45% 12.75% 34.15% 21.95% 13.66% 16.91% 24.14%

2011 10.06% 13.51% 5.22% 30.74% 4.35% 10.65% 12.53% 9.81% 10.63% 11.94%

2012 7.14% 5.22% 6.04% 10.54% 20.84% 2.31% 4.86% 5.82% 4.39% 7.46%

2013 -28.04% -31.13% -30.15% -18.76% -12.42% -29.45% -23.13% -16.30% -30.09% -24.39%

2014 -1.72% 11.99% 0.79% 0.45% 11.81% 4.48% 7.40% 7.44% 9.92% 5.84%

2015 -10.42% -0.25% -6.38% -6.16% -10.15% -5.27% 6.65% 0.33% -9.90% -4.62%

2016 8.56% 11.85% 16.13% 11.42% 5.35% 29.57% 5.60% 9.66% 10.46% 12.07%

2

Our investment thesis for gold does not involve financial Armageddon, Weimar Republic inflation or a collapse

of the U.S. dollar. Our thesis is that inevitable resolution of epic monetary and financial imbalances will

accelerate the rate of capital migration from global financial assets towards gold and other precious assets in

precipitous fashion. Given the comparatively tiny stock of investable gold, we expect gold’s price to stabilize at

significantly higher prices.

The motivating fundamental which powers our gold investment thesis is the decoupling of financial assets

(claims on future output) from underlying output itself (GDP). In essence, the United States economy suffers a

debilitating structural debt problem. We present in Figure 2, below, the single most representative chart in

understanding rationale for a portfolio allocation to gold: the ratio of total U.S. credit market debt (Fed’s Z.1

Report) to GDP. Despite popular perceptions of deleveraging in recent years, the ratio today rests at what we

regard as an absurd level of 352%, roughly double the high-end of historical experience outside the Great

Depression and the Greenspan/Bernanke/Yellen era. In our view, to balance the U.S. financial system and

return to healthy economic growth, some $20 trillion of outstanding U.S. credit will need to be rationalized

through default or debasement. We believe economic events of the past fifteen years strongly support our

contention that an $18.7 trillion dollar economy cannot support total outstanding credit of $65.7 trillion without

annual nonfinancial credit growth on the order of $2-$3 trillion. At least since 2009, whenever the U.S.

economy has been unable to generate nonfinancial credit growth on this order of magnitude, the Fed has felt

compelled to “bridge the gap” with equivalent rates of liquidity-creation through the auspices of QE asset

purchases.

Figure 2: Total U.S. Credit Market Debt as % of GDP (1916-Q3 2016) [Fed Z.1 Report BEA]

To us, variables such as individual U.S. economic statistics no longer hold much relevance to the gold

investment thesis. By way of illustration, with $65.7 trillion in outstanding U.S. credit atop U.S. GDP of

$18.7 trillion, no rate of GDP growth can possibly rebalance the U.S. economy in organic fashion. Even eight

straight quarters of 10% GDP growth would increase GDP only to $22.6 trillion, an amount of output no more

capable of supporting $65.7 trillion in debt than GDP of $18.7 trillion. And, of course, if ratios of the past 15

years were to hold form, such GDP growth would require creation of at least $15 trillion in additional credit. In

an economy this out of balance, is there really much importance to parsing the difference between 2.5% and

3.5% GDP growth-rates? Because the ratios of debt (and equity) claims on U.S. GDP only continue to

deteriorate, the rationale for gold ownership only continues to strengthen.

3

2016 In Review

With respect to gold markets, 2016 was clearly a year of two halves. Through the summer months, the gold

complex achieved scorching returns. During Q1, spot gold logged its strongest quarterly advance in 30 years,

climbing 16.13%. After consolidating these gains through May, bullion then carved out another five-week rally

to its 7/6/16 intra-day high of $1,375.45, up 29.59% year-to-date. Gold equites responded to bullion strength

with trademark verve, posting through mid-August by far the strongest year-to-date performance of any global

asset. Through 8/11/16, the Sprott Gold Miners ETF (SGDM) had erupted to a 128.52% gain, and the Sprott

Junior Gold Miners ETF (SGDJ) had advanced 148.83%. By way of context, through 8/11/16, the S&P 500

Index had achieved a total return of 8.40%, and the DXY Dollar Index had declined only 2.81% (from 98.631 to

95.857). Perhaps the investment variable most telling about gold’s first-half gains were 10-year Treasury yields,

which collapsed 31.29% year-to-date through 8/11/16 (from 2.2694% to 1.5593%).

Gold’s first half strength was primarily driven by downward recalibration in investor expectations for global rate

structures. We have long maintained that global central banks will remain powerless to raise short rates until

such time as elevated global debt levels are permitted to rationalize (default). The Fed’s early 2016 performance

lent credence to our views. After hiking rates in December 2015 and telegraphing four additional hikes during

2016, Fed stewards were forced to backtrack within weeks. The flare-up in financial-stress measures during

January, coupled with the surprise adoption of negative deposit rates by the BOJ on 1/29/16, forced Fed vice-

Chairmen Dudley and Fischer to public pronouncements in early February that global conditions might not be

supportive of further tightening. The 2016 poster boy for fickle Fed forecasts was St. Louis Fed President James

Bullard, who as late as 3/24/16 was still proclaiming, “You could probably make a case for moving in April

[2016],” but by 6/17/16 had become so chagrined with deteriorating economic visibility that he felt one

additional rate hike might suffice through December 2017.

A central macroeconomic theme of first-half 2016 was the methodical march of global sovereign yields into

negative territory. With the Fed’s 2016 QE activities limited to maintaining its balance sheet at $4.5 trillion

(requiring monthly purchases of $48 billion worth of MBS and Treasuries), the stimulus baton had been passed

largely to the BOE, BOJ and ECB (purchasing $185 billion worth of securities each month during 2016). The

Fed’s overseas counterparts added a new element to the monetary concoction known as policy: negative deposit

rates at the central bank for financial institutions (BOJ -0.1%, SNB -0.75% and ECB ultimately -0.4%). Given

the relatively limited supply of eligible bonds available for purchase by these CB’s, global sovereign yields

began an inexorable downward migration, reaching spasmodic climax following the 6/23/16 Brexit vote. By

mid-July, even mainstream media seemed troubled that the universe of negative-yielding sovereign bonds

exceeded $13 trillion. By this point, the sovereign curve of France was negative out nine years, of Germany and

Japan out 15 years, and of Switzerland out 30 years. Even Fed Chairman Janet Yellen was discussing the

legality of negative fed-funds rates in Humphrey Hawkins testimony!

