Warning: Market Correction This Week? Did You See the Opportunity?
While stocks fell around the world this week amid growing concerns over global economic growth, Europe’s slowdown can’t stop emerging market population growth that drives long-term commodity demand. If the short-term market volatility concerns you, a solution is short-term tax-free municipal bonds. Check out the 5 Reasons Why.
Putting Capital to Work in Commodities for the Long Term
This week we saw a continued selloff in energy stocks and a slump in commodity prices, specifically oil. In light of this, I’ve highlighted some key points I made during last week’s webcast that might offer our investors some clarity and insight into our management strategy when such market nervousness occurs.
One of the main drivers of commodity demand, as I often point out, is PMI, or purchasing managers’ index:
PMI: Commodities’ Crystal Ball
You look at the stock market as a precursor to economic activity six months out. If you’re looking at commodities, you must be looking at PMIs.
What our research has shown is that there is a 60- to 80-percent probability of commodities and commodity stocks rising when the global PMI’s one-month reading is above the three-month trend. When its one-month is below the three-months, there is a high probability of these sectors and stocks falling over the next six months.
The global PMI reading is a composite of each country’s unique PMI. So we look at individual countries and try to gauge what their monetary and fiscal policies are going to be. These government policies have a high correlation to commodity demand, which is significant to resource investments.
Brian Hicks, portfolio manager of our Global Resources Fund (PSPFX), stepped in to share his thoughts on the resources sector, devoting special attention to the recent performance of crude oil.
Despite the recent selloff, I believe it's actually an excellent time to be looking at resource stocks and energy stocks in particular.
The Polarity of the Dollar and Crude Oil
The following chart mathematically depicts the oversold nature of crude oil:
The dollar is significantly overbought relative to crude oil. The dollar is up almost two standard deviations, crude oil down almost one standard deviation. History has shown, whether it’s in 2011 or 2012, that this has been a good time to buy crude oil.
Natural Resources Stocks Priced to Move
Another factor that gets me excited about these energy stocks and natural resource stocks is the metrics that we’re seeing from a fundamental standpoint. Looking at the top 50 holdings for our Global Resources Fund, what jumps out immediately is just how cheap these stocks are relative to their growth rate, trading at 20 times in the last quarter earnings. Sales were growing at over 20 percent.
These companies are very profitable, generating return on equity of 25 percent, paying a dividend yield on average—about 2.7 percent—and growing that dividend at about a 30-percent click. And as you can see, these stocks have outperformed the S&P 500 Index so far year-to-date (YTD), even with this pullback.
A Thirst for Oil
Looking at global oil demand, you can see it’s been unrelenting through recessions, through bull markets, bear markets, and it looks like it’s going to continue to go up at a fairly steady level based on latest data from the U.S. Energy Information Administration (EIA).
Below is a very important point to consider. Where oil prices are now, we’re getting to the area where production could be cut off because prices are not high enough to incentivize new development, new production and new drilling.
If you look at crude oil price somewhere in the area of $80 to $90, we have about 650,000 barrels per day of production that need to be supported at that particular level. So we really can’t go too much lower in terms of pricing. Otherwise, we would see a significant drop in the supply of oil.
Just to give you a sense of the scale here, we’re expected to grow demand by one million barrels per day, and we have 650,000 barrels that need an oil price north of $80.
Pricing Black Gold to Stay in the Black
Another significant factor is the price that’s necessary for countries that produce crude oil or export crude oil out of the Organization of the Petroleum Exporting Countries (OPEC) or non-OPEC.
On average, you need to see $95-per-barrel prices in order for these countries to balance their budgets—their fiscal budgets. What really sticks out is Russia and Saudi Arabia. They’re the two largest exporters of crude oil and, as you can see above, Russia requires an oil price north of $100, Saudi Arabia right at about $95 per barrel on a Brent basis, and we’re below that number now.
The next OPEC meeting is in November. I would be surprised if we did not see another production cut if oil prices remain at these levels. I think that OPEC and the Saudis need to come in and support prices even more so than they already have following the cut in August.
U.S. Gushing Oil
One area that’s been very topical and interesting as of late is the growth in U.S. crude oil production. It’s at a new 25-year high.
We’ve gone from basically 4.5 million barrels in 2008 to 8.5 million barrels. Energy stocks are no longer just the commodity play. They’re also a volume growth play.
