As Economy Heats Up, Will Commodities?

By Frank Holmes

CEO and Chief Investment Officer

U.S. Global Investors

Thanks to the life support of $12 trillion and 515 rate cuts by the world’s central banks since March 2009, the global economy’s heart is beginning to beat again. As the market senses a robust economic recovery is underway, expectations are climbing that this growth will continue. Even the Federal Reserve has hinted that it may taper quantitative easing because of the improved economic situation. As a result, interest rates are increasing.

Europe was the lone wild card, but following Germany’s change of heart away from austerity, a positive outlook for growth, and therefore, rates, is rising in that area of the world as well.

In the chart below, you can see the close correlation between the eurozone’s positive economic surprises and bond yields. The Citi Eurozone Economic Surprise Index, which compares economic data to expectations, has improved, bouncing from a low in April. At the same time, the yield on Germany’s 10-year bond has also begun to increase.

Positive Economic Surprises in the Eurozone are Pushing Yields Higher

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Given this rising interest rate environment, we wondered how gold, oil, and commodities, as well as energy and materials stocks have historically performed. With a hot economy, will we see hot commodities?

We found some compelling results for resource investors.

Goldman Sachs’ historical playbook finds that “higher rates are ok for Asian equities.” Since 1990, there were 35 periods in which U.S. rates rose 50 basis points or more, and 75 percent of the time, the MSCI All Country Asia Pacific (excluding Japan) Index climbed higher, says Goldman.

The research firm plotted Asian countries as well as Australia according to their growth sensitivity compared to their U.S. rate sensitivity. You can see that the index tends to be positively impacted by rising rates in the U.S. and is relatively growth sensitive.

Across Asia, China, Korea and Taiwan—proxies for global growth—are the most positively affected by rising rates. These three countries are also the highest growth-sensitive areas of the world. That makes today’s situation of economic growth with rising rates a powerful combination for commodity investors. When economies such as China and Korea are growing, their use of commodities tends to expand as well.

Rising rates and better growth positivety affects countries that are proxies for global growth

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On the opposite end of the spectrum, countries such as India, Indonesia and the Philippines are negatively impacted by rising rates, as their economies are domestic driven and do not benefit from rising growth expectations in the U.S.

The Key is to Take Action Now

Don’t wait for the Fed to officially raise rates, as research shows that investors get the most benefit from materials and energy stocks by getting in now. Take a look at William O’Neil & Co.’s table below, which illustrates how critical it was to be invested in commodities before rates increased.

The firm looked at individual sectors, such as retail, technology, and utilities, along with broad indices, including the S&P 500 Index, the Dow Jones Industrial Average and the Nasdaq over four decades. It calculated the gains not only received during the period of the rate increases, but also six months prior to the initiation of rate increases.

In every instance, the energy sector performed “extremely well during these periods,” with basic materials also outperforming, says William O’Neil.

Energy and Materials Show Most Outperformance During Rate Increase Period

Percent Gain by Sector and Index

Period of

Rising Rates

Best-Performing Sector

Sector Gain

Best-Performing Index

Index Gain

August 1971 to

March 1974

Materials

27%

S&P 500

0%

July 1976 to

February 1980

Energy

62%

Nasdaq

59%

February 1987 to

March 1989

Energy

16%

Dow Jones Industrial Ave.

5%

November 1993 to

February 1995

Health Care

22%

Dow Jones Industrial Ave.

8%

February 1999 to

May 2000

Energy

46%

Nasdaq

45%

January 2004 to

July 2006

Energy

82%

S&P 500

11%

Source:William O’Neil & Co.

A Rerun of That ‘70s Show?

Looking ahead, if the economy starts to experience runaway inflation, history shows it makes sense to hold real assets. A decade ago, Investment Advisers Stephen Leeb and Donna Leeb wrote a very informative book on how to profit from the “Turbulent Post-Technology Market Boom.” The book, Defying the Market, discussed how to protect against deflationary and inflationary scares, comparing investment ideas that were likely novel to many people in their day, including energy, food, gold, and small-cap stocks.