However, a new development appeared on the global financial stage during 2016. Investors took pause with the

negative rate argument, and central bankers seemed to lose their uncanny ability to channel the inflation they

conjured directly into financial assets. After a one-day weakening, the yen strengthened 15% versus the U.S.

dollar in the five months following the adoption of negative rates by the BOJ. Similarly, the ECB’s bag of

stimulus tricks, unveiled on 3/10/16 (more negative ECB deposit rates and expanded monthly QE), weakened

the euro for only a matter of hours before it spurted to a 7.5% gain versus the U.S. dollar in a two-month span.

By the Fall, recovering financial markets indicated Brexit fears had been a bit trumped-up. The Fed began its

annual telegraphing of a December rate hike and sovereign rate structures appeared to be in the process of

carving out lows. Upticks in global PMI’s, combined with first returns for U.S. Q3 GDP in the 3% range,

rekindled congenital optimism in equity markets. And then came Trump! Between election night and year-end,

broad equity indices roughly doubled their year-to-date gains. The DXY Dollar Index rallied 8.1% from its

election night low (95.885) to a 12/20/16 high of 103.65. Bond vigilantes became so enamored with prospects

for growth and inflation, 10-year Treasury yields exploded 53.9% from an election night low of 1.7145% to a

12/15 high of 2.6394%. Not surprisingly, gold markets were jolted by such spontaneous ebullience for global

growth. From an election night high of $1,337.51, spot gold retreated 13.84% to a year-end close of $1,152.27.

The question at hand is whether gold’s Q4 correction was the end of a strong 2016 run, or a healthy retest of

early-2016 breakouts which will empower gold to new highs in 2017.

4

Gold’s Prospects in 2017 and Beyond

Trumponomics

Over the long run, we believe the gold investment thesis rests squarely on monetary, economic and financial

imbalances which continue to be resolved to the measurable benefit of investors choosing to denominate a

portion of their wealth in assets which can neither default nor be debased. Over the short run (one-to-two

years), gold’s performance can be impacted by consensus views on a wide array of market variables. We would

highlight five such variables as motivating the lion’s share of trading patterns in gold markets: Fed policy, the

U.S. dollar, 10-year Treasury yields, U.S. economic performance and U.S. equity risk premiums.

It is unusual for any single event to impart significant impact on all five of these variables simultaneously. The

Trump election has certainly proven to be such an event! Trump’s victory has unleashed one of the strongest

expressions of business and financial optimism in history, starkly affecting variables central to gold’s short-term

trading patterns. While optimism is never a bad thing, we suspect financial markets are reflecting classic

emotional blow-off. Investors, admittedly parched for a more normalized economic world unfettered by QE and

ZIRP, have, in our view, temporarily lost sight of immutable realities such as debt, valuation, debasement and

mathematics. Should our suspicions bear out that reigning euphoria proves short-lived, recent market

dislocations will provide excellent entry points for a wide array of investment assets. Given our confidence in

underlying fundamentals relevant to precious-metals, we view the Q4 back-up in gold markets as a rare

opportunity to achieve a significantly discounted entry point in gold’s unfolding advance.

Figure 3: NFIB Small Business Optimism Index (1975-2016) [NFIB, Zero Hedge]

While Trump’s ascendency has invigorated most sentiment-measures related to investment markets, no measure

has experienced such historic levitation as the NFIB Small Business Optimism Index. As shown in Figure 3,

above, this NFIB measure has posted a two-month surge exceeding any period since the election of President

Reagan. Indeed, Reagan comparisons are all the rage on Wall Street these days. The problem with these

comparisons, however, is that the current investment landscape bears little resemblance to conditions in place

when Reagan took office. In the Reagan experience, interest rates (20%) and inflation (13%) were sky-high and

had scope to fall; the U.S. economy had been in deep recession and had scope for cyclical recovery; the ratio

of federal-debt-to-GDP was 35% and had scope to expand; and savings rates were high, providing the seed-corn

for future capital formation. President-elect Trump, on the other hand, is inheriting eight years of ZIRP and

deflation-minded CB asset-purchases; below-trend inflation; a U.S. economic expansion already in its seventh

year; a federal-debt-to-GDP ratio of 100%; and a net national savings rate near zero for over a decade. No

matter what mix of growth initiatives Trump finally chooses to pursue, the resources and flexibility at his

disposal are vastly more constricted than those available to President Reagan.

5

Our friends at Cornerstone Macro have conducted exhaustive research on presidential cycles since 1980, and

their conclusions are decidedly pessimistic for President-elect Trump’s first year in office. Their work

demonstrates that, without exception, U.S. economic performance during the first year of any Presidency has far

more to do with economic cycles already in place than with policy initiative undertaken by the incoming

administration. By far, the single most telling variable is whether financial conditions are tightening or easing

when the new President takes office. The administrations of Presidents Obama, Bush Jr., and Clinton enjoyed

smooth sailing during the first years of their terms because financial easing was already “in the pipeline” when

they were elected. In contrast, because financial tightening was already in the pipeline when Presidents Bush Sr.

and Reagan took office, the first two years of those presidencies were marked by poor economic performance

and declining stock markets. In the Reagan experience especially, people seem to forget that the S&P 500 Index

traced out a 23.94% decline from inauguration day (1/20/81) through its 8/9/82 low.

As Trump takes office, financial conditions are clearly tightening. The Fed has just hiked the fed funds rate for

the second time, 10-year Treasury yields are at two-year highs, mortgage rates have exploded 75 basis points in

three months, oil has just doubled from February 2016 lows, the U.S. dollar is trading at the highest level in over

13 years, dollar funding costs are soaring (cross currency basis swaps) and bank lending standards are

tightening. At the risk of appearing downbeat, we would suggest that no collection of pro-growth policies, from

any incoming administration, would be able to power through such a phalanx of tightening financial conditions.