You can see this paradigm shift in that many of these shale producers have gone out and invested a lot of capital over the years and now, over the next two years or so, we’re going to start to see a free cash flow payback on that initial investment and infrastructure in fracking and developing their resource.
Because they’re going to start seeing free cash flow, I think there’s the potential we could get a rerating in multiples to that cash flow. Instead of trading four to six times, maybe we trade higher, somewhere between seven or eight times due to that positive free cash flow metric.
Commodities: A Value Play
Commodities have way underperformed other asset classes, bonds, U.S. equity, and we feel like this is where the value is at. This is the area where you can put capital to work for the long term and outperform, whereas some of the other areas such as in bonds or U.S. stocks may not perform as well.
There are pockets of strength within the commodity sector where I think we will see companies profit and do well. On the whole, given this pullback, I’m very optimistic about resources going forward.
No Faith in the G20 Central Bankers
This weekend the finance ministers and central bank governors of the world’s top 20 economies will meet in Washington to discuss, among other issues, Europe’s weak economic performance. The region, whose sluggishness has negatively affected the global market, is at risk of dipping into its third recession since 2008.
I have no confidence that this body can persuade Europe to act sooner rather than later to dig itself out of further economic hardship. As I’ve observed in my global travels, the G20 central bankers are not interested in promoting and facilitating trade among nations. Instead, they’re interested foremost in levying more taxes and imposing more regulations that actually impede international trade.
It’s Economics 101: Capital cannot be spurred or created with high taxes and strangulating regulations.
European Central Bank President Mario Draghi assures the media that the eurozone will recover soon, but as we wait, the region continues to underperform and drag the rest of the markets down with it. European growth in the second quarter was flat, and this quarter doesn’t look as if it will fare much better. France’s manufacturing sector has steadily contracted. Over the last 12 months, it’s seen only two PMI scores above 50, which would indicate expansion. Even usually-reliable Germany, the eurozone’s largest economy, is in the midst of a downturn.
The U.S. has been gradually recovering from its worst economic period since the Great Depression, and to continue this progress, we need strong trading partners. Investors have become impatient waiting for Europe to get its fiscal act together and stop trying to rationalize even more taxes and regulations.
If it weren’t for the U.S. and Canada propping up the rest of the world, Europe would likely be in a more depressed state than it already is.
Speaking of Canada: I want to wish all of my fellow Canadians a Happy Thanksgiving!
P.S. You can still catch the replay of last week’s webcast, which includes more on macroeconomics and a timely discussion of gold and gold stocks with portfolio manager Ralph Aldis.
- Major market indices finished lower this week. The Dow Jones Industrial Average fell 2.74 percent. The S&P 500 Stock Index dropped 3.14 percent, while the Nasdaq Composite declined 4.45 percent. The Russell 2000 small capitalization index fell 4.65 percent this week.
- The Hang Seng Composite rose 0.25 percent; Taiwan fell 1.54 percent while the KOSPI lost 1.78 percent.
- The 10-year Treasury bond yield fell 15 basis points to 2.28 percent.
Domestic Equity Market
The S&P 500 Index had two of the largest drops this week, yet the market action appears in line with standard volatility. The market continues to be affected by uncertainties on global growth, and the failure of global central banks to alleviate the doubts. The market held a small rally Wednesday afternoon after the Federal Reserve minutes were released, followed by the worst day in the market year-to-date. The bull market seems to be in effect.
- The REIT’s sector was the top performer this week as investors looked for a safe haven and a generally defensive area of the market. Bonds yields continue to lower on poor PMI numbers.
- Consumer staples rose against the market, as stocks such as Coca-Cola Enterprises, Monster Beverage Corp went against the trend. Utilities also outperformed with First Energy up over 4 percent.
- CareFusion Corp. was the best performer of the S&P 500, up 23.93 percent, followed by Becton Dickinson, up 10.39 percent, both medical equipment companies, whose industry showed some significant gains this past week.
- Technology was one of the worst performing sectors this week, as Micron Technology and Microchip Technologies called for a weaker outlook on the tech sector, which sent the whole sector tumbling
- The energy and materials sectors were also poor performers with a strong dollar and weak global manufacturing numbers. QEP Resources was down 16.1 percent and Chesapeake Energy was down 12.78 percent.
- Micron Technology, as mentioned above, was the worst performer for the week out of the S&P 500, down 18.12 percent
- The Fed’s minutes on Wednesday had a short-term positive impact on markets. Although it was minor news, their messaged proved to be more dovish than meaningful.
