Have Winds Shifted to Provide Relief to Investors?

 

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

 

 

Wind currents between the ocean and atmosphere affect climates around the world; likewise, government policy shifts and economic data have a similar ripple effect on markets.

During our Outlook 2012 webcast yesterday, our listeners heard a very passionate John Mauldin assess the debt situation in Europe, Japan and the U.S. and the need for immediate policy change. If you listened in, you may have wondered what economics and politics have to do with investments.

That’s a valid thought, as many investors hear predictions of which way the market will go or what stocks will outperform. As I often remind my readers, it’s not about political parties, it’s about the policies. And history says that government policy shifts can have a tremendous affect on the economy and the markets. While no one can predict the future, you can use probability in your favor.

For example, Chinese stocks have historically moved with money supply. In the webcast, Analyst Xian Liang showed the chart below plotting the year-over-year money supply in China against domestic B-shares (represented by the MSCI China Index) since the end of 2000.

The Chinese government is known for acting decisively in making policy changes to steer its economy in the right direction. In 2009, the growth in money supply was at an 11-year high of 30 percent after the government lowered the required reserve ratio (RRR) for major banks. Adjusting the reserve requirement is important inflation-fighting tool in China’s monetary policy. The lower the reserve requirement, the more money banks are able to lend out.

Throughout 2011, due to concerns about inflation, China had been raising the reserve requirement for banks and interest rates. This action reduced money supply to the low we see in the chart. This December, China shifted its stance as slow growth became a risk and inflation slowed. This action should increase money supply, and encourage markets, going forward.

China also recently announced an earlier-than-expected windfall profit tax cut for its oil companies. This special oil income levy raises the level at which a barrel of oil is taxed, going from $40 to $55. This $15 difference essentially translates to a substantial tax break for oil companies and extra money in their coffers.

Research firm Jefferies expected the tax adjustment, but thought that it would happen at the end of 2012. With this tax cut, it appears the government acknowledges the need for Chinese upstream oil companies to increase their cash flow so that they can increase domestic production, says Jefferies.

This tax cut was closely followed by analysts, and was seen as a “big positive” for China’s oil companies, specifically CNOOC, PetroChina and Sinopec, says Citigroup Global Markets. The market promptly responded positively, with each stock rising on the news.

Another economic measure that has a ripple effect on global markets is the Purchasing Managers’ Index (PMI), an indicator of manufacturing strength. We follow this index closely, as it is considered a leading indicator, meaning the markets react over the following three months after the PMI data is released.

As of December 31, the JP Morgan Global Manufacturing Purchasing Managers’ Index (PMI) crossed above the three-month moving average. Going back to the inception of the index in 1998, there have been 20 occurrences when the one-month number crosses above the three-month. When this has happened, it’s signaled higher prices for many commodities, especially oil, copper, and to less of a degree, materials and energy.

For copper, historically, 90 percent of the time, the price was positive over the next three months, with a median return of 10 percent over the following three months.

During the same three months, 85 percent of the time, West Texas Intermediate oil has also gone up. Its median three-month change has been an increase of 11 percent.

Materials and energy were also positively affected, with modest results: When the PMI crosses above the three-month average, 70 percent of the time, the S&P 500 Materials Index rose, with a median return of about 3 percent. The S&P 500 Energy Index had a median three-month return of about 5 percent, with an 80 percent chance of the three-month change being positive.

We believe the winds are shifting to bring needed relief to global investors. We’ve seen improving economic data from the U.S. lately, and this positive news from the world’s largest economy, along with an improving China—the world’s most populated country—offsets the negativity in Europe.

What’s the probability of the U.S. market heading higher in the year of a presidential election? Register today for our webcast next Tuesday to hear from Jeffrey Hirsch of the Stock Trader’s Almanac, the annual resource that countless money managers, traders and investors have come to rely on. We’ll discuss Jeffrey’s nearly 50 years of market research, along with the many other historical indicators such as the January Barometer and the Santa Claus Rally. Sign up now.

 

Index Summary

• The major market indices were higher this week. The Dow Jones Industrial Average rose 1.17 percent. The S&P 500 Stock Index increased 1.61 percent, while the Nasdaq Composite gained 2.65 percent.
• Barra Value outperformed Barra Growth as Barra Value finished 2.04 percent higher while Barra Growth gained 1.25 percent. The Russell 2000 closed the week with a gain of 1.19 percent.
• The Hang Seng Composite finished higher by 0.25 percent, Taiwan rose 0.68 percent, and the KOSPI gained 0.95 percent.
• The 10-year Treasury bond yield closed 8 basis points higher at 1.96 percent.

