Stay the Course As Mixed Signals Move Markets
By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors
Traders stampeded out of gold, emerging markets and bonds this month, setting record monthly outflows in June. Ever since the Federal Reserve hinted in May that signs of a stronger economy could allow for a slowdown of stimulus, markets have protested the news.
Gold has been hit hard by the tapering talk and resultant rising interest rates and liquidity drain, falling below $1,200 this week for the first time since August 2010. We’re also seeing India, the world’s biggest gold buyer, trying to stifle gold demand. As the government seeks to reduce its record current account deficit, it has hiked import tariffs on gold to 8 percent and introduced new constraints on rural lending against gold jewelry and coins. Ross Norman, CEO of bullion broker Sharps Pixley, said, “It’s almost as if the finance ministry is waging war on the gold sector, which would suggest that they feel they have lost control of the economy to some extent. In that environment, you would want to own gold more than ever.”
Other factors fueling the liquidation were the raising of margin requirements on gold by the CME Group, the largest operator of futures exchanges in the U.S., and global liquidity concerns in the U.S. and China. When the country with the largest GDP in the world and the country with the largest population on earth have liquidity concerns, traders run from stocks, bonds and gold and head to cash. Even though gold traders have pulled out of their financial investments, there has been a surge in physical gold buying and central bankers have maintained their positions.
We maintain that gold is in extremely oversold territory and mathematically due for a reversal toward the mean. Yet when gold prices plummet, fear takes over and some investors forget the fundamental reasons to own gold: Gold is a portfolio diversifier and a store of value. It is a finite resource with increasing global demand. I co-authored a book on gold five years ago based on a lifetime of experience with the metal. My advice hasn’t changed since then. When it comes to gold, moderation is key. Don’t try to get rich with gold because the corresponding risk is simply too high. Limit your exposure to gold as an asset class to 10 percent of your portfolio—no more than 5 percent in bullion and 5 percent in equities. Rebalance each year to keep that level of exposure and use volatility to your advantage.
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There seems to be an inherent emotional bias against gold by many in the financial media and among money managers, especially after gold corrects. Billions of dollars lost in gold makes for sensational headlines, yet two darling technology stocks have also taken it on the chin. I find it interesting that the naysayers aren’t talking about the fact that Facebook and Apple have caused more destruction in market capitalization over the past year than the biggest gold ETF. The chart below puts the magnitude of decline in context.
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Why is it that gold still struggles for acceptance as a permanent asset class? I, too, enjoy catching up with Facebook friends on my iPad, but I have more faith that millions of people in Asia and the Middle East will continue to adore the precious metal long after the novelty of Facebook and iPads wear off.
In many parts of the world, this deep cultural affinity for gold is expressed through the giving of gold coins and jewelry for momentous occasions. Gold will soon be entering its historical period of seasonal strength with Ramadan beginning in July, followed by the Indian Festival of Lights, wedding season and Christmas. We have often published on the impact of this powerful seasonal pattern.
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In addition to spooking the gold market, the likelihood of the Fed ending its easing also had investors fleeing fixed income investments. Rising interest rates and falling prices led to June bond fund outflows shattering the previous record set in October 2008. Yet downward revisions of economic data suggested that while the economy may be steadily improving, there aren’t yet signs of spectacular growth. In response, bond yields retreated by the end of the week. We see the exodus as an entry point for investors who may have been nervous about getting into the bond market.
Fed fears reached far and wide as emerging market equities also experienced record outflows this month as the sell-off extended to Latin America, Europe and Asia. Renewed worries over Chinese growth and concerns with tightening financial conditions accelerated the flight from emerging markets. Money that had been made in recently hot markets was pulled out, further drying up liquidity. We continue to see opportunity in emerging markets, where we seek out undervalued dividend-paying companies with growth prospects.
From time to time, in bull markets and bear markets, prices and fundamentals disconnect. Prices can swing too far on fear and rise too fast on greed. We believe fundamentals remain solid and much of the short-term swings are much ado about nothing. In volatile markets, it is important to trust your investment processes and asset allocation disciplines.
- Major market indices closed sharply lower this week. The Dow Jones Industrial Average rose 0.74 percent. The S&P 500 Stock Index moved higher by 0.87 percent, while the Nasdaq Composite gained 1.37 percent. The Russell 2000 small capitalization index rose 1.43 percent this week.
- The Hang Seng Composite rose 2.02 percent; Taiwan rose 3.45 percent while the KOSPI gained 2.22 percent.
- The 10-year Treasury bond yield fell 5 basis points this week to 2.49 percent.
