It May Take a Dragon to Breathe Fire into Markets

 

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

Kung hei fat choy!

On Monday, I’ll be returning home to Canada to speak at the Cambridge House’s Vancouver Resource Investment Conference. This year, I’ll be part of a special debate on whether China will boom or bust with bestselling author Gordon G. Chang. The title of Chang’s book, The Coming Collapse of China, states his position quite clearly and I look forward to the intellectual challenge of convincing him otherwise.

I’ve found many people are particularly energized about predicting a hard landing for China’s economy, but I believe the country is no sinking ship. China isn’t fast-approaching an iceberg in the dark of the night like the Titanic. Beijing has long been anticipating the ice chunks and subtly adjusting the rudder around inflation without steering the economic ship too far off course.

China’s government angled its vessel away from inflation by increasing the required reserve ratio (RRR) every month for the first six months of 2011 and raising interest rates three times. Once inflation was sufficiently under control, the country began to steer in a direction of growth again.

Recent results show how positive this easing has been. In its latest research this week, BCA Research reported that despite the policy tightening of 2011, the “most recent economic data out of China has all but confirmed that the economy remained incredibly resilient.”

One significant data point is the sharp increase in money supply. After the country hit a low level of monthly money supply growth, the three-month change in M-2 money supply climbed to record levels during the final month of the year, says Greg Weldon of Weldon Financial. He says that money supply “pegged at +6.419 trillion, easily exceeding the previous record 3-month increase, seen at the peak of the global crisis, in March of 2009.”

Easing in China is expected to continue through 2012, with ISI Group anticipating a potential RRR cut after Chinese New Year celebrations in February, then possibly again in April, June and August. Also, loans “have become more readily available in recent weeks,” says ISI. This should all be bullish for commodities, such as copper, oil and gold, and also trickle down to boost share prices of natural resources equities.

Chinese Copper Inventories Increase

Base metals were the laggards among commodities last year, with copper one of the worst performers, losing 21 percent. (Download our Periodic Table of Commodities now.)

Global consumption of copper increased only 4 percent in 2011, which is lower than the 10 percent growth in 2010, but higher than the decade-average of around 3 percent, says Macquarie Research. China’s consumption of copper—which makes up 40 percent of the global demand—was a primary reason for decreased consumption, as the country was drawing down on its own supply throughout the year.

This can’t continue forever, Macquarie says, adding that “demand made on new supply direct from producers would need to rise, with positive implications for prices.” Europe’s largest copper fabricator agrees with that sentiment, indicating that it anticipated China’s copper demand would be strong in 2012, according to Barclays.

A recent rise in copper imports is likely the result of restocking China’s depleted copper inventories. As is typical for China, after the metal fell in price last fall, the world’s largest buyer of the metal advantageously scooped up copper to replenish its cupboard, says Barclays Capital. As shown below, copper inventories into China reached a record low in 2011, but have sharply reversed recently.

An increase in copper demand places pressure on the supply side, which continues to experience shortfalls in mine output versus forecasts. These are caused by a variety of factors, such as weather, labor strikes, or simply a poor grade deposit. While Macquarie says there’s a possibility the world’s two largest copper mines, the Los Bronces mine in Indonesia and Peru’s Escondida mine, could deliver year-over-year increases in production, it concludes “it is highly unlikely that miners will succeed in delivering this level of additional output in total.”

While Chinese demand growth for commodities is not expected to be as robust as it has been historically, demand is expected to pick up throughout 2012. As confidence returns, Macquarie says there should be “a slow gradient of recovery in the near term before gathering pace into the mid-year.”

Increasing Reliance on Energy Imports

 

China’s rapid growth and increasing reliance on other countries for key resources has made a powerful case for commodities over the past several years. These three charts from BCA Research illustrate that once the country shifted from exporting to importing a commodity, there was no looking back.

You can see in all three how dramatically the energy balance has shifted to an ever-increasing dependence on imports. In each major commodity, after China began importing, growth took off.

China became a net importer of crude oil in 1994, and today, is the second-largest oil importer in the world. BCA forecasts the country is expected to surpass the U.S. as the largest oil importer in only a few years.