 

Domestic Equity Market

 

The domestic stock market as measured by the S&P 500 Index was higher this week by 1.67 percent. The best-performing sector for the week was materials which rose 3.82 percent. Telecom services was the worst-performer, down 2.73 percent.

Something that may have flown under the radar of many investors is the recent outperformance of the regional banks. The large money center banks tend to get all the attention in the media and most of that attention has been negative. Yet over the past few months regional banks have outperformed and this is one more positive confirming factor that the economy may be in better shape than many investors currently believe.

 

Strengths

• Fertilizer and agricultural chemicals was the best-performing group for the week, up 8.9 percent, led by Monsanto. Monsanto reported earnings this week and beat estimates on strong demand for genetically modified seed corn.
• The building products group outperformed by gaining 8.8 percent, led by the group’s single member, Masco Corp. November construction spending rose 1.2 percent and there is renewed hope that housing is finally turning the corner.
• The auto manufacturing group outperformed, led by the group’s single member, Ford. Ford rose 8.8 percent on strong industry-wide December auto sales. Ford’s sales rose 10 percent.

Weaknesses

• The wireless services industry group was the worst-performing group, down 6.7 percent as MetroPCS Communications fell 7.6 percent. The stock fell on disappointing fourth quarter subscriber growth.
• The home entertainment software group lost 4.4 percent on weakness in Electronic Arts. The stock dropped on concerns its new massive multi-player online game “Star Wars: The Old Republic” was not sustaining its early momentum.
• The general merchandise group fell 3.8 percent as Family Dollar declined 7 percent. Family Dollar reported earnings that essentially met expectations but concerns around narrowing gross margins drove the stock lower.

Opportunities

• U.S. economic data remains surprisingly strong and increases the odds that economic momentum can be maintained.

Threats

• An escalation in concerns over sovereign debt obligations in Europe would be negative for stocks.

 

The Economy and Bond Market

 

Long-term treasuries sold off this week sending yields higher as; once again, the schizophrenic market gyrates up one week, down the next, for over a month.

The sell off in treasuries this week could best be attributed to better than expected economic data. While there remains concern surrounding the ultimate outcome of the current European financial crisis, the market was able to put that anxiety to the side this week. The chart below depicts the JP Morgan Global PMI index which hooked up in December and is back into expansion territory. This is an interesting development as sentiment remains sour but the economic data is giving reason for optimism.

 

Strengths

• The unemployment rate fell to 8.5 percent as nonfarm payrolls expanded by 200,000 in December.
• The ISM manufacturing index increased more than expected and posted a solid gain in December. One particularly encouraging sign is the new orders sub-component hit the highest level since April.
• Factory orders in November rose 1.8 percent and is another factor confirming the strength in the manufacturing sector.

Weaknesses

• Overnight deposits with the European Central Bank hit a record high as banks are still unwilling to lend to each other in the overnight interbank market. This indicates significant lack of confidence in the European banking sector.
• The euro fell to the lowest level in more than a year as investors concerns build regarding the ultimate outcome in Europe.
• France plans on increasing its value-added tax (VAT) in the next few months even as a rate increase just took effect January 1.

Opportunities

• After surprisingly good economic news recently, next week’s December retail sales data will be the key economic data point to watch for continued confirmation.

Threats

• The situation in Europe remains extremely fluid and negative news is almost expected at this point, unfortunately it is politically driven and difficult to predict outcomes and ramifications.

 

Gold Market

 

For the week, spot gold closed at $1,617.95 up $54.25 per ounce, or 3.5 percent. Gold stocks, as measured by the NYSE Arca Golds BUGS Index, gained 3.7 percent. The U.S. Trade-Weighted Dollar Index rose 1.4 percent for the week.

 

Strengths

• Junior tiered mining stocks outpaced the senior peers by almost a two-to-one margin this week, demonstrating excellent relative strength in the first week of trading. Much of this can be attributed to the end of tax-loss selling. Seasonally, the January Effect seems to be on a good start.
• Rio Alto came out with its much anticipated updated resource statement for its La Arena project in Peru. Rio Alto added 434,000 ounces of gold in contained metal to oxide resources in some 25,000 meters of new drilling; bringing measured and indicated resources at La Arena up 41 percent to 1.5 million ounces of gold at a grade of 0.46 grams per ton. The market reacted positively to these results, up 14 percent for the week.
• The U.S. Department of Labor’s Mine Safety and Health Administration reported its second lowest number of mining deaths in a century for the past year.