Domestic Equity Market
The S&P 500 finished higher this week after dropping more than 2 percent last week on central bank policy fears. The traditionally defensive groups such as telecommunications and utilities bounced back strongly as they were the worst performers the prior week since they are viewed as bond proxies and moved with the bond markets.
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- The utilities sector rose roughly 3 percent this week in a broad-based rally. Macro factors are at work and virtually the entire group moved higher.
- The consumer discretionary sector was the second-best performer, as cable and media companies outperformed, largely driven by takeover speculation. Cablevision Systems and Time Warner Cable both rose by more than 10 percent while Comcast rose by more than 5 percent.
- Cablevision Systems was the best performer in the S&P 500 this week, gaining 12.43 percent. Liberty Media and Charter Communications are rumored to be interested in acquiring the company.
- The materials sector was the worst performer this week, as agricultural and fertilizer companies were under selling pressure as corn-planted acres unexpectedly rose in the most recent USDA report, implying potentially lower prices for corn and lower fertilizer applications. CF Industries, Mosaic and Monsanto were among the sector’s worst performers.
- The technology sector also lagged this week as Apple fell 4.25 percent. Investors remain concerned regarding margins and various unit shipments. Apple is scheduled to report on July 24.
- Accenture was the worst performer in the S&P 500 this week declining 9.37 percent. The company reported lower-than-expected sales, and sales forecasts for the upcoming quarter were also short of analysts’ expectations.
- The current macro environment remains positive as economic data remains robust enough to give investors confidence in an economic recovery but not too strong so as to force the Federal Reserve to change course in the near term.
- Money flows are likely to find their way into domestic U.S. equities and out of bonds and emerging markets, which should help the market find a floor.
- A market consolidation could continue in the near term, as macro concerns could dominate for the next couple of weeks while the market waits for earnings.
- Higher interest rates are a threat for the whole economy. The Fed must walk a fine line and the potential for policy error is potentially large.
The Economy and Bond Market
After a dramatic sell-off in the bond markets last week, treasuries recovered some this week as yields fell. Fed officials were out in force this week trying to convince the market it misunderstood the Fed’s message, and that may have played a role in calming the markets. The more plausible explanation is the market overshot and a normal retracing of some of the move was likely. The market is worried that the positive economic momentum we have seen recently will continue. This can be seen in the consumer confidence numbers that were released this week, which hit a five-year high.
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- The Conference Board’s Consumer Confidence Index hit the highest level in more than five years in June. The University of Michigan Confidence report for June was also better than expected.
- Existing home sales rose 6.7 percent in May to the highest level since 2006. Buyers appear to be rushing to lock in mortgages as rates move higher.
- Durable goods orders rose 3.6 percent in May, ahead of expectations.
- First quarter GDP was surprisingly revised lower to 1.8 percent from 2.4 percent. It is a little unusual to see such a large revision at this stage of the process. It also highlights how weak the economy has been.
- The Chicago Purchasing Manager Index (PMI) unexpectedly dropped sharply in June, but remained in expansion territory.
- Early in the week, China’s short-term repo market experienced a spike in yields and essentially a liquidity crunch. The government stepped in and intervened later in the week, but this highlights the risks to the global economy.
- Despite recent commentary, the Fed continues to remain committed to an accommodative policy.
- Key global central bankers, such as the European Central Bank (ECB), Bank of England and the Bank of Japan, are still in easing mode
- The recent sell-off in bonds is likely an opportunity as higher yields will act as a brake on the economy and potentially become self-fulfilling, thus postponing Fed tapering.
- 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.
For the week, spot gold closed at $1,223.96, down $72.60 per ounce, or 5.6 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, lost 1.39 percent. The U.S. Trade-Weighted Dollar Index gained 0.99 percent for the week.
- The last two trading days of the quarter saw gold stocks rebounding as well as some short covering. The bounce-back was not enough to reverse the early week losses where buyers stepped aside ahead of quarter-end producer gold liquidation. It is likely that the gold price pullback was a consequence of producers lining up to make gold sales, after likely having held off selling production over the course of the quarter due to the dramatic decline in the gold price. Having seen the price action this week, we feel more confident in our opinion that gold continues to be oversold and we believe investors should take this opportunity to take on or increase long positions.
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- Klondex Mines announced some outstanding high grade channel sampling results from its Fire Creek gold project in Nevada. The exploration returned results as high as 22,396 grams per tonne (g/t) of gold 74 feet north of the 5400 cross cut. It also returned 20,231 g/t gold 63 feet north of the 5400 cross cut, and 15,891 g/t gold 69 feet north. These grades will let the company minimize dilution while maximizing grade and allow it to be more selective in its mining process.