To obtain more natural gas, China spent years building massive pipelines to transport the commodity from Russia and other western Asian counties, and since 2006, natural gas imports have “gone vertical,” says BCA.

Coal, which accounts for the majority of total energy consumption in China has also been imported since 2008, and since that time, imports rose substantially.

Even with these imports, energy consumption is only a fraction of developed countries. The China story is just getting started: Urbanization just surpassed the 50-percent mark, hitting what I believe to be the pivotal moment that dramatically shifts buying patterns, driving an enormous demand for housing, consumer staples and durable goods. You ain’t seen nothing yet!

 

Happy Chinese New Year!

 

This weekend, the world’s largest annual migration takes place. Millions of people in China head home to celebrate Chinese New Year and welcome in the Year of the Dragon. U.S. Global Investors’ research analyst and Shanghai native Xian Liang recently talked about the significance of the dragon in Chinese culture:

“Unlike its western counterpart portrayed as evil, the Chinese dragon is an imaginary, mythical creature. Its body parts are from nine animals, including the horns of a deer, mouth of an ox, nose of a dog, trunk of a snake, and claws of an eagle. It has auspicious power because it can make itself invisible or visible at any time. It can both fly and swim. It makes clouds and rain. Because of these magnificent things, the dragon is associated with royal powers as well.”

After bounding through a tough Year of the Rabbit, we anticipate the Year of the Dragon will breathe fire back into Chinese markets in 2012. Kung hei fat choy!

 

Index Summary

• The major market indices were higher this week. The Dow Jones Industrial Average rose 2.40 percent. The S&P 500 Stock Index increased 2.04 percent, while the Nasdaq Composite gained 2.80 percent.
• Barra Value outperformed Barra Growth as Barra Value finished 2.19 percent higher while Barra Growth gained 1.91 percent. The Russell 2000 closed the week with a gain of 2.67 percent.
• The Hang Seng Composite finished sharply higher, gaining 4.57 percent, Taiwan rose 0.73 percent, and the KOSPI gained 3.96 percent.
• The 10-year Treasury bond yield closed 16 basis points higher at 2.03 percent.

 

Domestic Equity Market

 

The domestic stock market as measured by the S&P 500 Index was higher this week by 2.04 percent. We have seen a global rally in January with much of this performance coming this week. When trying to decipher the underlying cause it is often helpful to look at significant government policy actions.

On December 21, 2011 the European Central Bank (ECB) implemented the first tranche of the three-year long-term refinancing operation (LTRO) of approximately $635 billion, as the ECB attempted to secure long-term funding for banks that would allow them time to work through their current difficulties without the fear of a run on the bank. Another round of funding is scheduled for February. The chart below compares the timing of the current LTRO to the Federal Reserve’s quantitative easing and TARP program in 2008. The LTRO program is a form of quantitative easing and judging by the effect on the global equity markets, it appears to be working. The chart below looks at the global equity risk premium as a proxy for equity risk aversion and as can be easily seen in the chart , the end of 2011 was a very fearful time for equity investors. If 2008 and 2009 set precedent, then 2012 is shaping up to be a good year.

 

Strengths

• The information technology sector was the best-performing sector this week as several bellwether technology companies reported earnings that were well received by the market.
• The semiconductor equipment group was particularly strong, increasing by more than 8 percent as strong earning results combined with increased orders or capital expenditure announcements from Intel and Taiwan Semiconductor.
• The investment bank and brokerage industry group was also strong with Goldman Sachs and Morgan Stanley both up around 10 percent for the week on the back of well received earnings reports.

Weaknesses

• The utilities sector underperformed and was the only sector to post negative performance for the week, as the market rotates away from defensive areas.
• The auto parts and equipment industry group underperformed as Johnson Controls lowered guidance on weak European production and currency effects.
• The educational services group also underperformed as talk surfaced on possible legislation that would reduce incentives for for-profit colleges to target and aggressively recruit veterans and service members.

Opportunities

• Early earning results have been encouraging so far and the market has responded, and we move into the heart of earnings season next week.

