What the Next Decade Holds for Commodities

 

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

What a decade! A rapidly urbanizing global population driven by tremendous growth in emerging markets has sent commodities on quite a run over the past 10 years. If you annualize the returns since 2002, you find that all 14 commodities are in positive territory.

A precious metal was the best performer but it’s probably not the one you were thinking of. With an impressive 20 percent annualized return, silver is king of the commodity space over the past decade with gold (19 percent annualized) and copper (18 percent annualized) following closely behind.

Notably, all commodities except natural gas outperformed the S&P 500 Index 10-year annualized return of 2.92 percent.

Last year did not seem reflective of the decade-long clamor for commodities. In 2011, only four commodities we track increased: gold (10 percent), oil (8 percent), coal (nearly 6 percent), and corn (nearly 3 percent). The remaining listed on our popular Periodic Table of Commodity Returns fell, with losses ranging from nearly 10 percent for silver to 32 percent for natural gas.

Download a pdf of the commodity table here

I think this chart is a “must-have” for investors and advisors because you can visually see how commodities have fluctuated from year to year. Take natural gas, for example, which posted outstanding increases in 2002 and 2005, but has been a cellar-dweller for the last four years as a result of overabundant supply and softening demand. The industry is also still trying to digest breakthrough technology that opened the door to vast shale deposits at a much lower cost.

On the other hand, oil finished in the top half of the commodity basket six out of the past 10 years. No stranger to volatile price swings, oil possesses much more attractive fundamentals as we continually see restricted supply coupled with rising demand.

After 11 consecutive years of gains, some are questioning whether gold can keep its winning streak alive in 2012. One of those skeptics is CNBC’s “Street Signs” co-host Brian Sullivan. In an appearance on Thursday, I explained how I believe the Fear Trade and Love Trade will continue to fortify gold prices at historically high levels.

Watch the interview

I explained that one of the reasons the Fear Trade will persist in purchasing gold is the ever-rising government debt across numerous developed countries. During our Outlook 2012 webcast, John Mauldin kidded that the Mayans were not astrologers predicting the end of the world, but economists predicting the end of Europe. Whereas John believes the U.S. has wiggle room to decide on how to deal with deficits and debt, Europe and Japan are running out of time.

The situation is quite somber when you consider how much debt Europe, Japan and the U.S. owes this year alone, says global macro research provider Greg Weldon. In his preview of 2012, Weldon says that the maturing principal and interest on U.S. Treasury debt due this year totals just under $3 trillion. Austria, Belgium, France, Germany, Italy, Portugal and Spain together face nearly $2 trillion in principal and interest payments. Japan is the leader in the clubhouse, owing just over $3 trillion in 2012. With the combined debt for these developed countries totaling nearly $8 trillion, the interest payments alone dwarf the total GDP of many countries in the world.

This week, Germany sold a five-year government note for less than 1 percent, the lowest interest rate on record. Bids for the low-yielding debt were three times more than the amount sold, even as the consumer price index stands at more than 2 percent year-over-year. This means that investors have so few acceptable safe havens they are willing to accept negative real rates of return.

This is good news for gold as a safe haven alternative against depreciating currencies such as the euro, the yen and the U.S. dollar.

The overwhelming debt burden in developed countries translates to an expected slowdown in imports from the emerging world. However, the grandest of those countries, China, likely won’t be affected as much as some people assume. This is “the biggest misconception” about the country’s economy, says CLSA’s Andy Rothman. Exports only play a supporting role for the Chinese economy. The world’s second-largest economy is actually largely driven by domestic consumption from a population more than 1 billion strong with more padding in their wallets.

Andy says 10 years of tremendous income growth and little household debt, make China the “world’s best consumption story, for everything from instant noodles to luxury cars” in 2012.

According to December Chinese trade figures, month-over-month and year-over-year imports of aluminum and copper increased significantly. This may be a result of China restocking ahead of Chinese New Year, but M2 money supply growth rapidly rose in recent months, a sign the government is attempting to reaccelerate the economy. Also, the urban labor market has been robust over the past two years, with an annual change just below 5 percent—a record high over the past 15 years.