- U.S. financial majors begin reporting next week, including JP Morgan, Citigroup and Wells Fargo. With no negative news expected, the previous theme of the U.S. being a beacon in the developed world could continue to be bolstered.
- The overall market has proven so far to be resilient to weak global growth numbers, furthering the thoughts that we maintain a “classic” bull market phase.
- Continued weak numbers from Europe and China, along with lack of action from their corresponding central banks, continue to threaten the global growth outlook.
- With volatility on the rise, and the markets getting closer to the 200-day moving average, the threat to the U.S. bull market is becoming more real.
- Geopolitical tensions continue to remain high and while the market has been able to cope with these events so far, an escalation could be the catalyst for a long-awaited correction.
Treasury yields continued lower this week primarily on weak global economic data. The two- year Treasury fell sharply to near August yields lows of 0.42 percent. The main driver is a fear of a global slowdown and a stronger dollar posing a potential risk to the U.S. economic outlook. The 30-year bond fell Wednesday before the U.S. sold $13 billion of debt on Thursday.
- The U.S. dollar had its first down week since early July. It ended the week, however, on an upward trend
- Treasury notes posted the biggest weekly gain in 13 months on the Fed’s dovish view
- Canada’s jobless rate falls to a six-year low, similar to recent employment data out of the U.S.
- Looking around the world, the manufacturing purchasing managers indexes (PMIs) generally disappointed. Europe was weak, China was just as expected and the U.S. disappointed.
- The European Central Bank took a wait-and-see approach that disappointed the market, which wanted a more definitive QE plan of action. This news has greatly affected Germany as its market has fallen nearly 8 percent on recession fears.
- Finland lost its top rating as S&P cut the country’s rating to a AA+, citing a weak economy, as the euro region bonds yields fell this week to record lows, further signaling a slowdown. Italy fell on fears of being downgraded to junk status.
- U.S. fixed income yields are relatively attractive and will likely attract money flows from overseas.
- Consensus among traders, according to Bloomberg, is moving toward the point that the Fed will not tighten as previously expected by July 2015.
- With key global central banks back into easy policy mode and inflation trending lower in many parts of the world, the path of least resistance for bond yields likely remains down.
- With both Romanian and Polish central banks looking toward a rate cut, the U.S. economy is going to have spillover from global pressures with a strong dollar and low interest rates.
- The U.S. economy does have some positive momentum and appears poised to continue to build on that as we move into the fall. If the economy gains strength, it could force the Fed’s hand.
- The geopolitical situation remains unsettled and a flare up could occur at any time.
For the week, spot gold closed at $1,223.09, up $31.74 per ounce, or 2.66 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 0.24 percent. The U.S. Trade-Weighted Dollar Index fell 0.90 percent for the week.
|Oct 15||Germany CPI YoY||0.8%||--||0.8%|
|Oct 15||US PPI Final Demand YoY||1.8%||--||1.8%|
|Oct 16||Eurozone CPI Core YoY||0.7%||--||0.7%|
|Oct 16||US Initial Jobless Claims||290K||--||287K|
|Oct 17||US Housing Starts||1005K||--||956K|
- After the one-week holiday, Chinese consumers returned to the gold markets. Gold futures rose this week as many anticipate the Chinese will take advantage of lower gold prices. Indeed, gold seemed to withstand recent decreases in oil prices as well as increases in the dollar, implying that many investors are taking advantage of the bargain prices. On Friday, the Bank Credit Analyst highlighted that gold prices are unlikely to break down after successfully bouncing off support at $1,200 and are poised to stage a relief rally into the end of the year.
- Franco-Nevada Corp. has entered into an agreement with Lundin Mining Corp. to acquire a gold-silver stream. Lundin recently purchased an 80-percent interest in Freeport-McMoRan’s Candelario/Ojos del Salado mining complex in Chile.
- There was a significant amount of positive news from many companies this week. Balmoral Resources Ltd. reported that its drill results revealed a higher-grade potential at its Martiniere property. Romarco Minerals, Inc. received its awaited 401 Water Quality Certification for its Haile project. Lastly, Richmont Mines raised its gold output view to 85,000-90,000 ounces, claiming strong performance from Island Gold mine.
- This week, Deutsche Bank recommended shorting gold due to the strong dollar environment.