Threats

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

 

 

The Economy and Bond Market

 

Long-term treasury yields rose sharply as once again the schizophrenic market gyrates up one week and down the next, which is what we have experienced since mid-November.

Yields rose throughout the week as we appear to be in another “risk on” mode where risky assets rise and safe assets fall.

Economic data generally met expectations this week as inflation continued to slow on a year-over-year basis and housing data was generally in line with forecasts. The big surprise of the week was initial jobless claims, which hit the lowest levels since 2008. This number is often viewed as a leading indicator, which bodes well for the economy going forward.

Strengths

• The weekly initial jobless claims are indicating the economy is picking up steam.
• Both the Producer Price Index (PPI) and Consumer Price Index (CPI) came in below expectations, giving the Fed plenty of room to maneuver if it were to decide additional stimulus is needed.
• China reported fourth quarter GDP which rose 8.9 percent and beat expectations. The Chinese hard landing many pundits were worried about has yet to materialize and government policy has already shifted to an easing bias, likely resulting in a reacceleration in the second half of 2012.

Weaknesses

• Overnight deposits with the ECB hit another record high at roughly $685 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 and is at odds with the equity performance of many European banks of late.
• Greece has yet to come to an agreement with private creditors on the level of haircut that will be taken. This remains an overhang on the financial markets.
• Industrial production rose 0.4 percent but came in shy of expectations.

Opportunities

• The Fed is expected to release its Fed funds rate forecast at the conclusion of the Wednesday Federal Open Market Committee (FOMC) meeting. This new openness is welcome but depending on the detail and how well the information is explained, will ultimately determine how the market takes this new news.

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 $1,666.65 up $27.65 per ounce, or 1.7 percent. Gold stocks, as measured by the NYSE Arca Gold BUGS Index, fell 3.4 percent. The U.S. Trade-Weighted Dollar Index slid 1.7 percent for the week.

 

Strengths

• Gold continues to attract attention as it remained above its 200-day moving average this week and closed above the 50-day moving average on Friday. It had previously crossed below the 200-day moving average on December 14 of last year, and only crossed back above on January 10, giving confidence for higher gold prices to come for the year.
• Traders in India are saying that the current marriage season is being a strong driver for purchases of gold jewelry. They also have said that almost 70 percent of gold jewelry is sold during the wedding and festival season, with the country being host to approximately 10 million marriages a year. Even with current high prices, people appear to spending as much, if not more, this year.
• Romarco Minerals released drilling updates on Friday this week from their Haile Mine, to which the market reacted positively, with shares up 6.0 percent for the day. The project in South Carolina reported an intercept of 21.3 meters with a grade of 43.1 grams per ton from the Snake zone and other strong infill results. Earlier in the week Romarco reported very encouraging drill results from its regional gold exploration program in the Carolinas which was positive for the share price.

Weaknesses

• Catching the market by surprise, India’s government raised the import duty 90 percent on bullion to 2 percent on value from the previous flat rate of 300 rupees per 10 grams. The import duty on silver was also raised to 6 percent on value from 1,500 rupees per kilogram. Trading was light on new orders coming from India, with analysts forecasting that this could have a significant impact on the country’s gold appetite in the long term. As the rupee fell 18.7 percent in 2011, this may be a government reaction to marginally curtail gold buying, but historically the public has found other ways to acquire gold.
• Kinross Gold took it on the front, with shares taking a nose-dive 21 percent on Tuesday after releasing news on possible delays that would impact the Tasiast mine in West Africa and that it was conducting “a capital and project optimization process aimed at improving capital efficiency, project sequencing, and investment returns for its three main growth projects.” Furthermore, the company announced that it expects to record a goodwill charge for Tasiast in connection to the 2010 Red Back acquisition. The Tasiast mine is one of Kinross’s largest sources for future production growth.
• Senior gold mining shares fell better than 5 percent this week while the junior gold mining stocks were up about 1.5 percent. The sell off in the senior names largely reflects generalists rotating out of some of their “fear trade” positions based on some of the better than expected economic numbers. It is very positive though that the junior mining stocks are finally catching a good bid after a dismal 2011.