Weaknesses

• India’s gold imports tumbled to 35 tonnes in December, from the 75 tonnes recorded a year earlier. The country’s imports for November also fell 75 percent from the same period a year ago, with only 20 tonnes imported recorded. Higher prices, a week rupee, and increasing inflation for the country are all drivers of the decrease in sales and imports.
• Rye Patch Gold slid 22 percent for the week largely on drilling results from its Garden Gate Pass Project that was a technical success in intersecting the right host rocks, which are on trend with Barrick Gold’s Red Hill/Goldrush discovery announced earlier in the year, but these holes only carried anomalous gold.
• Peru’s overall gold production slid 12.22 percent for the month of November, and cumulatively from January to November 2011, fell 1.17 percent. Silver and copper production also fell 6.45 percent and 1.72 percent cumulatively from January to November 2011.  

Opportunities

• Peru’s government, which has been making a considerable effort to curb anti-mining protests that are threatening the mining industry in the country, said that companies now must set up an environmental conservation fund as part of future contracts. The fund will be used should any damage be done to natural surroundings in protest-related events. The Cabinet Chief, Oscar Valdes, said that they will also create an office in charge of settling social conflicts related to mining and other industries. After Peru’s new president ran for office on somewhat of an anti-mining platform, he has to come to terms with the fact that mining is the county’s biggest source of revenue and wealth cannot be created without jobs.
• According to Frost & Sullivan, the world’s second-largest gold jewelry market, China, may boost gold consumption by 35 percent in 2012, on rising income and continuing urbanization. Factors such as demographics and proliferation of wealth will be driving the increased demand.
• Gold retailers in India have now taken a new incentivized approach to selling gold, luring in buyers with the promise of an iPad and allowing citizens to buy gold using their credit and debit cards. "Earlier we used to give 10 percent discount, or silver idols or free pendants. We have now moved to smaller electronic items to bring in more footfalls,'' said Saumesh Gargi, a gold retailer in Mumbai's teeming Zaveri Bazaar. An iPad was given to the highest gold jewelry transaction through credit or debit every hour at a retail shop in Mumbai during the festive season.

Threats

• The Environmental Protection Agency released its Toxic Release Inventory (TRI), reporting the United States’ metals mining as the largest contributor of toxic chemicals released into the environment of 2010. Contrary to this, the National Mining Association maintains that nearly 85 to 90 percent of the substances reported by mining operations for the TRI inventory occur naturally in the local rock and soil.
• Readers should be aware that it is only after the rock containing these naturally occurring elements is loaded into a truck and moved that the reclassification of the rock to toxic material is triggered. The latest TRI report showed that 3.93 billion pounds of toxic chemicals were released into the environment, a 16 percent increase from 2009. Ironically, if one considered all the soil and sediment that is moved by rivers and streams each year for which the EPA regulates these waterways, then the EPA itself would likely be the largest polluter of toxic materials in the U.S.
• HSBC and Barclays cut their 2012 gold price forecasts by more than $100 per ounce, but still uphold their bullish view on the precious metal. The change in forecasts came after gold posted a gain of 10 percent last year, and although it maintained its 11th consecutive year of gains, it was the smallest annual gain in three years. James Steel, HSBC’s chief commodity analyst, cut his 2012 forecast to $1850 per ounce from $2025, attributing the euro weakness, liquidation related to equity losses and a slump in physical demand from emerging markets. Mr. Steel, however, did keep his 2012 silver forecast unchanged at $34 an ounce.

 

Energy and Natural Resources Market

 

Strengths

• First Quantum Minerals Ltd. resolved a long-running dispute with Eurasian Natural Resources Corporation Pls (ENRC) for $1.2 billion over mines in the Democratic Republic of the Congo (DRC). The controversial dispute over ownership of the Kolwezi project will be settled with ENRC paying $750 million plus a deferred consideration of $500 million as part of the settlement with First Quantum, the former owner of the project until its license was revoked by the DRC in 2009.
• Crude oil futures (WTI) moved higher by nearly 3 percent this week to close at $101.56 per barrel as geopolitical tensions surrounding Iran continued to escalate.
• Barclay’s highlighted that China raw coal production in November rose 4.4 percent year-over-year to reach 321 million tonnes while total output in the first 11 months of the year rose 11.6 percent to 3.46 billion tonnes.