Will Commodity Investors See

a Rerun of That ’70s Show?

Nominal

Annualized

Returns

Gold/Silver

33.10%

Gold Stocks

28.00%

Oil

26.40%

Oil stocks

14.20%

Equity REITs

12.10%

Commodities

11.00%

Real Estate

10.10%

S&P 500 Index

8.40%

CPI

8.10%

T-Bills

6.80%

Government Bonds

3.90%

Source: Defying the Market, Stephen Leeb and Donna Leeb, Leeb Investment Advisors

One table listed the performance of these investments during an earlier era when Americans faced high inflation—the 1970s.

In that decade, gold, silver and oil outperformed many other areas of the market. Gold stocks rose 28 percent on an annualized basis and oil companies grew 14 percent. The S&P 500 Index, on the other hand, grew 8.4 percent on a nominal basis. After factoring in sky-high inflation of 8.10 percent, gold and oil still added significant real returns. The real return of the overall stock market, on the other hand, was nearly zero.

“Stocks leveraged to growth, such as the oils and oil drillers, did splendidly. But the big-cap stocks [i.e. the general market] … were complete duds,” wrote the Leebs.

While it is still too early to tell whether investors will see “That ‘70s Show” again, one valid consideration to protect from inflationary measures is an allocation to real assets like commodities.

Index Summary

  • Major market indices closed higher this week. The Dow Jones Industrial Average rose 0.88 percent. The S&P 500 Stock Index moved higher by 0.78 percent, while the Nasdaq Composite gained 0.38 percent. The Russell 2000 small capitalization index rose 0.35 percent this week.
  • The Hang Seng Composite Index fell 3.68 percent; Taiwan declined 1.93 percent while the KOSPI dropped 3.86 percent.
  • The 10-year Treasury bond yield rose 5 basis points this week to 2.18 percent.

Domestic Equity Market

The S&P 500 finished higher this week after two down weeks and a modest 5 percent correction. The traditionally defensive groups bounced back this week even as treasury yields moved higher. A key data point out this week was nonfarm payrolls, which increased by 175,000 and was more or less in line with expectations. This was enough encouragement for the market to rally nicely on Friday in a classic “Goldilocks” situation, not too hot and not too cold.

Domestic Equity Market - U.S. Global Investors

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Strengths

  • The telecommunication services sector was the leader this week with AT&T and Verizon both bouncing back after a sharp sell-off in those names the past two weeks.
  • The consumer staples sector was the second-best performer, also bouncing back from recent poor performance. Campbell Soup, Walgreen and Coca-Cola were all strong performers.
  • Monster Beverage was the best performer in the S&P 500 this week, gaining 12.88 percent. At the company’s annual meeting this week, the CEO indicated that the company’s sales were improving. The company has recently received a fair amount of negative publicity regarding the health effects of energy drinks in general.

Weaknesses

  • The materials sector was the worst performer this week. The sector was only modestly lower overall with weakness seen in household names such as Alcoa and US Steel.
  • The technology sector lagged this week and was essentially unchanged for the week.
  • Iron Mountain was the worst performer in the S&P 500 this week, declining 19.22 percent. The company plans to convert to a real estate investment trust, but the IRS is questioning their eligibility.

Opportunity

  • The current macro environment remains positive as economic data remains robust enough to give investors confidence in an economic recovery, but not too strong as to force the Federal Reserve to change course in the near term.
  • The market pulled back 5 percent and bounced right on cue as it has done all year.

Threat

  • A market consolidation could continue in the near term, as the S&P 500 kept trending higher beyond its all-time record for a month, defying the proverbial “Sell in May” seasonal pattern.
  • Mortgage rates rose above 4 percent this week and if housing were to slowdown or pause for a period of time that could be a significant drag for both the real economy and the markets.

The Economy and Bond Market

Treasury yields moved higher again this week as the employment report on Friday was good enough to keep Fed “tapering” (reducing quantitative easing and the first step on a long road toward tightening monetary policy) fears alive.