- Troy Resources, which operates mines in Brazil and Argentina, is setting an example by announcing its CEO Paul Benson will cut his AUD$540,000 base salary by one quarter; senior executive salaries and directors' fees will be reduced by 10 percent. In January 2013, Gran Colombia Resources’ management embarked on a comprehensive review of its operations which identified $12 million in annual cost savings, a significant part of which will come from cuts to its senior executive salaries. We endorse and commend the example these two companies are setting in aligning their objectives with those of shareholders.
- Citibank published a gold equity commentary this week in which it applied its proprietary global gold cost curve model to determine which companies have out-/under-performed peers on the global cost curve. A global gold unit cost increase of 15 percent year-over-year, and all-in costs increase of 1.3 percent suggests that companies are trying to adjust to the lower gold price environment by cutting capital expenditures, exploration and corporate costs. However, these cuts are insufficient given the expected fall in revenues and Citi estimates that most of the global gold producers are burning cash at spot levels.
- In a recent study, Fitch noted a potential dip below $1,000 per ounce in the gold price could result in dividend cuts by gold producers, as cuts to capital expenditures already have been implemented across much of the sector. Fitch added that, while companies may look to shed assets, capital raising continues to be difficult for small-to-midsized companies, advising that increased royalty and streaming transactions, as well as gold price hedging may occur.
- A survey by the Ontario Securities Commission (OSC) has found only 20 percent of National Instrument 43-101 reports filed by mining and exploration companies with the OSC are actually in compliance, while 40 percent are unacceptable. This is despite the strenuous requirements to qualify as an Independent Person under NI 43-101. The move increases the regulatory threat faced by junior developers and explorers, and is likely to slow down the mine development stage, while adding pressure to the already strained capital formation process.
- On its Gold Sector Note this week, Paradigm comments that despite the meltdown in the gold price on June 20 and June 26, and the subsequent sell-off in the gold equities, there are healthy signs for the sector. The current downturn, which started in September 2011, is pushing 1.8 years. Since 1976, there have been four major cycles in the gold sector. The average duration of the four previous downturns has been 3.6 years. However, noting that the two previous downturns were just two years apiece, and given the fundamental conditions observed, Paradigm believes this is likely to turn into a short downturn, in which the gold price will be bottoming out this summer.
- Mebane Faber, author and portfolio manager at Cambria Investment Management, wrote an article this week on what happened if and when you bought the U.S. equity sectors back when they were “really hammered.” Average three-year nominal returns when buying a sector down since the 1920s are 172 percent when the sector is down 80 percent and as much as 240 percent when the sector is down 90 percent. He admits it’s hard to buy something down 80 percent, especially if you owned it when it was down 30, 50, and then 80 percent. However, this tends to be the best time to be wading i n. He goes on to mention recent examples of assets that fit the criteria: tech in 2002, homebuilders in 2009, and junior gold miners now.
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- BCA, in its Commodity Strategy note this week noted how in the 1990s miners retained operating margins above 15 percent and EBITDA margins above 30 percent despite chronically low metal prices. The tricks employed then to achieve profitability can also be use today. In addition to deferring capital expenditures, miners also enjoy natural savings from labor costs as activity is reduced. The chart above shows how the huge expansion in mining employment is topping out as layoffs in the Australian mining sector and deflation in South African wages hit the labor market.
- The government announced on Wednesday gross domestic product expanded at an annual rate of 1.8 percent in the quarter, significantly below the previous report of the economy having grown at a pace of 2.4 percent. Both the federal government and independent economists cautioned that growth may weaken as the Fed ponders curtailing its monetary stimulus. Similarly, ISI cautioned this week that the growth assumption of 3.3 percent of GDP the Fed has forecast would be the fastest in a decade. As such, it may well not be achieved and the roadmap would have to be altered. The likely outcome, as Marc Faber noted late last week, is that the Federal Reserve will have no other option but to continue expanding the monetary base, a move that has supported gold’s price increase for more than 40 years.
- BMO reported in its Bond Market Focus of this week that the reason for the money supply remaining muted despite the massive increase in the monetary base is the low velocity of money we are experiencing. Money velocity is currently at its lowest level of the past 50 years which is why inflation remains subdued. The most likely reason for velocity reaching such low levels is the fact that banks are using the funds injected by the Fed to increase monetary reserves, rather than increasing the credit creation process by repeated rounds of loans and deposits. An artificially subdued inflation may pose a threat to the economy, as even a small change in the multiplier effect (the bank’s propensity to lend) could cause an inflation outbreak given the Fed-fueled expansion of the monetary base.