Weaknesses

• Weekly data released by the U.S. Department of Energy indicates that 4-week trailing total demand for oil and oil products is down 7.2 percent year-over-year and gasoline demand is down 4.9 percent year-over-year.
• Alcoa Inc., the biggest U.S. aluminum producer, will close 12 percent of its global smelting capacity after the price of the lightweight metal slumped amid a global surplus.
• Indonesia, the world’s largest exporter of power-station coal, cut the benchmark price for sales in January by 3 percent to the lowest in 13 months. The Directorate General of Coal and Minerals at the ministry said on its website today in Jakarta that the cost of coal with a gross energy value of 6,322 kilo calories per kilogram was set at $109.29 a ton on free-on-board basis at vessel compared with $112.67 a ton in December.

Opportunities

• This week on the front page of the Financial Times, it was reported that a cut in Saudi posted prices to Asia is seen as a signal that Asian buyers are looking for new sources to reduce their dependence on Iran as U.S. pressure builds over sanctions. However, RBC Capital highlighted that Saudi looks to be the most willing to offer incentives, as International Oil Daily reports that the United Arab Emirates has increased February prices, albeit only by a nominal 2 cents per barrel.
• The Chairman of the China Iron and Steel Association said this week that China's total apparent crude steel consumption is expected to rise about 4 percent to 700 million tonnes this year.
• Tudor Pickering reported that preliminary estimates show global oil production rebounded significantly quarter-over-quarter following third quarter maintenance. Biggest estimated additions quarter-over-quarter are Libya with 418,000, United Kingdom with 111,000, and Brazil with 109,000 barrels per day.
• BofA Merrill Lynch global investment strategist raised energy and gold commodities to overweight in its tactical asset allocation model for the first quarter of 2012. In their view, energy is well supported by easy monetary policy and the risk of a spike due to geopolitical events. Their model continues to overweight gold due to high risk of a sovereign default in Europe and low/negative real interest rates around the globe.

Threats

• A potential short-term rise in pricing for Colombian coal may force European buyers to seek other sources. Heavy rains have led to a two week delay in coal transport from the mine site to the ports for Colombia’s two largest producers – Drummond & Prodeco. The rains have also resulted in reduced coal production at the mines for the two companies.
• Deutsche Bank highlighted that India’s gold imports, the largest consumer, is expected to drop by 48 percent in the first quarter as a decline in the currency boosts prices and high interest rates cool investment demand, according to the Bombay Bullion Association.
• Zhu Jimin, head of Shougang Group, one of China’s biggest steelmakers, addressed members at CISA's annual meeting, saying that prospects for the steel sector remained gloomy, with the entire sector facing falling profits in 2012. "Enterprises are facing increasing operating risks, under pressure from a variety of factors such as rising costs, falling demand and difficult and expensive financing," he said. Zhu said a series of policies introduced last year to control the real estate sector had reduced demand for steel, and if the policies were not adjusted the situation could worsen in 2012. Slowing growth in domestic manufacturing, railway, shipbuilding and auto sectors could also take its toll, he added.
• Resource Daily reported that Nigerian unions are calling for indefinite strike action on January 9 to shut down both the up and down stream oil sector. The strike is in reaction to the recent government decision to remove fuel subsidies which has seen gasoline prices double. In 2010 Nigerian production accounted for 13 percent of Shell volumes and 12 percent for Total, 10 percent for Eni and 2 percent for Statoil.

 

Emerging Markets

 

Strengths

• China’s December official PMI rose 1.3 percent to 50.3 from November’s 49. PMI above 50 indicates the manufacturing activities are at expansion. The better than expected PMI may indicate China is in a soft landing. China’s December non-manufacturing PMI also went up from 49.7 in November to 56.
• Central Huijin recently bought bank stocks to support the weak market.
• Debts issued by mainland companies increased by 52 percent to RMB 2.58tn in 2011
• Philippines headline inflation dropped to 4.2 percent year-over-year in December, better than expected. On Bangko Sentral’s own expectations, the inflation outlook for 2012 is benign, paving the way for monetary easing. On separate news, Indonesia’s December inflation rate also came down to 3.79 percent, better than expectation.
• The People’s Bank of China will not issue short-term bills before the Chinese New Year, indicating a required reserve ratio (RRR) cut after the holiday.
• The two-day National Commercial Work Conference will be closed today. The market expects some positive policy for home appliances, such as the trade-in policy implemented in 2009 to stimulate the economy.
• Hong Kong’s November retail sales rose 23.5 percent, higher than estimated 21.6 percent.
• China’s benchmark money-market rate declined the most since February of last year as Premier Wen Jiabo vowed to adjust policy to safeguard growth, spurring speculation lenders’ RRR will be cut.
• China Petroluem & Chemical Corp., Asia’s biggest refiner, said the Ministry of Finance increased the threshold for the nation’s oil windfall tax to $55 per barrel from $40 effective Nov. 1, 2011.
• Indonesia plans to spend $196 billion on infrastructure development during 2012-2025. Construction materials and engineering companies will benefit.
• The China Bank Regulatory Commission may delay the implementation of stricter rules for commercial lenders to the second half of this year and most likely to July, China Daily reports. The Chinese banking regulator had earlier announced tougher rules for lenders’ capital adequacy ratios which were to have taken effect at the beginning of this year, according to the report.
• Macau’s December gaming revenue grew 25 percent to MOP 23.6 bn, translating to 43 percent for 2011. In spite of a high growth rate, it had been coming down over the year, and the market was disappointed.
• Goldman Sachs sees a turnaround for China stocks by late first quarter, early second quarter.
• Chile’s economy grew 4 percent in November 2011 from November 2010, driven by gains in the retail and communications industries, offsetting declines in mining.