10-Year Treasury Yield

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Strengths

  • Nonfarm payrolls grew 175,000 in May, modestly ahead of expectations. The unemployment rate ticked higher to 7.6 percent as participation and labor force expanded.
  • Retail sales results from individual companies came in a little better than expected, but we will get official government data next week.
  • The nonmanufacturing ISM index improved in May, with new orders and output showing an uptick.

Weaknesses

  • The average 30-year fixed-rate mortgage yield hit 4.07 percent, the highest level in over a year.
  • The ISM manufacturing index unexpectedly hit a 4-year low and fell into contraction territory. This was definitely a negative surprise, particularly with recent brisk auto sales.
  • April construction spending grew a modest 0.4 percent, well below expectations.

Opportunity

  • The Fed continues to remain committed to an extremely accommodative policy.
  • Key global central bankers, including the European Central Bank (ECG), Bank of England and the Bank of Japan, are still in easing mode. The Bank of Japan, in particular, is aggressively easing and the ECB recently cut interest rates.
  • The recent sell-off in bonds may be an opportunity as growth remains weak and this wouldn’t be the first time the markets got ahead of themselves.

Threat

  • Inflation in some corners of the globe is getting the attention of policymakers and may be an early indicator for the rest of the world.
  • Trade and/or currency “wars” cannot be ruled out which may cause unintended consequences and volatility in the financial markets.
  • The recent bond market sell-off may be a “shot across the bow” as the markets reassess the changing macro dynamics.

Gold Market

For the week, spot gold closed at $1,381.74, down $6.18 per ounce, or 0.45 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, lost 1.82 percent. The U.S. Trade-Weighted Dollar Index lost 2.05 percent for the week.

Strengths

  • Bloomberg contributor Nicholas Larkin reports gold traders are the most bullish since before the bear market began two months ago after a retreat in equities from an almost five-year high and a weakening dollar spurred demand for bullion. In a survey conducted by Bloomberg, 19 analysts reported they expect gold to rise next week, with only eight expecting a drop in prices.
  • As a matter of fact, the U.S. dollar showed some pronounced weakness over the course of the week before partially recovering on Friday. Already on Monday the weaker-than-expected ISM numbers sent the dollar index breaking below the 50-day moving average. In addition, the ADP report mid week showed private sector employment numbers are not keeping up with economists’ expectations. Furthermore, our relative strength models show it takes on average 80 days for the dollar to cross above the 50-day moving average. Based on this information, we are at a stage at which the dollar should continue to show weakness, thus setting a base upon which gold prices could recover.

Dollar Falls Below the 50-Day Moving Average

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  • Centerra Gold commented this week on a potential restructuring of its operating agreement with the Kyrgyzstan Government. As part of the agreement, the Kyrgyz Government would cease to be a shareholder of the company, and instead would be part of a new Joint Venture that would own and mine the Kumtor deposit. Steven Butler of Canaccord Genuity believes the Kyrgyz Republic would seek to increase its Kumtor ownership percentage to a maximum 45 percent; however, the proposed transaction would only be 4- to 6-percent dilutive for current shareholders. Yet, shareholders would realize greater returns on the exploration and production upside on the assets outside of Kyrgyzstan and would see some relief to the share price, which is currently pricing in major political risk.

Weaknesses

  • Geoff Candy at Mineweb reports silver prices may see weakness coming from reduced industrial demand. According to the note, silver demand from solar panels accounts for 10 percent of physical demand, and despite growing sales of solar panels around the world, the product’s main market is Europe, a market that will likely see significantly lower sales in 2013. As a result, silver may take longer than gold to see a price reversal.
  • In a Project Syndicate article this week written by Nouriel Roubini, the famed economist listed six reasons why he believes gold has further downside. He listed the selling of gold reserves by governments facing liquidity problems and the rise of real interest rates as two of the reasons to justify his belief. However, what shocked us the most was his one-sided analysis of these arguments. It may be true that the Cypriot Government announced the selling of gold reserves to cover part of its liquidity needs; however it is also true that governments around the world are buying more gold than they are selling. We have reported numerous times on the sizeable bullion purchases by central banks around the world.
  • Continuing with the discussion above, Roubini argues rising real interest rates will cripple demand for gold. As we see it, the Federal Reserve has a cap on acceptable interest rates given the effect such moves create in its hefty portfolio of such securities. Should nominal rates rise above that cap, the Fed would have no option but to increase the rate of intervention. Similarly, a weakening dollar will help fuel inflation, which coupled with capped or falling nominal yields, would have the effect of lowering real rates, rather than increasing them as Roubini argues.