Along with rising urban employment, income growth has been tremendous as well. CLSA says that last year was “the eleventh consecutive year of 7 percent-plus real urban income growth,” with disposable incomes rising 152 percent over the past decade.

Investors shouldn’t expect China’s growth to be as robust as it’s been, as the country’s fixed asset investment growth drops below the 25 percent year-over-year pace of the last nine years, says CLSA. China’s 12th Five-Year Plan has less infrastructure spending compared to the 11th five-year plan. Transport and rail spending is also expected to drop, with only water and environmental protection spending growth rising.

As shown in the BCA chart above, GDP growth has declined below 10 percent, but the growth is currently not the lowest we’ve seen in recent years. CLSA believes that China will prevent GDP growth from slipping below 8.5 percent for the full year, as “Beijing has the fiscal resources and political will to quickly implement a much larger stimulus.”

Judging by the record number of articles mentioning a hard landing in China in late 2011, investor sentiment has swung from euphoria to excessive pessimism, according to BCA Research. Last fall, more than 1,000 articles discussed the risk of a “China Crash.”

As I’ve mentioned before, contrarians view extremely bearish sentiment as a potential attractive entry point. BCA believes the pessimism has been priced in, as technical indicators as well as valuations for domestic and investable markets appear “deeply depressed.”

What will happen over the next 10 years? I believe the supercycle of growth across emerging markets will continue with rising urbanization and income rates. This bodes well for commodities, especially copper, coal, oil and gold, and we’ll continue to focus on companies that will benefit the most from these much-needed resources.

 

Index Summary

• The major market indices were higher this week. The Dow Jones Industrial Average rose 0.50 percent. The S&P 500 Stock Index increased 0.88 percent, while the Nasdaq Composite gained 1.36 percent.
• Barra Value outperformed Barra Growth as Barra Value finished 1.49 percent higher while Barra Growth gained 0.37 percent. The Russell 2000 closed the week with a gain of 1.93 percent.
• The Hang Seng Composite finished sharply higher, gaining 3.84 percent, Taiwan rose 0.86 percent, and the Kospi gained 1.77 percent.
• The 10-year Treasury bond yield closed 9 basis points lower at 1.87 percent.

 

Domestic Equity Market

 

The S&P 500 Index was higher this week by 0.88 percent. For the second week in a row, the best-performing sector was basic materials which rose 3.93 percent. Energy was the worst-performer, down 1.24 percent. Within the basic materials sector, top performers included Eastman Chemical, Freeport-McMoRan Copper and Gold, and CF Industries. The worst performers in energy included Cabot Oil & Gas, QEP Resources and EQT Corp.

 

Strengths

• Diversified metals and mining, led by Freeport-McMoRan, was the best-performing group for the week, up 7.9 percent. Improving sentiment surrounding China’s economic prospects drove copper up 6.3 percent this week.
• The auto parts and equipment group outperformed by gaining 7.5 percent. The group was led by Borgwarner, which issued better than expected earnings guidance for 2012.
• The homebuilding group also outperformed rising 7.5 percent. The group was led by Lennar, which reported a 20 percent increase in new orders.

Weaknesses

• The tire and rubber industry group (Goodyear Tire) was the worst-performing group, down 10.9 percent. Goodyear Tire noted recent weakness in volume trends globally.
• The home entertainment software group lost 8.4 percent on weakness in Electronic Arts. The stock dropped on reports that U.S. video game sales dropped 21 percent in December.
• The coal group fell 5.5 percent as sharply lower natural gas prices put pressure on thermal coal pricing. Consol Energy declined 11 percent.

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 rallied this week, sending yields lower as the schizophrenic market continues to gyrate up one week and down the next. This is what we’ve experienced since mid-November.

Most of the gain in Treasuries came on Friday as Standard & Poor’s (S&P) downgraded several European countries including France, Italy and Austria. The U.S. dollar and Treasuries rallied on this news, while stocks sold off.