Figure 4: 5-Year Annualized Forward-Looking GDP Growth (1985-2006) [Cornerstone Macro]

Having studied the campaign of President-elect Trump, we have been intrigued by the prospect for true change

in U.S. business conditions with respect to regulation, taxation and governmental accountability. However, the

fact remains that President-elect Trump’s two most central campaign platforms, tax cuts and fiscal spending,

have achieved checkered performance histories in altering established economic cycles. As shown in Figure 4,

above, neither tax increases of Presidents Bush Sr. and Clinton, nor tax cuts of President Bush Jr., redirected

prevalent business-cycle trends for several years. Further, the Trump camp’s tax-cut paradigm does not include

short-term growth boosters such as stimulus checks to individuals or retroactive enactment.

6

On the corporate side of the ledger, history also demonstrates that tax cuts rarely outweigh the more relevant

variable of capacity utilization in influencing corporate behavior. As shown in Figure 5, below, the recently

reaccelerating decline in U.S. capacity-utilization rates (byproduct of legacy malinvestment and ZIRP-nurtured

zombie credit) suggests any excess corporate cash flows generated by tax cuts and foreign cash repatriation are

more likely to be directed towards stock repurchase and dividends than to growth-supportive capex.

Figure 5: NFIB Capex Plans (3-mos.mov.avg.) Versus U.S. Capacity Utilization (advanced 2-years)

(1976-Present) [NFIB, Federal Reserve, Cornerstone Macro]

Our conclusion about the Trump phenomenon is that investor sentiment and expectations may be peaking just as

growth encounters significant headwinds of tightening financial conditions. This dichotomy foreshadows

prospects for significant investor disappointment in the weeks and months ahead. Nowhere is this volatile set-

up more evident than in U.S. equity markets. Despite high historical readings versus long established valuation

methodologies, it has been a fool’s errand to handicap where, when or why the current run in the S&P 500 Index

may finally peak. Along the way, the one variable which has been missing from a traditional market-top

scenario has been excessively bullish sentiment. Since 2009 lows, the market has truly climbed a continuous

wall of worry. The Trump bump, however, has vaulted sentiment of equity-market participants to an altitude

generally indicative of an important market top. To site but one example, the Investors Intelligence poll

registered 60.2% bullish during the week of January 2, its sixth consecutive week above the traditional danger

zone of 55%.

Populism

No discussion of the Trump phenomenon would be complete without addressing the ascension of populist

political movements. While populist leaders such as Greece’s Alexis Tsipras (Syriza) and France’s Marine Le

Pen (National Front) have garnered attention in recent years, the subtle implication in western media has been

that European populists are like spoiled teenagers who don’t really understand how the world works—they are

to be tolerated but not taken that seriously. Then, in the space of just five months, the United Kingdom and

the United States were rattled to their respective cores by completely unforeseen national populist victories.

7

Figure 6: Time Magazine Covers (8/22/16; 10/24/16 & 12/7/16) [Time Inc.]

We believe investors should be circumspect about post-Brexit and post-Trump investment analysis emanating

from institutions completely blindsided by both developments. Populism is all about rejection of status quo.

Wall Street investment banks and mainstream media are at the epicenter of status quo, and they will never

foreshadow change which dilutes their sphere of influence. We find the three Time magazine covers pictured in

Figure 6, above, to be poignant metaphor for how out of touch U.S. mainstream media has become. Further, we

find the ease with which Wall Street has flip-flopped on the implications of a Trump Presidency to be highly

self-impeaching. Our concern is that in the rush to extrapolate positive investment implications from an

administration only recently perceived as anathema, Wall Street solons are glossing over the inconvenient truths

powering the Trump movement. Trump is President-elect because of chronic structural unemployment,

debilitating economic bifurcation and stagnant real incomes in the United States. Yet, the entire investment

world is consumed with handicapping what will be Trump’s first tax-cut, executive order or fiscal stimulus

project. Is that really what is important for investors to consider? Perhaps investors focused on recalibration of

Fed policy in response to potential Trump stimulus should be more concerned with whether Fed elitism enabled

the Trump Presidency in the first place. Perhaps capricious decisions on the price of money, which enrich

bankers and penalize savers are finally being rejected by the U.S. collective. We are not suggesting Steve

Mnuchin is about to abolish the Fed. What we are lampooning is the consensus conclusion that U.S. rates

should rise because the animal spirits of a completely disenfranchised U.S. electorate are about to power heady

GDP increases in an economy which has morphed to 70% consumption.

In our view, Trump is far less relevant as political figure than as symptom of deep-seeded economic and social

problems in the United States. We believe it a grave mistake to assume Trump’s ascendency will serve as

magical palliative to the simmering malcontent powering his election. The bottom line is that contrary to

prevalent headlines, the U.S. economy has been mired in a deep funk for over a decade. The last year in which

the U.S. achieved real GDP growth of 3% was 2005. Government statistics do not accurately reflect the

declining standard of living experienced by most Americans. While President Obama pats himself on the back

for creating 14 million jobs during his Presidency, the BLS reports that “persons not in the labor force” rose to

95.1 million Americans in December, a new all-time high. Professors Lawrence Katz (Harvard) and Alan

Krueger (Princeton) estimate in their 9/13/16 treatise, “The Rise and Nature of Alternative Work Arrangements

in the United States 1995-2015” (NBER https://krueger.princeton.edu/sites/default/files/akrueger/files/katz_krueger_cws_-

_march_29_20165.pdf), that fully 94% of net job growth in the United States between 2005 and 2015 accrued from

“alternative work arrangements—defined as temporary-help agency workers, on-call workers, contract workers,

and independent contractors and freelancers.” Trulia estimates that 40% of Americans aged between 18 and 24

live with their parents, the highest percentage since 1940. The BLS reports that the number of Americans

reporting two jobs hit an all-time high in November 2016 (8,107,000).