Opportunities

  • The spike in the 10-year treasury yields last week triggered a whole new round of analysis of the current positioning of the U.S. dollar and its impact on our funds. As mentioned in the gold strengths section, we are of the opinion that the dollar will see some sustained weakness in the short to medium term. A strong dollar has previously been associated with lower inflation, which tends to negatively affect the gold price. The chart below shows how the correlation between inflation and the trade-weighted U.S. dollar has strengthened over the last 12 months. As we prepare for a period of dollar weakness, we anticipate inflation numbers are likely to increase in the medium term, which should bode well for a gold price recovery.

Stronger Dollar is Helping Dampen Inflation Expectations

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  • Although nonfarm payrolls for the month of May came in just over consensus expectations, the unemployment rate increased from the previous 7.5 percent to 7.6 percent. The disappointment further diminishes the probability of the Fed engaging in any form of quantitative easing tapering in the medium term. The lower possibility of early tapering should bring back some interest to the gold space.
  • John Mauldin, the renowned financial writer and economist, dedicated the latest issue of his newsletter Thoughts from the Frontline to analyzing the situation of excessive monetary easing, this time from the Japanese perspective. It was a great reminder of why investments in gold and real assets are an essential portion of any investment portfolio. The following section of his commentary summarizes the madness taking place in the markets today; “It costs the Japanese government 24 [percent] of its revenues just to pay the interest on its debt at current rates. According to my friend Grant Williams (author of Things That Make You Go Hmmm…), if rates rise to just 2.2 [percent], then it will take 80 [percent] of revenues to pay the interest. Even at the low current rates, the explosion in Japanese debt has meant that interest rate expense has risen from Y7 trillion to over Y10 trillion. [The] Japanese government is now issuing more in bonds than it pays in in terest. Somewhere, Charles Ponzi is smiling.”

Threats

  • A class action lawsuit has been filed against Barrick Gold in the United States District Court for the Southern District of New York. The lawsuit was filed on behalf of all purchasers of common stock between May 7, 2009, and May 23, 2013. The plaintiffs’ argument relates to “false and misleading statements and concealed material information relating to the cost of and time to production projections for the company's Pascua-Lama Project [on] the mountainous border between Argentina and Chile.”
  • The Environment Secretary of the Philippines mentioned during an interview this week that an increase in mining taxes would likely be part of the ongoing mining reform. The measure will have to go through congress before being ratified; however, speculation at the moment calls for a 10 percent excise tax from the previous 2 percent. While additional taxation on miners has become a rule rather than the exception, the open questions regarding the timeline and amount of the measure are more disruptive for gold miners in the country than the tax itself.
  • In India, the world’s largest bullion market, taxes on gold imports have been hiked once again in a futile attempt to dampen record imports of the yellow metal. The South Asian nation is battling a record current account deficit at a time when physical demand for jewelry and investment is at its highest level. Effective immediately, bullion imports would be subject to an 8 percent levy, up from the previous 6 percent. It is worth noticing that the levy stood at 2 percent at the beginning of last year. The tri-fold increase over the last 15 months has had minimal effects on improving the trade deficit as Indian merchants and buyers find alternative ways to circumvent the unsubstantiated measure.

Energy and Natural Resources Market

2013 Commodity Scorecard

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Strengths

  • The price of crude oil (WTI) gained 4 percent this week to $96 a barrel on the back of a favorable jobs report, indicating further growth in the U.S. economy.
  • U.S. scrap steel prices firmed toward the end of this week, with some settlements now reported at stable to up $15 per ton from early May deals. The improvement was due to lean inventories and a rise in lead times.
  • The platinum price increased this week on fears of further supply disruption due to labor unrest in South Africa and improving demand.