Opportunities

• China, which is speculated to outpace India in the next few years as the largest gold consumer, recently added more reason to this prediction. Some of the country’s leading banks offer accounts that accumulate gold, and are quickly gaining attention. One bank, the Industrial and Commercial Bank of China, launched the accounts in April 2010 and drew 2.33 million investors by the end of November, just 19 months after the launch, with 22 tons of gold held. Investors buy as little as a gram a month through the accounts, which would quickly add up. The Industrial and Commercial Bank of China has more that 200 million prospective accounts to market its gold products to.
• Eric Sprott, the well-known Canadian fund manager, recently made public his reservations on cyclical commodities, but remained bullish on gold and oil. He cited the ongoing current economic contraction as the main reason for his bearish view on iron ore, coal, steel, lead and zinc. He does, however, expect gold to hit a record above $2,000 an ounce this year, with silver not far behind, reaching an all-time high of more than $50 an ounce. Strong physical gold demand should remain intact with encouraging import numbers coming from China and Turkey late last year. He recently filed last week to launch a platinum and palladium product which would allow investors to redeem the physical metals.
• Argentinean provincial laws banning the use of cyanide in gold processes were repealed for the Rio Negro province, giving a further boost to the mining sector for the country. Pan American Silver said this week that changes to the mining legislation in this province will allow the company to advance its Calcutreu gold development project located in the province. Argentina’s mining industry is continuing to expand with a record $2.57 billion in investments last year.

Threats

• In the midst of earnings season, companies are reporting on average much higher operational costs, namely due to increases in labor, transportation and energy prices. This is a theme throughout the industry, with costs estimated to have increased 10 to 15 percent in 2011. Increases in sustaining capital have also been creeping upwards, giving advantage to the senior names due to their pre-established economies of scale.
• Following the increasing number of its African neighbors, Zambia’s government has introduced a number of policies aimed at tightening the country’s booming mining sector. Analysts view the changes in Zambia as part of a broadening shift throughout the continent toward resource nationalization.
• The Congressional Western Caucus notes on its web site under “Job Killing Policy #10” that “the EPA has also declared the mining industry their number one target for writing rules pursuant to CERCLA §108(b) (Superfund) to require financial assurance. An EPA financial assurance program will be duplicative of federal land management agency and state programs which already have extensive environmental programs and financial assurance requirements in place. Worst-case scenario bonding by the EPA will cause some existing mines to close prematurely and prevent new mines from opening by unnecessarily tying up capital that would otherwise be used to create new wealth and jobs.” Historically, states have had the authority over what could be done on private land but recently the EPA has been asserting that they have authority if air or water might come in contact with development.

 

Energy and Natural Resources Market

Strengths

• The Global Resources Fund performance over the last week has bested its benchmark largely through stock selection in the energy sector and specifically in the oil services and equipment area.
• Barclay’s capital highlighted that base metals have started the year with a “bang;” prices are up on average 11 percent since the start of the year making it the best-performing sector so far. Copper gained approximately 10 percent for the week.
• One of the key leading indicators of U.S. non-residential construction, the American Institute of Architects Billings Index, remained above 50 in December, representing an increase in the month.
• Consultancy Steel and Metal Market Research said this week global crude stainless steel production hit a new record high of 35.5 million tons in 2011, but the pace of growth was slower than the previous year.
• Freeport McMoRan has resumed copper concentrate shipments from its Grasberg copper-gold mine in Indonesia, which had recently only resumed work from a three-month strike ending in December. Freeport is the world’s second-largest copper mine and supplied the global market with nearly 2.5 percent of the global demand.