8

Figure 7: Trailing 10-Yr. Percentage Change in Real U.S. GDP Per-Capita (1957-2015) [BEA, Bloomberg]

Narayana Kocherlakota, ex-President of the Minneapolis Fed, summed things perfectly in a 10/04/16

Bloomberg editorial entitled, “Why Americans Feel Poor, in One Chart.” The article’s featured graphic,

reprinted as Figure 7, above, portrays 10-year trailing change in U.S. GDP per-capita. President Kocherlakota

interprets the importance of the graph in his own words:

In every year between 1966 and 1973, per-capita income was up between 30% and 40% from a decade earlier…In

every year from 1984 to 2007…per-person income was up between 20% and 30% from a decade earlier…

Cumulative per-person growth from 2005 to 2015 was lower than in any prior decade in the sample. That certainly

helps explain why many Americans are unhappy with the nation’s recent economic performance.

We are optimistic that the U.S. economy’s inherent vibrancy is capable of achieving future heights. Our

sincere hope is that a Trump administration will help reestablish conditions conducive to trademark

American entrepreneurship and opportunities for true capital formation. Given existing structural

imbalances, however, we expect this process will be painstaking and marked by significant setbacks. In

our view, any reorganization to productive economic conditions will involve a great deal of painful

revaluation in many financial-asset classes. Along the way, during this rationalization of financial-asset

valuations, gold will play an invaluable role as portfolio-diversifying asset.

Can Long-Rates Rise?

We believe the greatest miscalculation in contemporary financial markets is the consensus view that interest

rates can rise and the U.S. dollar can strengthen without causing serious damage to the global financial system.

We would argue that reigning global debt levels now preclude even moderate rate increases without catalyzing

immediate upticks in relevant measures of financial stress. With total U.S. non-financial credit now standing at

$47 trillion, every 1% increase in market rates causes total interest charges in the U.S. to soar $470 billion, or

over 2.5% of GDP. Further, eight years of ZIRP have fostered duration dynamics in institutional bond

portfolios which leave them especially vulnerable to even modest upticks in rate structures. Goldman Sachs

(Charles Himmelberg) suggests each 100-basis-point interest-rate increase will translate roughly to a

$1 trillion principal loss to the Barclay’s U.S. Aggregate Bond Index ($19.1 trillion market cap). These

potential losses highlight the tightrope now facing corporate and government pensions grappling with trillions-

of-dollars-worth of funding shortfalls—while an increase in interest rates would help sponsors meet elevated

return assumptions, it would also decimate the value of existing fixed-income portfolio assets.

9

As shown in Figure 8, below, 10-year Treasury yields have marked ever-lower cyclical highs for the past 35

years. There is certainly more than one way to interpret cause and correlation between the declining rate peaks

in this graph and the ten highlighted crises coincident with these peaks. Our synopsis would be that aggregate

debt levels have become so burdensome that even modest rate-upticks catalyze default episodes, in one

economic sector or another, which in turn require even lower rates to ameliorate. Importantly, each outbreak of

credit stress exposes prior malinvestment. In our view, the financial system has hit the point at which interest

rates simply cannot rise until nonproductive debt is cleansed from the financial system.

Figure 8: U.S. 10-Year Treasury Yields (1971-Present) [MacroMavens]

A significant distinction between our views and consensus is the considerable skepticism with which we view

creditworthiness of outstanding credit in the United States. During the past eight years, Fed stewards have

artificially depressed the entire U.S. rate curve—on the short end through ZIRP and on the long end through

$3.6 trillion in QE asset purchases. The stated purpose of QE programs has been to artificially depress long-

term interest rates by inflating prices of the world’s two most important financial assets (Treasuries and MBS).

Because almost all financial assets are priced in some manner to these bulwarks, the Fed successfully

suppressed rate structures around the world and ignited the greatest global search for yield in financial history.

Economic behavior, decision making, tradeoffs and commitments have all been distorted by artificially

suppressed interest rates. Especially given the extended duration of Fed-imposed ZIRP, the global financial

system has morphed into something totally different from that which existed during “normal” rate structures.

To assume the world can now readjust to normalized rates without years of painful rebalancing seems to us to be

remarkably naïve perspective. We find it far more likely that significant amounts of U.S. credit will be exposed

as uneconomic. Using our preferred lens of historical U.S. debt-to-GDP relationships, at least $20 trillion of

U.S. total-credit-market debt is likely to succumb to an inevitable rationalization process.

10

Interest rates, at their core, are the price of time preferences. In the production of any good, there is a cost for

each input and a cost for securing that input. In producing a car, inputs from all over the world must be secured,

and it takes time to do so. In a ZIRP world, chains of production can evolve which might not otherwise be

profitable. In a ZIRP world, long-lead time and capital intensive projects (i.e., an iron-ore mine) can be

undertaken which might not otherwise be profitable. Global supply chains and global trade have employed ever

lengthening global value chains (GVC’s). After eight years of ZIRP, is it logical to assume the global financial

system can painlessly adapt to higher rates? We think not.

Since 2007, global debt levels have only continued to expand. Total credit-market-debt in the United States has

increased $16.9 trillion since 2007 (and $2.9 trillion during the 12-months through Q3 2016). The balance

sheets of the top five central banks have expanded over $12 trillion since 2007. McKinsey & Company

estimated in its infamous early 2015 report (“Debt and not Much Deleveraging”) that global debt increased $57

trillion since 2007 to $199 trillion. On 1/4/17, the Institute for International Finance estimated that global debt

increased an additional $11 trillion during the first nine months of 2016 to a new high of $217 trillion. We

view accelerating rates of global credit-creation as proof-positive that the world economy is in no position to

endure the tightening effects of rising rates.

Figure 9: Trailing 5-Month Percentage Change 10-Year Treasury Yields (1962-Present) [MacroMavens]

Past instances in which 10-year Treasury yields have risen 50% against the backdrop of ebullient equity

markets, such as 1999 and 1987, have ended in tears for equity investors who failed to take notice. Of course, in

each of these prior episodes, the 50% increase in Treasury yields took roughly six-months to unfold. In the

current experience, yields backed-up 54% in just seven weeks! As demonstrated in Figure 9, above, this yield

surge already qualifies as the most dramatic tightening in over 50 years. Some will shrug off this percentage

jump because yields still remain at historically low levels. We think this is a critical miscalculation. We view

the backup in Treasury yields during the second half of 2016 as highly problematic for the U.S. economy,

and we do not expect these higher rates to stand. Indeed, the investment surprise of 2017 is likely to be a

retreat of Treasury yields back towards the lows of 2016.