- Gold Stock Analyst commented on a note this week on the difference between the Comex and the NYSE when it comes to shorting. On a stock exchange, like the NYSE, a broker has to borrow the shares in order for one to sell them short, in addition to depositing the required margin funds. If the buyer of your shorted shares demands delivery, they have to be sent or your broker buys you in and you risk a loss. But on the Comex, all a shorter needs is the margin money, with no requirement that the quantity of the commodity shorted be found and available for delivery. This is a naked short, and is an exploitable loophole for investors with enough financial strength to manipulate a market lower by relentless selling. This type of activity has been weighing on gold prices, despite the fact that in a stock exchange it could be considered market manipulation.
Energy and Natural Resources Market
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- Data from China show that May’s total apparent oil demand grew 3.1 percent year-over-year and year-to-date oil demand is growing at 4.3 percent.
- Benchmark Australian thermal coal prices fell below $80 per ton and broke through what the market had expected to be a floor, as thin Chinese demand and an oversupply of the fuel weighed on prices. Australia's Newcastle spot daily index dropped to $78.87 per ton on Thursday from $82.32 a week earlier, data from online trading platform globalCOAL showed.
- The average price of natural gas (NYMEX) prices fell 6 percent this week as weekly inventories in the U.S. continue to build at a higher rate than expected.
- In a report published earlier this week, Bank Credit Analyst made a bullish case for industrial mining stocks with a look back to the 1990s as a template for the cost savings miners will need to deliver to thrive as Chinese growth downshifts from double digits to 7-8 percent. The firm highlights the change in mining CEO mindsets, from growing production to containing costs, suggesting output cuts could occur swiftly and help provide support for metal prices. Additionally, further support for metal prices could emerge as the potential for unprofitable Chinese metal production declines as the new leadership pushes energy efficiency and market-based reforms.
- Bullion must rise to $1,500 an ounce for the gold mining industry to be sustainable, according to Gold Fields CEO Nick Holland. “The industry is not sustainable at $1,230 an ounce, which is where the gold price is at the moment,” Holland said. “We’re going to need at least $1,500 an ounce to sustain this industry in any reasonable form… There’s going to be significant rationalizing in the gold industry,” Holland said. “You can’t keep mines producing if they’re losing money,” he added.
- Anglo American’s new CEO, Mark Cutifani, said he fears a cash crunch in China will curb investment, hurting commodities demand, the Wall Street Journal reported, citing an interview with the executive. Cutifani said the fallout from Beijing squeezing the financial system as a warning to overenthusiastic lenders was a concern, the report stated. Cutifani said the policymakers needed to act swiftly to prevent a credit bubble.
- The Russian ruble fared well relative to the emerging market currency sell-off, as oil was unaffected by the risk-off environment that ensued after Bernanke’s comments last week. In addition to the strength in oil, the ruble has stabilized with support from the demand of state-controlled exporters who bid up the currency as they prepared for Friday’s ruble-denominated tax payment deadline.
- Brazil’s central government budget surplus for the month of May was reported above analysts’ consensus, as the government continues to cut costs to meet a primary surplus goal of 2.3 percent of gross domestic product (GDP) this year. Finance Minister Guido Mantega said Brazil will trim spending to meet this year’s fiscal target, as the government implements measures to slow inflation.
- The People’s Bank of China (PBOC), the central bank of China, said it will maintain the interbank money market rate at a reasonable level, and China’s banking system has plenty of liquidity. It predicted interbank liquidity tightness will fade after a panicked interbank rate hike earlier in the week. The overnight Shanghai Interbank Offered Rate (SHIBOR) had dropped to 4.94 percent from the recent high of 13.4 percent after the PBOC injected liquidity into the banks.
- Gasoline demand in China remained robust, up by 13.7 percent in May, though crude demand growth was at 4.9 percent.
- China’s State Council made the decision to renovate shantytown in China, which offers profitable opportunities for developers and home appliances. It also improves living conditions for the residents.
- China asked local governments to study policy support for the development of solar energy in their areas and to explore new markets for the distribution of solar technology.
- Singapore’s April to May IP was up 2.1 percent in growth, better than the market consensus of 2 percent, and rising 1.2 percent sequentially.
- The Philippines’ current account surplus soared to 5.3 percent of GDP in the first quarter this year. Besides most of the current account surplus being attributed to resilient remittance, it was surprising to note that the trade deficit was 42.9 percent lower year-over-year. This helps to alleviate fears that the recent fund net outflow can cause instability in its currency.
- South Korea’s current account surplus widened to a record, with favorable exports to the U.S. and other emerging markets. The news is welcome as it dissipates fears of a weaker Japanese yen, reducing the competitiveness of South Korean exports. As a result, the finance minister increased the country’s 2013 GDP forecast to 2.7 percent from 2.3 percent.