Weaknesses

• After another soft reading of the weekly storage withdrawal, natural gas prices tumbled further this week as warmer than normal weather curbs demand. Natural gas futures fell 12 percent this week to close at $2.35 per mmbtu.
• Total steel shipments rose just 5 percent year-over-year for their smallest increase in nearly two years. Shipments fell 14.7 percent month-over-month on a days-adjusted basis, while total steel inventories rose 3.1 percent month-over-month and 8.3 percent year-over-year.
• According to Deutsche Bank, Norsk Hydro, the world's fifth-largest primary aluminum producer with market share of nearly 4 percent, has confirmed that it will close one of the three potlines at its 180,000 tons per annum Kurri Kurri smelter in Australia in response to the price weakness of recent months. Rio Tinto and Alcoa, the world's second- and third-largest producers, have also announced plans to close some capacity.
• ArcelorMittal will extend the closure of it Sestao plant in Spain as it does not expect southern European steel demand to improve in the near future, it said. The company had announced last October that it would halt steel production at the Sestao plant in November and December. "ArcelorMittal Sestao will restart operation as soon as market conditions turn around," a spokesperson said in an e-mailed statement.

Opportunities

• Deutsche Bank highlighted that the International Energy Agency (IEA) said that China’s oil-product consumption is expected to rise 400,000 barrels per day to 9.9 million barrels per day in 2012, almost 40 percent of the increase in global consumption. According to its forecast, global crude oil consumption is expected to increase 1.1 million barrels per day to 90 million barrels per day.
• BP Plc said that China will drive the world’s growth in oil demand in the next 20 years and in 2027 will overtake the United States as the world’s top oil consumer.
• Deutsche Bank reported that Japan’s largest copper smelter suspended its Saganoseki smelter operation, with an annual capacity of 200 000 tons, due to fire damage. On top of this, Philippine’s PASAR copper smelter is also facing production problems. On the back of production disruptions, London Metal Exchange (LME) copper cancelled warrants increased significantly from New Orleans, where more free copper units exist globally.
• Freeport McMoRan reported that downstream demand in the U.S. is positive and project a tight and encouraging copper market in 2012, with the auto sector strong and signs of improvement in construction.
• U.S. service center steel inventories rose 3 percent month-over-month for December and were still 18.7 percent below average historical levels. December inventories were 52.8 percent below peak levels and 42.5 percent above trough levels. Inventory restocking likely has helped boost steel prices in recent months.

Threats

• Nigeria’s government ordered a fresh audit of its entire oil and gas sector covering the last three years. This move follows the opening of an investigation into the sector by the corruption watchdog and a separate Senate investigation into fuel subsidies - all announced this week. In response to a reduction in fuel subsidies, the country has witnessed a country-wide strike threatening the gas and oil sector.
• Crude oil is the most vulnerable to near-term supply disruption from geopolitical tensions. The sustainability of commodity supply is being challenged by rising state political interference and local self-interests that is delaying and constraining the resource development needed to meet emerging demand growth.

 

Emerging Markets

 