Economic data was mixed but one outlier was the consumer credit report from the Federal Reserve, which grew by more than $20 billion in December. The 9.9 percent annualized increase is the fastest growth since November 2001. Consumer confidence and retail sales have improved over the course of the quarter but it appears a sharp reversal in consumer credit may dampen the outlook going forward.

 

Strengths

• The University of Michigan Confidence Index and the IBD/TIPP Economic Optimism Index both registered strong increases in January.
• The three month rate in China’s M2 money supply index has accelerated very sharply and is an indication that the government is addressing the concerns of an economic hard landing. China’s bank loans rose 14 percent in December and reinforce the idea that policymakers are taking action.
• Italian 10-year bond yields fell sharply this week as bond auctions in Europe were met with strong investor demand.

Weaknesses

• Overnight deposits with the European Central Bank (ECB) hit another record high at $591 billion 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.
• Weekly jobless claims rose back near the 400,000 level and are at the highest level in six weeks.
• Consumer credit surged $20 billion this week as consumers levered back up in November.

Opportunities

• Inflation data will be released next week and should confirm the declining trend in inflation. We also have housing starts and building permits which will hopefully confirm some of the recent positive data points in housing.

Threats

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

 

Gold Market

Strengths

• Gold, which had been trading below the 200-day moving average, crossed above on Tuesday with momentum players joining the markets. For the week, gold closed just above the 200-day moving average at $1,639.30 an ounce. Palladium also had a strong move, up almost 3 percent for the week on warnings of power supply curtailments in South Africa which could effect mine production.
• China’s Ministry of Industry and Information Technology reports that China produced 32.61 tons of gold in November, a 2.7 percent increase from the previous month. Total output for the first 11 months of 2011 rose 4.85 percent. More importantly, the latest trade data shows China imported 102 tons of gold from Hong Kong in November, the most ever. In addition, gold coin sales in the U.S. surged to 85,500 ounces sold during the first 12 days of January, according to the U.S. Mint. At this pace of sales, January could be the highest level of gold coin purchases since December 2009.
• In the midst of earnings season, a number of companies reported very positive results. Yamana Gold forecasted a 13 percent increase in gold equivalent production for 2012 after producing a total of 1.1 million ounces in 2011. Goldcorp also forecasted a 70 percent increase to 4.2 million ounces of gold production in five years and 2012 gold production guidance of 2.6 millions ounces. This comes after the company met 2011 gold production guidance at 2.5 million ounces. Freeport McMoRan reported that workers who returned to their Grasberg mine in Indonesia continued to ramp up production. The strike had gone on for three months, tightening copper production. The stock was up nearly 8 percent for the week on this positive news.

Weaknesses

• With earnings being reported for a number of companies, investors took short-term profits where they could on Friday. This led gold and the NYSE Arca Gold Miners Index (GDM) down 0.68 and almost 1.3 percent, respectively, for the day. Although the gold rally was dented, it was not reversed. Senior gold equities were hit the hardest on Friday, down 1.14 percent for the day, while juniors were only down 0.21 percent. On a country-specific basis, South African gold stocks were hit the most as currency and electricity restrictions weighed on their performance. Junior gold exploration and development stocks outperformed senior gold equities on the whole for the week, with added strength seen in the senior silver names.
• Momentum in the gold market stalled on Friday with a bit of profit taking from short-term players. The Shanghai Gold Exchange also announced it would temporarily raise margin requirements on gold and silver ahead of the week-long Lunar New Year holiday.
• Hecla Mining's Lucky Friday mining project has turned out to be not-so-lucky. The company announced this week that it would be shutting down a silver shaft on the project due to maintenance and a safety review following a rock burst in late December. This mine accounts for 25 percent of its silver production. Accordingly, the company reduced its 2012 silver guidance by 2.5 million ounces to 7 million ounces. Hecla was down over 20 percent on the news.