11

Figure 10: Yr./Yr. Basis Point Change U.S. 10-Year Treasury Yields (1990-Present) [Cornerstone Macro]

One legitimizing aspect of our argument that Treasury yields will fail to maintain second-half 2016 increases is

the fact that our logic requires no new information or speculative conclusions. To us, the body of economic

evidence during the past 15 years is entirely consistent with our contention that debt levels in the U.S. are

simply too elevated to tolerate rising interest rates. Cornerstone Macro suggests that the tipping point to U.S.

financial stress in the past quarter-century has been a year-over-year increase of 75 basis points in 10-year

Treasury yields. In Figure 10, above, a simple plot of the trailing 12-month basis-point change in the 10-year

Treasury reveals that without exception, any year-over-year increase in excess of 75 basis points has led to

significant financial stress. Should 10-year Treasury yields remain at 2.5% through early April 2017, the 75

basis-point year-over-year barrier will be breeched, and by June, the year-over-year increase will exceed 100

basis points. Quite simply, if rates do not recede from current levels, the long-overdue process of U.S. debt

rationalization will begin anew.

Figure 11: U.S. 10-Year Treasury Yield (Inverted, Advanced 6-mos.) versus NAHB Index

(2009-Present) [Cornerstone Macro]

Underlying our confidence that long-rates are headed lower from 2016 year-end highs, we site two critical

transfer mechanisms which are already flashing red with respect to future U.S. economic growth: housing and

automobiles. With respect to housing, the linkage between long-rates, homebuilder sentiment and economic

growth is well-documented. As shown in Figure 11, above, the recent advance in 10-year yields suggests

slowdowns in both homebuilder sentiment and housing starts are “baked in the cake” for at least six-to-nine

months.

12

The 3-month, 75-basis-point leap in 30-year mortgage rates through 1/6/17 adds roughly 10% to the mortgage

payment on the average U.S. house. With affordability already stretched in recent years, housing turnover and

price momentum look to have peaked. As shown in Figure 12, below, mortgage applications have already

started to recede.

Figure 12: MBA Mortgage Applications (2001-Present) and MBA Mortgage Refi Index (2005-Present)

[Mortgage Bankers Association, Zero Hedge]

With respect to second-derivative impacts of rising mortgage rates, we highlight in Figure 12, above, that cash-

out refi’s have collapsed all the way to Lehman lows. Refi’s and HELOC’s seem like yesterday’s news—the

days of home-equity withdrawal are long gone, right? Truth be told, the importance of cash-out refi’s in

subsidizing retail-sales growth has exploded during the past two years. As shown in Figure 13, below, the

percentage of annual retail-sales growth financed by cash-out refi’s and credit-card borrowing averaged roughly

one-third between 2012 and 2014. Then, in 2015, fully 100% of retail-sales growth was bankrolled, at the

margin, by refi’s and plastic. In 2016, this percentage is set to exceed 102%! Given the fact that the refi spigot

may have just closed, we would expect retail sales to remain significantly challenged throughout 2017. Along

these lines, the Commerce Department reported on 1/13/17 that December U.S. retail sales (ex-autos and ex-gas)

were statistically flat at 0.0% (versus consensus expectations for a 0.4% increase), the second-worst December

reading since 2008.

Cash out Refinancing

Annual $ Credit Card Borrowing

Annual $ Retail Sales

Annual $

2012 64.6 5 224

2013 59.2 11 187

2014 42.3 30 193

2015 65.9 46 112

2016 est $70.6 $59b $126b

Source=Freddie Mac, Federal Reserve

Figure 13: Cash-out Refi’s, Credit-Card Borrowing and Retail Sales Growth (2012-2016E) [MacroMavens]

13

A striking example of the degree to which U.S. economic growth now relies on unfettered credit-creation is the

domestic automobile industry. Given the second and third derivative effects on employment and GDP of auto

manufacturing, impacts on the U.S. economy are huge. From the depths of 2009, the annual rate of U.S. auto

sales has now roughly doubled, from nine million units to just over 18 million units. This recovery appears

impressive, until one examines the degree to which this growth has been fueled by reckless credit-creation.

Indeed, as MacroMavens illustrates in Figure 14, below, it has required a 34% increase in outstanding auto

credit just to return annual auto sales to their pre-crisis levels. In a Kabuki opera eerily reminiscent of 2007

Miami condos, auto-financing terms have trended towards borderline ludicrous. Experian reports that 30.7% of

new-auto loans originated during Q3 2016 featured repayment periods of 73-to-84 months.

Figure 14: Annual U.S. Automobile Sales versus Aggregate U.S. Automobile Credit Outstanding

(1994-Present) [MacroMavens]

Obviously, seven-year car loans raise the prospect of “upside-down” automobiles. We outlined in our

November report that 25% of all vehicles being traded in for used-car purchases in the U.S. in Q3 2016 involved

rollover of negative equity from the trade-in car averaging $3,635. Since then we learned that negative-equity

baggage is even more prevalent in the new-car market. Edmunds reports that fully 32% of trade-in vehicles in

new-car loans (originated in the U.S. in Q3 2016) involved rollover of negative equity from the trade-in car

averaging $4,832! With the average new car priced at $33,000 during the quarter, this means that initial

principal balances for these new-car buyers amounted to 115% of the new car’s value. Only in America! Of

course, with a 7-year loan available at a 2% interest rate, what’s another 15% tacked on to principal to be

amortized? Not only is it apparent the automobile cycle is breathing its last tortured gasps, but it is also a pretty

good bet the recent backup in interest rates will short circuit the latest financing innovation of “hot potato”

negative trade-in equity.

14

Can the Fed Hike Rates?

We view Fed prognostication for three FOMC rate hikes in each of the next three years with the same

bemusement we have viewed similar projections in each of the past eight years. As shown in Figure 15, below,

the Fed’s annual “dot plot” rate projections have become utterly risible. We wonder why consensus continues to

pay any heed to Fed rate forecasts. They have been so wrong for so long, isn’t it obvious the Fed feels they

cannot raise rates? We attribute the cognitive dissonance in consensus acceptance of Fed rate forecasts to the

intoxicating power of successive weekly highs in the S&P 500 Index. As long as stocks hit new highs, who

cares if the Fed can’t raise rates. It’s all good!