Weaknesses

• China's top four state banks extended new loans of RMB 210b in December, lower than expected. They also failed to meet their annual new loan target last year, Caixin Online reported.
• Property land sales in China decelerated, and December home prices dropped for the fourth month, Soufun (a housing website in China) says. The Chinese cities of Guangzhou and Nanjing may follow Shanghai and Chongqing in starting property taxes, Shanghai Securities News reports today. In fact in its recent article, People’s Daily, an official newspaper, had suggested property taxes structured to prevent housing market speculation is a way for the government to get out of the current housing tightening policies.
• By December 31, all Tier 1 cities and many Tier 2 cities have announced that they would continue to implement the Home Purchase Restrictions (HPRs) in 2012. Nevertheless, after interviewing housing officials, analysts in China believe HPRs may be lifted in the next several months when new house starts slow to a negative growth rate.
• China is considering imposing stand-alone carbon tax, separate from the environmental carbon dioxide tax, on materials companies, Economic Information Daily reported. Some analysts have thereafter checked with government officials and were told no such tax is currently considered.
• The Chinese premier Wen Jiabo said on his tour meeting corporate CEOs this week that the first quarter will be difficult for the economy. This might have been priced in by the market since it is clearly not new news.
• China had increased usage taxes for large vehicles; mid-range car sales will benefit. This may not deter those who can afford luxury cars.
• Fitch cut Hungary’s long-term foreign and local currency rating by one level after similar moves by Standard & Poor’s and Moody’s, saying there remained doubts whether the government will submit to conditions for aid from the International Monetary Fund and the European Union.
• Turkey’s December inflation spiked into double digits on lira depreciation, registering at 10.45 percent year-over-year, up from 9.5 percent in November. Additional to the inflationary effect, higher costs for food and tobacco contributed to the increase, which brought the 2011 average inflation to 6.47 percent. Roubini Global Economics noted that the central bank may continue to look past rising inflation, believing that its new variable interest rate policy may be enough and will tighten monetary conditions.
• The National Statistics Agency said that Brazil’s industrial production contracted the most since 2009, as it dropped 2.5 percent in November from a year earlier. The President and the Central Bank President are using stimulus measures including interest rate cuts, tax reductions and looser bank lending requirements to try to shore up growth.

Opportunities: China's Windfall tax reform is significant for the oil companies.

• After China raised its crude windfall tax threshold from $40 to $55, the earning per share improved from 10 percent for CNOOC to 16 percent for PetroChina, estimated by CITI Group, please refer the chart below.

• Roubini Global Economics highlighted that despite hostile policies towards investors, capital investments have been the fastest-growing segment in the Argentinean economy. Approximately 20 percent expansion rates have been driven from construction and the imports of capital goods.
• As we highlighted in our November-end Investor Alert, with likely sources of funding not being sufficient to cover the size of the European bailout fund, the European Central Bank had no choice but to follow in the footsteps of the U.S. Federal Reserve and expand its balance sheet. The BCA chart below shows deposits held by European banks at the ECB have skyrocketed, in a way reminiscent of what occurred after the Troubled Asset Relief Program (TARP) and the Fed’s QE1.

Threats

• The brokerage firms are now downgrading corporate earnings due to slower GDP growth in China, and therefore, the stock market will probably continue its volatility in the near term unless China cuts RRR aggressively and implements fiscal stimulus policies in the first quarter.
• Recent days have seen very heavy rainfall in Brazil’s Minas Gerais state, the heart of the iron ore mining industry. While this has not yet fed through into major weakness in shipping data, it does promote the likelihood that the first half of 2012 Brazilian iron ore exports will follow the historical pattern of falling approximately 10 percent sequentially during the first calendar quarter.

 

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