Opportunities

• Asian demand for gold seems to be picking up again. While the Indian rupee has slightly strengthened, prices have remained stable, laying the groundwork for improved Indian demand for the metal. With the Chinese New Year holiday just around the corner on January 23, news reports show gold imports through Hong Kong are at record levels and the Chinese government is successfully managing its economy by taming inflation. This is reassurance that gold demand will continue to rise from the country.
• While central banks have been net purchasers of gold since 2009, pension and insurance funds only hold 0.3 percent of their assets in gold and mining shares. A commentary on Mineweb.com made the point that with continuing losses and growing pension deficits, these funds may be forced to hold gold because it is the only asset class negatively correlated to financial assets such as stocks and bonds. With over $200 trillion of global financial assets, this would represent a massive shift from the $2 trillion in gold bullion privately held today.
• Argentina is expecting the mining sector to continue to expand over the next six months as two Canadian miners, Pan American Silver and Goldcorp, plan to start construction on sizeable projects. Although it still lags behind regional heavyweights such as Chile and Peru, Argentina’s mining industry has been experiencing rapid growth since 2003.

Threats

• Research analysts expect gold mining to be socially challenged in 2012 as industry participants will need to demonstrate that the existing formal mining models in the host country, rather than the informal/illegal type of mining, are working and contributing to the country. A significant shortage of skilled labor and a necessity for companies to show that their activities are socially responsible and positively contributing to the local communities will also prevail.
• Members of the London Metal Exchange (LME) are pushing the LME to retract a new user trading fee that would boost the exchange’s revenues and encourage potential bidders. Brokers are concerned that it would hurt their way of doing business. Traditionally, the LME has kept trading fees low. Mineweb.com reported that industry sources say members were not consulted on the levy and some are rallying their peers to try and persuade the LME board to head off the move scheduled to take effect in March.
• Poland’s controversial mining tax has been approved by the committee that prepares government legislation and now only requires final clearance from the government and parliament. This new mining tax would be helping to raise 1.8 billion Polish zlotys for state coffers this year. KPGM Polska Miedz SA, the country’s most profitable company and sole copper producer, is now considering returning to the debt markets for the first time since 2003 should the government approve this new mining tax. The company will need to pay 1.8 billion zloty in new taxes this year.

 

Energy and Natural Resources Market

Strengths

• Desjardins highlighted that Chinese December base metal import data is showing that unwrought copper imports reached 508.9 thousand metric tons, up 12.6 percent month-over-month and 47.7 percent year-over-year. Iron ore imports of 64.1 million metric tons were down 0.2 percent month-over-month while up 10.3 percent year-over-year.
• The latest SteelBenchmarker assessment by World Steel Dynamics shows a continuation of the upward trend in U.S. steel prices. The U.S. hot-rolled coil (HRC) assessment topped $800 per ton for the first time since July and scrap prices hit $466 per ton of shredded material, the highest level since August 2008.
• Reuters noted that OPEC’s crude oil production was more than 30 million barrels per day in December 2011, the highest volume since October 2008.
• Preliminary shipping data shows that Brazilian shipments were up 5.6 percent year-over-year. Shipments to China exceeded the 200 million tons per annum mark for the first time last year and iron ore exports reached an all-time high run rate in December.

Weaknesses

• The Global Resources Fund (PSPFX) underperformed its benchmark by a small amount over the last week due to being underweight large capitalization basic materials stocks and being overweight U.S. exploration and production stocks with natural gas exposure.
• Natural gas fell 14 percent this week to $2.64 per British thermal unit (Btu), a decade low. Supply growth in North America from rapid oil and gas shale basin development has created a glut of natural gas that will require a combination of increased industrial and power generation demand as well as a reduction in natural gas well drilling to balance the market.
• Deutsche Bank reported that the dry bulk index has fallen sharply in the beginning of 2012 while iron ore prices remain relatively supported. Deutsch Bank believes the decline in shipping rates is a function of slowing demand from Chinese steel production ahead of its New Year and lower shipments from Australia and northern Brazil due to rainy weather. China steel production has declined for six consecutive months. Deutsche Bank expects spot iron ore and freight rates to face ongoing headwinds in the first and second quarters of 2012. However, an end to the rains and an improvement in global growth during the second half of 2012 could lead to subsequent strength.
• China’s import growth fell to a two-year low in December, underscoring a slowdown in the fastest-growing major economy that deepens risks for the global outlook.
• The Central Dispatch Department of the Fuel and Energy Complex said that Russia’s crude oil exports fell by 3.9 percent year-over-year to 212 million tons in 2011.