- A continuation of the prevailing socialist model in South America, Chile’s Supreme Court granted a petition by the Diaguita communities to overturn a resolution to develop the El Morro gold-copper project joint venture (JV) in Chile. This is the third time Goldcorp’s El Morro project has been suspended in three years.
- This week Luna Gold established a special committee of independent board members to look into strategic alternatives. The stock tumbled as much as 30 percent on the news.
- Multiple opportunities relating to the Swiss National Bank Gold Initiative:
- Switzerland has decided to hold a vote on the initiative, which would force the central bank to hold at least 20 percent of its assets in gold. The initiative, scheduled for a November 30 vote, would forbid the sale of any holdings and require them to be held in Switzerland.
- If passed, the Swiss National Bank would have to buy roughly 1,500 tonnes of gold over five years to meet the 20-percent requirement. Since 1993, the Bank has reduced its gold holdings by 1,550 tonnes, the largest liquidation by any central bank. Changing from the largest seller to a rapid buyer should create serious tailwinds for gold.
- The initiative put forth in Switzerland is part of a larger theme relating to increased gold purchases by central banks. Global central bank reserve holdings had been declining without interruption since 1989 until the financial crisis. Since 2008, there has been a steady rise in central bank gold holdings. With the possibility of substantial purchases from the Swiss National Bank, this rise should continue.
- This week, BMO Capital Markets, Morgan Stanley and ANZ all reinforced their negative outlook for gold prices. While this consensus is negative, such wide consensus agreement usually coincides with a reversal in the going trend.
- The World Gold Council is calling on India to mobilize and monetize its household savings imbedded in physical gold stocks. If the Indian government decides to use the idle gold from households and temples, it would reduce the need for future imports, which would be negative for global gold demand.
- Uncertainty from residents of the Mokopane area in the northern Limpopo province of South Africa is threatening to hold up Robert Friedland’s platinum project. The billionaire promised the residents a 20-percent stake in the project, but the residents remain unsure of the exact method of repayment for the project.
- The dollar saw its first weekly decline this week since early July, falling 0.91 percent. The recent and rapid rise of the dollar has caused a global selloff in commodities. Therefore, its recent downturn could spur a significant rally in the global resources space.
- Precious metals rallied this week on the back of a weaker dollar and more dovish Fed minutes. After a severe downturn in precious metals, one can see a potential rally on the horizon. Gold, platinum and palladium were up 2.47 percent, 2.97 percent, and 4.17 percent respectively.
- Fertilizers and packaged food stocks were relative outperformers this week. The two defensive areas tend to outperform in a stronger dollar environment and have weathered the recent storm fairly well.
- Oil explorers and producers fell heavily this week as global crude oil prices sunk to their lowest levels in two years. However, given the extent to which oil has fallen and OPEC’s incentive to intervene, oil may have reached a bottom. The S&P Supercomposite Oil & Gas Exploration and Production Index declined 8.01 percent this week.
- The decline in explorers and producers stocks has negatively affected oil and gas equipment and services stocks as well. Poor performance has reduced capital expenditure expectations for 2015, weighing on pressure pumpers, drillers and fracking sand companies. The S&P Supercomposite Oil & Gas Equipment and Services Index fell 6.43 percent this week.
- Diversified metals and mining stocks continued their decline this week as global growth scares have not mitigated. The economic outlook report issued by the International Monetary Fund (IMF) this week made matters worse, as it cut the global GDP growth forecast by 0.2 percent. The S&P/TSX Capped Diversified Metals and Mining Index fell 7.74 percent this week.
- According to the 14-day relative strength index (RSI), many global energy stocks have never been this oversold. The unusually rapid decline in global resource stocks, while negative, also provides an opportunity to buy at lower prices. If the RSI is any indicator of when to purchase and sell stocks, now is certainly the time to buy.
- The July Organisation for Economic Co-operation and Development (OECD) crude and product inventories are 1 percent below 10-year norms. This is a supportive crude oil data point as the market looks to higher demand in the winter months.
- OPEC is planning to hold a meeting at the end of November to discuss the decline in global oil prices. Well below their target of $100 a barrel, many members of the oil cartel are calling for supply cuts to boost prices. Time will tell to what extent OPEC intervenes in the global oil markets, but it is likely that they will take some measures to boost crude prices.
- The number one threat facing commodities continues to be a strong U.S. dollar, which has appreciated more than 7 percent since the start of July. The possibility of a near-term pause or consolidation of the dollar still exists, despite its decline this week.