Weaknesses

  • The price for iron ore (63.5 percent FE) to China fell again, by $2 to $113-$114. Steel mill sources quoted on how the fundamentals throughout this volatile week were essentially unchanged and that sentiment was driving moves.
  • Commodities remain the worst-performing asset class on a total returns basis since the end of last year. We believe commodities are feeling the strains posed by the scaling back in expectations towards quantitative easing by the Fed.

Opportunities

  • BTU sees world coal demand rising to 7.95 billion metric tons this year (vs. 7.665 billion in 2012), and says Chinese and Indian coal imports may rise to 480 million metric tons (vs. 425 million in 2012). The company sees about 450 gigawatts of new coal fired power generation coming on stream by 2017, implying an additional 900 million metric tons of coal demand.
  • A plummeting South African rand has meant South African platinum group metals miners are receiving a higher price for their metal than might be realized. This is providing some relief against the cost pressures facing the industry, and suggests a weaker dollar platinum price.

Threats

  • Baosteel chairman Xu Lejiang said on Tuesday that the company sees Chinese steel production rising just 1-2 percent in 2013. Baosteel expects steel consumption to weaken into the third quarter, which will “force mills to be more rational in their production plans.”
  • India's central bank, the Reserve Bank of India (RBI), announced new measures on Tuesday to reduce gold imports. The RBI extended its requirement, announced last month, that banks could only import gold on a consignment basis if it was for exporters of gold jewelry, to all nominated agencies/trading houses importing gold. It also put in place other restrictions about buying gold on a non-consignment basis.

Emerging Markets

Strengths

  • The Peruvian Finance Minister Castilla, speaking in congress, reiterated the country will grow at the forecast rate of 6.3 percent during 2013. Later the same day, the Central Bank Governor Velarde suggested economic growth in April likely reached 7.4 percent and GDP growth for the second quarter of the year could reach 6.4 percent. The news came as first-quarter growth disappointed at 4.8 percent compared to analyst estimates of a 5.9 percent rise. Despite the disappointment, the country remains the only major Latin American economy growing at a pace greater than 4 percent.
  • The Hungarian market posted a 4.31 percent rise for the week, significantly outpacing its emerging market peers as positive macroeconomic indicators were released and encouraging statements on the central bank’s growth program were released. According to Bank Director Marton Nagy, the Funding for Growth Program will add as much as 50 basis points to GDP through 2014 as the bank targets easing credit to selected selectors. In addition, industrial production surprised to the upside at 2.9 percent, compared to 1.4 percent forecast by analysts. The data underscores the government’s prediction of an economic turnaround as the country fights its way out of a second recession since 2008.
  • China’s official Purchasing Managers’ Index (PMI) rose to a higher-than-expected 50.8 in May from 50.6 in April, signaling still resilient overall manufacturing activity given its broad survey sample of 3,000 companies across 21 industries.
  • South Korea’s export growth in May reaccelerated to an above-consensus 3.2 percent year-over-year and 3.9 percent month-over-month, despite persistent weakness of the Japanese yen, as strength in technology exports more than offset the weakness in auto.
  • Taiwan’s exports rose 0.9 percent year-over-year in May versus an expected shrinkage, thanks to stronger shipments of technology products such as smartphones and tablet PCs. Trade balance expanded to $4.46 billion.