Opportunities

• BCA research showed that equity multiples now discount a severe global growth slowdown at a time when mining stocks still offer leverage to the bullish China income convergence story. The unfolding recession in Europe and property slowdown in China have crushed mining share prices.
• Macquarie reports that Vale has now declared force majeure on certain iron ore deliveries, accounting for around 20 percent of January output. They emphasized that this now serves to indicate that the seaborne iron ore market will become fundamentally tighter during the quarter, requiring both destocking in China and a reincentivization of Chinese domestic output through higher prices.
• Deutsche Bank noted that oil production in the state of North Dakota climbed 42 percent (year-over-year) in November to 510,000 barrels per day. Success in developing tight oil plays across the country has created a realistic prospect that U.S. net oil imports as much as a percentage of total usage could fall significantly further. The figure has already fallen from 65 percent in 2005 to 47 percent in 2011.
• The U.S. Energy Information Administration (EIA) released its first Short Term Energy Outlook for 2012, in which the agency revised global oil demand downward by 140,000 barrels per day in 2012. This brings the EIA’s annual growth rate in-line with Barclays’ forecast at 1.27 million barrels per day. However, the key feature of the report was the large downgrade to non-OPEC supply for both 2011 and 2012. Non-OPEC supply growth for 2011 was reduced by a massive 310,000 barrels per day to just 90,000 barrels per day.

Threats

• Italy faces a “significant chance” of a downgrade by Fitch Ratings, which is reviewing all European sovereigns and will make a decision by the end of the month.
• Workers in Nigeria began a national strike, threatening to shut ports and disrupt oil production and exports. Workers are striking in reaction to the government’s decision to lift fuel subsidies, more than doubling gasoline prices. The strike makes Nigeria the third OPEC nation with an ongoing supply threat.
• Vale, the world’s largest iron ore exporter, reported that it had to halt some iron ore shipments from Brazil due to heavy rainfall that has killed dozens of people. Due to the rains that have affected its operations in Brazil, the miner estimates it will lose approximately 2 million tons of iron ore shipments, almost 1 percent of its annual output.

 

Emerging Markets

Strengths

• The People’s Bank of China (PBOC) 2011 financial statistics show that M2 growth rebounded significantly to 13.6 percent year-over-year at the end of December. With seasonal adjustments, this represents a 26.8 percent month-over-month increase on an annualized basis. Many attribute the monetary expansion to fiscal expansion measures taken by the Chinese government. In an early December Investor Alert, we discussed that we were at the beginning of a monetary easing cycle in China as the government tries to fine-tune the economy.
• The amount of new loans in China during December was Rmb 640.5 billion, higher than the estimated Rmb 575 billion.
• After targeting Rmb 7.5 trillion in 2011, China may set its 2012 new bank loan target at Rmb 8 trillion. Money supply growth is expected to be 14 percent and CPI at 4 percent, the Oriental Morning Post reported. The government may ease lending to infrastructure projects and local government financing vehicles (LGFV) this year.
• China’s online gaming revenue rose 32.4 percent (year-over-year) to Rmb 2.85 billion in 2011, while the mobile game market’s revenue rose 86.8 percent year-over-year to Rmb 1.7 billion, Xinhua News reported.
• After sinking 28 percent in value during 2011, China’s domestic stock markets (as measured by the CSI300 Index) have started 2012 by posting a 6.5 percent gain after the first five days of trading. The increase is driven by monetary easing policy and market participations by domestic institutions. After Premier Wen Jiabao called for boosting confidence in the domestic stock market, the China Securities Regulatory Commission (CSRC) will pursue reforms in IPO pricing mechanisms to prevent excessive high pricing, will encourage improving corporate dividend payouts, and will try to increase the proportion of corporate bonds financing.
• China’s December CPI dropped to 4.1 percent, a 15-month low, after peaking in July. This drop will provide room for China to increase money supply. China’s December PPI dropped 1 percent from November, indicating core input prices are declining faster than the market expectation.
• Korea’s December PPI rose 4.3 percent from the previous year but was down 5.1 percent from the previous month. The Bank of Korea maintained its benchmark interest rate at 3.25 percent for the seventh straight month, a widely-expected move.
• The China Auto Association announced that December 2011 passenger car sales were up 4.6 percent. The market had expected no gain due to a high base effect in December 2010 when the stimulus plan came to expire. The Association also forecast 2012 passenger car sales to grow 7 percent after growing 5.19 percent in 2011.
• Macau gaming names gained in the week after reporting 850 million a day (Macanese pataca) in gaming revenues for the first eight days of the year. This is similar to last year’s Golden Week in October.
• China’s National Energy Administration plans to double solar capacity this year and add four times the capacity by 2015. Solar stocks globally jumped on the news this week.
• Russia’s inflation dropped lower than post-Soviet lows, falling to 6.1 percent on a year-over-year basis. December’s inflation number is significantly lower than the 2010 average annual figure of 8.8 percent. However, Roubini Global Economics is forecasting inflationary pressures to reemerge in the latter part of 2012.