- Despite positive economic data from the United States, markets remain worried about growth in Europe and China. This week’s gloomy economic outlook report from the IMF speaks to the real threat being posed by slowing global growth, which in turn threatens commodities, especially to industrial metals.
- Election news out of Brazil actually had extremely positive results this week, boosting the country’s currency and equities. The first runoff election results revealed that Aecio Neves, a strong pro-business candidate, came in second to the incumbent Dilma Rousseff. The next runoff election between the two remaining candidates is scheduled for October 26, and recent polls are showing a close race. After weeks of disappointing poll data out of Brazil, the recent news is a tremendous relief for investors. The Bovespa Index was up 1.78 percent this week.
- Vietnam continued to decouple from the rest of Asian markets this week as one of the best performers. Growth in domestic vehicle sales remained elevated at 52.8 percent year-over-year in September. Moody’s gave six banks in Vietnam positive ratings, citing stabilization in the operating environment.
- The dollar had its first weekly decline since early July, falling 0.89 percent this week. The eagerly anticipated decline in the dollar appears to be occurring, which should alleviate many of the headwinds facing emerging markets and their currencies. The Brazilian real, the South African rand, and the Polish złoty all saw their currencies rally this week alongside the declining dollar.
- Emerging market funds reported outflows of $3.49 billion for the week ending October 8, 2014, the largest weekly amount since March. A significant amount of outflows, roughly $2 billion, came from exchange-traded funds (ETFs), while China reported the largest outflows, totaling almost $1 billion.
- Greek equities suffered again this week as investors remain concerned over the stability of the country’s banking system. Political factors continue to play a large role as well, as Prime Minister Antonis Samaras held a confidence vote on Friday to head off the opposing party’s attempts to force a snap election. The opposition Syriza party, which is proposing fiscal reforms that would bring the country’s fiscal position back into a deficit, has gained considerable public support. A fiscal policy shift in Greece is viewed negatively given the country’s recent history. Furthermore, the current government remains determined to exit its financing contract with the troika early, claiming that the country’s financial position is solid. Markets, however, appear to be unconvinced. The Athens Stock Exchange declined 4.27 percent this week.
- South Korea was the worst performing Asian market this week, as bellwether Samsung Electronics Co. Ltd. announced disappointing preliminary results for the third quarter. There was little sign of reprieve for the ongoing weakness of its smartphone business, as rising competition from Chinese peers put pressure on its profit margin.
- The Federal Reserve minutes released this week highlighted the growing concern over slowing global growth. Many are viewing this consideration as support for a more dovish Fed stance, which implies rates will remain low for quite some time. If this proves true, the dollar should face downward pressure, which would be positive for emerging markets and global growth.
- As part of the growing theme of global monetary stimulus, the Polish government cut its benchmark rate to an all-time low this week. While the policy move is not necessarily positive for the Polish banking system, the boost in monetary stimulus should help foster economic growth in Poland.
- Smoggy weather has staged a comeback in northern China including Beijing lately, with demonstrably lower daytime visibility. China’s health care- and clean energy-related companies might be able to regain their leadership with the upcoming drafting of China’s 13th Five Year Plan, where environmental protection and pollution control is expected to claim policy priority.
- On Tuesday, the International Monetary Fund (IMF) downgraded its outlook for global growth in 2015 from 4 percent to 3.8 percent. The IMF cited reduced growth in Germany, France and Italy and warned that the probability of the eurozone heading into a recession in the next six months has roughly doubled since April. Growth slowdowns are not limited to the eurozone, as China, Brazil and Russia are all expected to see reduced growth. A weaker eurozone and China implies reduced imports from emerging markets for raw materials and consumer goods.
- The Fed is expected to officially halt its quantitative easing (QE) program on October 15. The completion of the program will reduce the degree of monetary stimulus in the U.S. economy, which could put upward pressures on rates and the dollar, negatively affecting emerging markets.
- Political jostling intensified in Indonesia ahead of President-elect Joko Widodo’s October 20 inauguration, ranging from the opposition party’s appointment of the Speaker of the House to the former president’s potential appointment of professional politicians as cabinet members. Foreign investors have been significant net sellers of Indonesian equities for the past four weeks, and rising skepticism may continue to weigh on market sentiment whether Widodo can still deliver on reform agenda.
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