- Earlier in the week, the outflows from emerging markets reached their fastest pace in two years as the prospect of less global stimulus depressed currencies from India to Brazil. Nearly $20 billion left emerging market funds this month up until June 26, the largest monthly outflows recorded, according to Morgan Stanley. Despite the International Monetary Fund (IMF) cut in its prediction for developing nation growth to 5.1 percent from 5.5 percent, the growth prospects remain very favorable when compared with the 1.2 percent projection for advanced economies. Thus, the selloff in emerging markets, which has left stocks deeply in oversold territory, may provide a compelling entry point for contrarian investors.
- India’s rupee plunged to a record 60.76 per dollar as investors fled currencies in countries with sizeable current account deficits in favor of the U.S. dollar. The currency weakness adds to inflationary pressures as the government may widen the fiscal deficit to make up for lower monetary flexibility, without having a positive effect on the current account deficit.
- Mainland news said some Chinese banks have tightened mortgage lending amid the liquidity crunch. Several banks in first-tier and second-tier cities like Beijing, Shenzhen and Hangzhou have removed the lending rate discount for first-time home buyers.
- Fitch expects more than 1.5 billion yuan in wealth management products (WMP) to mature next week. Chinese banks are asked to de-leverage from WMP and trust loan investments, which is part of the credit expansion curb to rein in financial risks.
- Thailand’s May exports were down 5.25 percent versus up 2.89 percent in April, coming in below the consensus -4.7 percent. The weakness was mainly from the slump in exports of agricultural and electronic goods. Imports fell 2.1 percent.
- Bond yield went up across Asia, including China, which will increase the cost of corporate financing.
- Hong Kong’s exports growth unexpectedly relapsed to a 1 percent decline in May, which is lower than the consensus of 0.5 percent. Imports growth also came in weaker than expected at 1.7 percent.
- Midweek, the MSCI Emerging Markets Index was headed for the worst first half since 1998. The index has trailed the MSCI World Index of developed nation stocks by 21 percentage points in 2013 through June 21, the biggest gap in 15 years. The emerging markets index now is valued at the biggest discount since 2005, according to weekly data compiled by Bloomberg. The chart below shows emerging markets have fallen to the buy region, and to oversold levels not seen since August 2011. The alert triggered by emerging markets this week has been followed by strong, positive corrections in the past.
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- Mexico is beginning to beat China as a manufacturing base, according to a new report from Boston Consulting Group. The report cites manufacturing wages, adjusted for superior worker productivity, are likely to be 30 percent lower than in China by 2015. In addition, Mexico has more free trade agreements than any other country. Besides the North American Free Trade Agreement (NAFTA), which gives Mexican goods easy access to the U.S. and Canada, the country has free trade agreements covering 44 countries. That’s more than the U.S. (20) and China (18) combined.
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- As shown in the graph above, tourism business is booming in South Asia. In particular, the Tourism Authority of Thailand reports May 2013 tourist arrival growth of 19.4 percent. Thailand is expanding airport capacity to accommodate increasing tourism demand. Tourism demand also helps restaurant and hotel businesses in Thailand.
- Poland is seeking to overhaul its pension system in order to curb the country’s public debt, as the country battles its worst slowdown in 12 years and tax revenues fall short of plan. The plan is likely to eliminate the present structure which relies on a second “pillar” of privately managed pension funds. Poland’s finance minister argued the current system is a gigantic burden on public finances, and recommended transferring the 16.2 million Poles enrolled in second-pillar funds back to the state-run pension system. Goldman Sachs notes the pension reform could have positive growth effects by relieving pressure on the fiscal budget. However, the reform increases longer-term fiscal risks and puts less pressure on the administration to push ahead with much-needed structural reforms.
- China is in the process of wide banking system de-leveraging by curbing credit growth in the form of shadow banking, which is part of a call by Premier Li Keqiang to use the expanded credit in the last few years in the real economy. The process may reduce loans to property developers and local governments. In turn, it may cause a lending rate increase, an increase in corporate financing costs, and a reduction in profitability. For the equity market, a cut-back on money supply will de-rate stock valuation.
- Russia will downsize the privatization program of its state-controlled enterprises in the next three years, bringing revenue from asset sales to 630 billion rubles ($19 billion), instead of the originally planned 925.9 billion rubles. The delays are being caused by “the energetic lobbying of individual agencies and individual officials,” according to Prime Minister Dmitry Medvedev. The government continues to rely on state-controlled companies’ hefty dividends to help finance its fiscal budget, at the cost of depriving them from investing earnings in increasing their productive capacity.
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