Figure 15: Fed Estimates for Future Fed Funds Rates (Dot Plot Midpoints 2013-Present) [Deutsche Bank]

We continue to search for any significant aspect of economic, monetary and financial conditions which may

have changed substantively enough to permit the Fed to raise rates when they have felt powerless to do so in

recent years. As shown in Figure 16, below, relevant economic measures in the U.S. remain today at levels

below those at which the Fed felt compelled to launch QE2 and QE3. Even the lone metric showing relative

improvement, the unemployment rate, appears a bit pyrrhic in the context of a new high in Americans not in the

work force (95.1 million) and a near 38-year low in labor-force participation rate (62.70%).

Figure 16: Comparative Economic Statistics at Launch of QE1, QE2, QE3 and Today [MacroMavens]

Labor Partic. Rate

Unemploymt Rate

Core PCE Deflator yy

Retail Sales yy

Nom GDP yy

QE1 Launch Nov ‘08

65.9% 6.8% 1.7% -9.7% -1.0%

QE2 Launch Nov ‘10

64.6 9.8 1.0 6.5 4.6

QE3 Launch (Sep12)

63.6 7.8 1.7 5.4 4.5

Today 62.7% 4.6% 1.6% 3.8% 2.9%

15

On 1/12/17, St. Louis Fed President James Bullard augmented his reputation as the Fed’s maverick jawboner by

becoming the first FOMC member (though non-voter until 2019) to suggest that, now that the FOMC has

undertaken two rate hikes, the Fed “may be in a better positon” to suspend its $48 billion worth of monthly asset

purchases designed to replace maturing securities and maintain the Fed’s balance sheet at $4.5 trillion. Given

that consensus projected outright asset-sales from the Fed as early as 2010, a decision to permit asset roll-offs

some six years later is hardly an earth-shaking development in U.S. monetary policy. We would caution,

however, that the Fed’s balance sheet has come to play a critical role in maintaining sufficient global dollar-

liquidity (Triffin dilemma). It is our strong contention that the current Fed policy stance is already creating

serious strains in global dollar-liquidity (the Fed is already too tight). Significant dollar-funding shortages are

popping up around the globe. Andy Lees (MacroStrategy) calculates that through year-end, the dollar-value of

global money supply had fallen $3.2 trillion from its 9/30 peak ($77.938 trillion), a -15.70% three-month

annualized rate of decline. We are fairly certain the Fed will need to address this declining-global-liquidity

trend in earnest before the first calendar quarter expires. Stay tuned.

Even domestically, we believe consensus fails to recognize the importance of the Fed’s balance sheet in

supporting commercial bank liquidity. As commercial banks have increased their lending since 2014, aggregate

cash liquidity levels have fallen from their 2014 peak of roughly 20% of total assets to today’s level of 14.1%.

As shown in Figure 17, below, while there is some room for the Fed to reduce its balance sheet from current

levels, completely removing the Fed’s balance sheet would be impossible, as it would reduce commercial banks’

cash liquidity to negative 8.1% of total assets.

Figure 17: U.S. Commercial Bank Cash Liquidity (Measured as Percentage of Overall Assets)

Excluding Fed Balance Sheet (3/7/97-Present) [MacroStrategy Partnership]

Can the U.S. dollar strengthen?

In our experience, no opinion clears out a room quicker than questioning the pedigree of the U.S. dollar. We

find Western investors remarkably closed-minded about the dollar’s reserve-currency status. The dollar bug

doctrine cites that no country can rival the depth and liquidity of U.S. capital markets; that the dollar is the

world’s least dirty shirt, and that no arrangement could possibly replicate the dollar’s dominance of global

affairs. While we are not suggesting the dollar’s role in global monetary affairs is about to disappear anytime

soon, we are quite certain that many of the world’s worst economic ills emanate directly from the dollar-

standard system. We are sympathetic to the view that the U.S dollar is facing late-stage, destabilizing, Triffin-

dilemma quandaries.

16

The Triffin dilemma was first enunciated by Belgian-American economist Robert Triffin in the early 1960’s. In

impassioned testimony to Congress, Mr. Triffin warned against the failure of Bretton Woods by arguing no

single country can perpetually issue the reserve currency for the world. Mr. Triffin’s elegantly simple logic was

that fiat control of a global reserve currency by any one nation will always lead to the currency’s over-issuance,

overvaluation and eventual demise. In essence, external demand for the currency necessitates that the host

country run an ever expanding current account deficit to satisfy external commerce demands for the reserve

currency. An inevitable consequence of chronic capital-account deficits will be overvaluation of the currency,

leading in turn to eroding competitiveness of the issuer’s domestic economy.

While Mr. Triffin’s analysis correctly foreshadowed the eventual demise of Bretton Woods in 1971, his work is

even more relevant to the fate of the contemporary (floating exchange rate) dollar-standard system. While our

views are decidedly non-consensus, our confidence increases with each passing day that the Fed’s eight years of

QE and ZIRP have only hastened the dollar’s demise as hegemonic reserve currency. Global pressures linked to

the issuance of $10 trillion in offshore dollar-denominated debt are now so acute, the Fed will remain trapped in

a near-zero rate environment until such time as this uneconomic obelisk of debt is allowed to rationalize

(default).

To those who might suggest that the U.S. economy is sufficiently strong, and the Fed’s mandate sufficiently

narrow, for the Fed to ignore overseas implications of FOMC rate hikes, we would cite in counterpoint the

percolating monetary pressures now roiling the Chinese economy. So much is written about China, we hesitate

to labor a long narrative in this context. However, we wish to highlight a critical change in focus by Chinese

apparatchiks in recent months: it has become all about capital flows! Recognizing that no country can

simultaneously control domestic monetary policy, currency exchange rates and capital flows, Chinese stewards

are notably shifting their focus to the capital-controls side of the equation. It is just our speculation, but this

clear shift suggests to us that a change in policy may be on the horizon for one of the other two points on the

monetary triangle. Assuming the PBOC will always view control of domestic monetary policy as sacrosanct, it

is logical to assume probabilities for an exchange-rate recalibration are rising.