Weaknesses

• China’s December exports were up 13.4 percent while imports were up 11.8 percent. Imports were lower than the market consensus, indicating slower export/import growth and increased pressure for China to further ease money supply.
• Continued weakness in electronics shipments drove Philippine exports to drop 19.4 percent year-over-year in November, the seventh-straight month of declines. Consensus estimates were for a 10 percent drop. Nevertheless, Philippine exports are a small share of the country’s GDP. The 2012 Philippine economy will be driven by domestic consumption, infrastructure investments and overseas remittance.
• Malaysia’s industrial production gained 1.8 percent year-over-year in November, the slowest pace in four months, as mining contracted and manufacturing eased.
• China’s foreign-exchange reserves dropped for the first time in more than a decade as foreign investment moderated. The holdings fell to $3.1 trillion on December 30 from $3.2 trillion on September 30, data released on the People’s Bank of China shows.
• China’s power use growth may slow to 8.5 percent this year, Xinhua reported, citing the deputy director of China’s State Electricity Regulatory Commission. Electricity consumption slowed to 11.7 percent last year from 14.5 percent in 2010.
• Signs that Chinese lenders will postpone losses on trillions of yuan loans made to local governments may undermine investor confidence in the banking sector, Standard & Poor’s said on Thursday. This local government loan issue can never be fully understood or go away by the like-minded institutions and speculators. We believe it is a huge issue but resolvable given time and time is always on the side of the Chinese government.

Opportunities

• Russian producer TNK-BP’s PetroMonagas venture with Petroleos de Venezuela SA plans to boost output of heavy oil by 20 percent to 145,000 barrels a day in 2013.
• Weibo, a Chinese microblogging service run by Sina, has seen its user base reach more than 50 percent of the country’s entire Internet population of 500 million people, according to J.P. Morgan. As a leader in microblogs, Sina Weibo possesses unique opportunities to monetize the phenomena. Proliferation of tablets and smartphones should also give additional push to the microblogging trend.

Threats

• With China in a monetary easing cycle and the U.S. experiencing a slow but steady recovery, the European sovereign debt issue is the single biggest question for the market. Therefore, it is still advisable to not be surprised by short-term market volatility.
• BCA Research published a piece this week highlighting themes among the emerging market space. Among them, a U.S. dollar breakout coupled with emerging market currency weakness was mentioned. Unlike in 2008, the problems are now in Europe and developing countries, while U.S. growth is set to outperform other regions. BCA believes this only reinforces the case for a strong U.S. dollar as global capital favors U.S. assets, while emerging market currencies remain more volatile than they have been in the recent past.

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