Weaknesses

  • Standard & Poor’s cut its outlook on Brazil’s sovereign credit rating from stable to negative on the country’s BBB rating. The rating agency cited sluggish economic growth and an expansionary fiscal policy which could lead to an increase in the government’s debt load. The move follows a recent government lowering of its economic growth expectations from 3 percent to 2.77 percent for 2013, and a 50 basis point rise in interest rates by the central bank, adducing a necessity to curb rising inflation. The move threatens to reverse the pace of rating upgrades received by many Latin American nations in the prior decade.
  • Russian inflation accelerated for a second month in a row and at the fastest pace since 2011. The official consumer price index measure rose 7.4 percent in May from a year ago, beating analyst estimates of a 7.3 percent rise, and more than 100 basis points above the 6 percent cap of the central bank’s target range. The increase is mainly attributed to higher food prices. The new measure continues to limit the ability of the central bank to ease monetary conditions which forces private banks to absorb the effect by accepting lower net interest margins, as they are pressured by President Vladimir Putin to lead the necessary credit expansion.
  • Thailand recorded another $558 million net fund outflows this week, the highest weekly outflow in the past 20 months, as investors worried about macro overheating risks continued to take profits after sizable gains in the market.
  • Indonesia also registered net fund outflows of $395 million this week, as a near-term correction in Southeast Asia, led by Thailand and the Philippines, dampened investor sentiment, as did to weak leading indicators of Chinese demand.
  • Singapore’s loan growth momentum slowed in April to 0.7 percent month-over-month from a 6.2 percent pace in the first quarter, with the slowdown most evident in manufacturing. The overall loan-to-deposit ratio rose to 99 percent, a record high since 1999.

Opportunities

  • The Brazilian Minister of Finance announced earlier this week the elimination of the tax levy previously imposed on fixed-income products purchased by foreigners. Traditionally, foreigners were charged a 6 percent levy on money brought into the country for purchases of fixed-income securities. The abolishment of the levy should have a positive effect on the trading volume of the Bovespa and the foreign trading of derivatives in the country.
  • Although the political instability in Turkey will add near-term volatility, we believe it is highly unlikely to pose a threat to the market in the long run. Much talk on the protests in the country has been analyzed from an “Arab Spring” perspective, a flawed analysis in our opinion. We believe these protests resemble the Russian protests ahead of Putin’s reelection last year, which leads to the conclusion that the current situation in Turkey is not meant to last. In these two cases, the protests were about the suppression of political freedom, rather than the mass protests against authoritarian states whose citizens are poverty stricken and prepared to unleash serious violence, for they really have nothing to lose. In the case of Turkey, the protesters are relatively prosperous members of the middle class with jobs and rising purchasing power. As such, the fundamental valuation metrics have not changed and Turkish equities appear to be undervalu ed at current levels, extending a new opportunity to add exposure to the country.

Turkish Stocks Still Attractive After Selloff

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  • The recent sell-off in the Philippines’ market belies the ongoing structurally positive investment cycle in the country. Real investment has grown on a sequential basis for five consecutive quarters, largely driven by construction, taking a rising share of GDP. Secular growth potential remains unchanged for the financials as well as the consumer sector.

The Philippines' turnaround in Investment Cycle Should Limit Near-Term Market Correction

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Threats

  • Investors are losing faith in Mexican President Pena Nieto’s ability to revamp the domestic oil sector and have his proposed energy bill passed by congress. Pemex, the state-owned oil company, is struggling to maintain its output capacity as it meets high payout requests from the government. The proposed bill aims to address the unreasonable tax burden faced by the company, which paid 55 percent in taxes in 2012, and exudes the lowest margin of any oil company with at least $100 billion in revenue, as well as to allow for profit sharing contracts between Pemex and private companies who can advance on the exploration and development of new fields.
  • Days of torrential rain led to the worst flooding in at least a decade in Prague and other areas of the Czech Republic over last weekend, threatening to flood the city’s historic districts and crops grown on the banks of the Vltava River. The repairs may total as much as $1.78 billion which may cause a further 0.7 percent decrease in GDP growth for 2013 in an economy whose GDP has dropped for six quarters in a row and remains in the longest recession in the country's history. Ironically, the floods may prove beneficial in the long run as the country may be eligible to receive significant funding from the EU Solidarity Fund for flood relief.
  • Weak seasonality in Chinese manufacturing activity in the coming summer months, coupled with lack of material government policy action, may weigh on the investor psyche and reintroduce volatility to the market.

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