Our colleague and resident China expert, Seth Daniels (JKD Capital), has cobbled together a list of recent

Chinese edicts designed to stem capital outflows. Because we believe the full scope of Chinese efforts remains

somewhat under consensus radar, we summarize Seth’s list for general consideration. In the past month,

Chinese officials have announced:

requirements for all banks and financial institutions to report to the PBOC

all domestic and overseas transactions of more than 50,000 yuan ($7,201)

versus 200,000 yuan previously,

restrictions on the annual $50,000 F/X quota for Chinese nationals,

including outright bans on overseas purchase of property, securities or life

insurance,

vetting by State Administration of Foreign Exchange (SAFE) of corporate

outbound transfers of $5 million or more, down from $50 million

previously,

new limitations on Bank of China (China’s largest commercial bank)

customer purchases of foreign currency to $1million versus no prior limits,

restrictions on Macau ATM withdrawals and currency “imports,”

steps to curb the ease of gold imports,

prohibitions against banks issuing dual currency credit cards,

restrictions on outbound corporate M&A and dividend remittances,

restrictions on issuance of debit cards,

restrictions on Bitcoin trading, and

increased taxes on luxury car imports.

17

While western consensus assigns the Fed little responsibility for China’s unfolding monetary challenges, we see

the two as inextricably linked. The Fed’s eight years of QE and ZIRP unleashed an historic search for yield

leading to massive accumulation of global F/X reserves. Indeed, global F/X reserves doubled in six years to

their August 2014 peak of $12 trillion. We see it as no coincidence that the explosion in global F/X reserves

coincided precisely with the launch of QE1 and has now reversed sharply, coinciding precisely with QE3’s final

taper (Figure 18, below). While it has become de rigueur to chastise the Chinese for their management of

capital markets, little credit is given to China for its valiant defense in recent years of the renminbi peg to the

U.S. dollar. From the launch of QE1 through June 2014, Chinese foreign exchange reserves doubled to

$4 trillion. We would suggest $2 trillion in F/X reserve-growth was the tangible cost of Chinese efforts to cool

hot money inflows during the QE era. Now that the Fed is attempting to reverse eight years of unprecedented

largesse, the immediate and reflexive consequence is spirited EM outflows which are destabilizing global

currency markets.

Figure 18: Total Global Foreign Exchange Reserves (4/4/2008-1/13/2017) [Bloomberg]

It is one thing for us to suggest FOMC rate hikes are contributing to monetary turmoil in China, but quite

another for Fed stewards to ascribe to the same reasoning. On 1/6/16, just three weeks after the FOMC’s

12/16/15 rate hike, Fed Vice-Chairman Stanley Fischer remarked, “If all China’s neighbors and other large parts

of the world are negatively affected to a considerable extent by China, then that would be an impact [on Fed

policy]. The rest of the world matters to us.” After the Shanghai composite collapsed 28% in five weeks

following the Fed’s 12/16/15 rate hike, Fed Vice-Chairmen Fischer and Dudley took to the airwaves in the first

week of February to quell expectations for further 2016 rate hikes. Given the urgency with which Chinese

officials are now raising the dikes on capital outflows, we would expect any further FOMC tightening to be met

with strenuous Chinese objection and reaction. In the meantime, China continues to dump Treasuries at an

accelerated monthly clip ($41.3 billion in October and $66.4 billion in November) and reduce its reliance on the

dollar peg. On 12/29/16, the China Foreign Exchange Trade System reported it had reduced the dollar’s

weighting from 26.4% to 22.4% in the foreign-currency basket to which the yuan is managed.

18

Figure 19: Trailing Twelve-Month Long-Term Foreign Official U.S. Treasury Purchases

(1992-November 2016) [TIC Report, Meridian Macro]

While overseas impacts of Fed policy are most vividly portrayed in China, they are felt just as urgently across

the globe. The world has made no secret in recent years of growing resentment toward imbalances linked to

dollar hegemony. As demonstrated in Figure 19, above, the rush by global central banks to exit Treasuries,

despite their vaunted yield-premiums to competing sovereigns, continues to accelerate. Having watched the

entirety of President-elect Trump’s 1/11/17 news conference, we are betting global interest in U.S. Treasuries is

not about to skyrocket any time soon. With all due respect to published estimates for the 2016 U.S. federal

budget deficit (roughly $600 billion), we would observe that the U.S. public debt on the last day of 2016 totaled

$19.977 trillion, an increase of some $1.054 trillion versus year-end 2015. To those projecting multiple Fed rate

increases and a declining Fed balance sheet in 2017, we would pose the question, exactly which buyers are

going to plug the gap between reaccelerating U.S. Treasury needs and declining foreign interest therein? As

shown in Figure 20, below, that trailing 12-month gap already measures roughly $1 trillion. Given Trump

(campaign) promises for increased fiscal spending, tax cuts, import tariffs and border walls, we would rate 2017

probabilities for additional Fed Treasury purchases as significantly higher than those for additional FOMC rate

hikes.

Figure 20: Trailing Twelve Month U.S. Treasury Issuance Versus Net Foreign Purchases

(1990-Present) [U.S. Treasury, TIC Report, MacroMavens]

19

2017 Outlook

A seminal characteristic of the 2017 investment landscape is limited visibility. Given the unprecedented scale

of monetary stimulus during the past decade, now clashing with the unpredictable nature of populist sentiment,

it is fair to say no one has any idea how financial markets will perform during the next twelve months. Stating

that the future is uncertain is hardly a novel maxim, but in this instance, we seek to emphasize that the range of

potential investment outcomes has never been wider. Because so many market variables are registering such

elevated readings, and because market plumbing is now measured in milliseconds, it seems inevitable that

volatility will be a prominent market feature during the coming year.

During the past three months, market sentiment has shifted on fundamentals dominating short-term trading in

gold markets. Consensus views have gravitated towards further Fed tightening, rising Treasury yields and a

strengthening U.S. dollar. In the body of this report, we have outlined our reasoning as to why each of these

assumptions may be short-sighted. In our view, cumulative and immutable imbalances (debt levels, valuations,

dollar liquidity) will soon test recent sentiment shifts, we expect decidedly in gold’s favor. While we are not

stocking canned goods, oiling muskets, or bottling water, we are suggesting that a modest portfolio allocation to

gold has never been more prudent.

A consistent theme at investment conferences during 2016 has been the compression of investment returns.

Especially in the pension and endowment world, very few institutions are achieving chartered rates of return.

While institutions might have expected historically to achieve real rates of return of 5% on equities and 2 ½% on

bonds, the realities of achieved returns during the past several years are tracking (at the high end) roughly half

these historical levels. We believe the root cause for compressed returns is far simpler than much of the

sophisticated quantitative analysis we have encountered. The United States has a structural debt problem, and

the Fed has employed ZIRP for eight years to forestall rationalization of this untenable debt load. As every

student of economics is aware, marginal returns gravitate towards marginal costs. The longer the U.S. economy

operates in a ZIRP environment, the closer to zero will migrate the sum-profit-total of U.S. economic agents.

Recognizing this, the Fed has telegraphed for years a desire to normalize rate structures. Consensus has

recognized the Fed’s poor track record in achieving rate normalization but, in our view, has failed to grasp the

true impediment to higher rates. It is not popular to suggest U.S. debt levels cannot sustain higher rates, but we

believe these are the root facts.

During the past decade, global productivity has collapsed to its lowest level in the modern financial era.

Optimists shrug off these statistics as outdated and unreflective of vast productivity enhancements enabled by

the internet, I-Phones and social media. We cite this example (which we will develop further in our February

report) as a metaphor for a broader condition in global asset markets. Most investors sense that there are

looming risks in financial markets and troubling impediments to healthy global growth. Yet, the relentless

performance of the S&P 500 Index has reinforced the inclination to ignore these nagging concerns. In the

institutional arena, excessive bearishness or even adoption of defensive and hedged strategies can handicap

performance and introduce career risk. To us, an allocation to gold is a powerful tool to help insulate portfolios

from potential dislocations in a complicated financial world. In essence, a gold allocation can provide a bit of

cheap insurance to any ongoing investment program.

We continue to marvel at gold’s lack of institutional sponsorship. During the past hundred years, even a modest

portfolio commitment to gold has been proven to push total portfolio returns further to the right along return

frontiers for any reasonable asset mix, generating equal returns with less risk and standard deviation, or superior

returns with equivalent risk and standard deviation, versus identical portfolios without a gold investment

component (World Gold Council). During the past 16 years, gold’s non-correlated and market-leading returns

have provided invaluable portfolio alpha in an increasingly challenging investment environment. During the

next several years, mounting monetary, economic and financial imbalances, which appear to be approaching

important tipping points, suggest gold is a portfolio-diversifying asset worthy of serious consideration.

20

We view corrections in gold markets during the fourth quarter of 2016 as fairly standard retests of early 2016

breakouts from established downtrends. To us, underlying fundamentals suggest significantly higher gold prices

during the next several years. While we view the investment merits of gold equities as substantially different

from those of gold bullion, we expect the shares of high-quality gold miners to provide significant portfolio

leverage to any advance in the gold complex in future periods. Given inherent volatility, we are loath ever to

cite specific targets or forecasts for future performance in the gold sector. On the other hand, we have for the

past 15 years dedicated our firm’s resources to exhaustive analysis of underlying fundamentals and future

prospects for gold and gold shares. We feel we have developed strong and informed perspective on valuations

in the precious-metal space.

Figure 21: NYSE ARCA Gold Miners Index (June 2000-Present) [Bloomberg, Sprott Asset Management]

Along these lines, our study of past performance cycles suggests that the Q4 2016 pullback in gold equities is

largely consistent with historical patterns. After a sharp initial leg of advance during the 2000-2008 cycle, for

example, gold equites suffered an initial correction on the order of 38%, which demoralized gold investors and

emboldened non-participants. Interestingly, the recent pullback in the NYSE Arca Gold Miners Index, from its

8/10/16 high close of 870.28 to its 12/16/16 low close of 529.09, measured 39.20%. While past performance is

never a predictor of future results, we document in Figure 21, above, the strong performance of gold equites

subsequent to their 2002 correction. With underlying fundamentals today even more supportive than in 2002, it

is anyone’s guess what the future holds.

At Sprott we have developed a suite of best-in-class products in all segments of the precious-metal space. From

our passive Physical Bullion Trusts through our actively managed Global Gold partnerships, we believe Sprott

vehicles are the most innovative, investor-friendly and best performing offerings in the marketplace. We

welcome the opportunity to visit with all Sprott clients in coming weeks to review their allocations to precious

metals during 2017.

We are enthusiastic about gold’s prospects and we look forward to hearing from you.

Sincerely,

Trey Reik

Senior Portfolio Manager

Sprott Asset Management USA, Inc.

(203) 656-2400

This report is intended solely for the use of Sprott Asset Management USA Inc. investors and interested parties. Investments and commentary are unique and may not be reflective of investments and commentary in other strategies managed by Sprott Asset Management USA, Inc., Sprott Asset Management LP, Sprott Inc., or any other Sprott entity or affiliate. Opinions expressed in this report are those of a Senior Portfolio Manager of Sprott Asset Management USA Inc., and may vary widely from opinions of other Sprott affiliated Portfolio Managers. This information is for information purposes only and is not intended to be an offer or solicitation for the sale of any financial product or service or a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the objectives of the investor, financial situation, investment horizon, and their particular needs. This information is not intended to provide financial, tax, legal, accounting or other professional advice since such advice always requires consideration of individual circumstances. The investments discussed herein are not insured by the FDIC or any other governmental agency, are subject to risks, including a possible loss of the principal amount invested. Generally, natural resources investments are more volatile on a daily basis and have higher headline risk than other sectors as they tend to be more sensitive to economic data, political and regulatory events as well as underlying commodity prices. Natural resource investments are influenced by the price of underlying commodities like oil, gas, metals, coal, etc.; several of which trade on various exchanges and have price fluctuations based on short-term dynamics partly driven by demand/supply and also by investment flows. Natural resource investments tend to react more sensitively to global events and economic data than other sectors, whether it is a natural disaster like an earthquake, political upheaval in the Middle East or release of employment data in the U.S. Past performance is no guarantee of future returns. Sprott Asset Management USA Inc., affiliates, family, friends, employees, associates, and others may hold positions in the securities it recommends to clients, and may sell the same at any time. All figures in this report are expressed in U.S. dollars unless otherwise noted.