Strengths

• China’s fourth quarter GDP growth was 8.9 percent, better than the expected 8.7 percent.
• China’s December retail sales were up 18.1 percent, better than the estimated 17.2 percent. For 2011 it was up 17.1 percent year-over-year, showing strong consumption demand.
• Disposable income for urban residents grew 14.1 percent in 2011, and 8.4 percent. In 2011, China’s urban population increased by 21 million to 690.79 million at the end of last year. For the first time in China’s history, urban population has exceeded the rural population, the National Bureau of Statistics said.
• December industrial production was up 12.8 percent, higher than the estimate os 12.3 percent. Industrial production grew 13.9 percent in 2011, better than estimated.
• HSBC China’s Flash Purchasing Manager’s Index (PMI) is 48.8 for January, higher than 48.7 in December last year. PMI below 50 indicates manufacturing activities are in contraction. The HSBC Flash PMI is a survey among small and medium sized enterprises (SME) in China, which means it reflects part of the industrial activities in China. In China, as in many other countries, SMEs are mostly disadvantaged for financing. We hope Wen Jiabao’s SME loan policies can eventually help resume their growth.
• Chinese bank lending in the first quarter may exceed the 2.26 trillion yuan from a year earlier.
• China’s central bank, PBOC, injected Rmb 183 billion into the system via reverse repos on Wednesday, and Rmb 200 billion again on Thursday while urging more lending.
• China is said to consider relaxing capital requirements for banks. The China Banking Regulatory Commission is delaying implementing the most stringent capital adequacy ratios and may lower risk weightings for loans to small businessmen and companies.
• The Chinese banks totally issued Rmb 16.5 trillion worth of wealth management products, of which listed companies spent Rmb 30.4 billion buying these bank products. This was one reason that deposit growth was slowing.
• China’s National Social Security Fund has won approval to invest Rmb 100 billion from local pensions in stocks and bonds.
• Online advertising spending in China will rise 33 percent to Rmb 63.8 billion ($10 billion) this year from last year, the South China Morning Post said citing a broker report.
• Moody’s just upgraded Indonesia’s sovereign credit to investment grade after Fitch did the same in December last year. This will reduce borrowing costs for corporations and help stabilize currency.
• The Philippines’ central bank cut its benchmark rate by 25 basis points down to 4.25 percent. It was the first rate cut since July 2009. The Philippines runs an independent monetary policy since its economy is mostly domestic. Philippines overseas remittance rose 10.6 percent year-over-year in November to $1.78 billion, the biggest increase in three months.
• Thailand’s exports dropped 2 percent on a year-over-year basis in December as factories and supply chains began to recover from the flooding. The result was much higher than expectations for a 10 percent drop and a significant improvement from November’s 12.4 percent decline.
• Malaysia’s CPI rose 3 percent year-over-year in December, slowing to a nine-month low.
• Government statistics show that Colombia’s industrial production rose 6.5 percent in November from a year earlier.
• Indonesia received its second investment-grade rating from Moody’s this week, raising the country’s sovereign credit rating to Baa3. A month prior, Fitch had upgraded Indonesia’s credit rating as well.

Weaknesses

• Taiwan’s December export order declined 0.7 percent, for the first time since mid 2009.
• Due to housing market tightening and postponement of high speed rail projects by the government, China fixed asset investment still grew 23.8 percent, lower than 2010 and providing some clue to 2012’s slower investment growth. CITIC Securities predicts housing investment will decline in the first half of this year before the government lifts its control on the real estate market.
• China’s December home prices posted their worst performance last year, with only two of the 70 cities tracked posting gains, as the government reintegrated its plans to maintain housing curbs. In fact, sales transactions dropped sharply, between 15 to 20 percent on average, but the price drop was still very mild.
• China’s foreign direct investment declined 12.7 percent in December after a 9.8 percent drop in November on a year-over-year basis, a further reason for moderate money supply growth.

Opportunities

• The fiscal deposit decrease since September, particularly in December of last year, indicated that the Chinese central government had started fiscal expansion to fine-tune the economy. Evidence such as improved PMI and industrial production in December proved the government has changed its policy focus to supporting growth from economic adjustment (tightening).

• Barclay’s Capital reported that China may allow its local pension funds to be invested in its stock market in the first quarter of this year, according to the China Securities Journal. The report said that a province in southern China was approved to transfer 100 billion Yuan of local pension funds to the National Council for Social Security Fund (NCSSF) for operation. In view of the NCSSF's assets structure, about 30 percent to 40 percent of such capital will be invested in the stock market.
• A BCA credit cycle lead indicator is giving a positive signal for European equities and risk assets in the first half of 2012. Shaded areas in the chart below denote periods of anticipated market weakness, while clear bars forecast market strength based on an upturn in the global credit conditions six months previously. With the second 3-year LTRO tranche due in February, the ECB’s balance sheet is expected to expand by 1 trillion euro, amount almost identical to the U.S. Fed’s balance sheet expansion of $1.4 trillion in 2008/09.

Threats

• Two major sets of economic data that can continue to decline are GDP growth and property investment in the first half. Before the economy touches its lowest growth rate, hopefully by the middle of the year, the market may have to adapt to a lot of bad news in the property market, such as a sales contraction and sharp price fall.
• A number of upcoming important economic data will be released next week, including Turkey’s monetary policy decision, Poland’s 2011 GDP data, and Russia will report December industrial production.
• The World Bank warned on Tuesday that developing countries should brace for a growth slowdown stemming partly from Europe’s debt woes. Furthermore, the bank also warned that political tensions in the Middle East and North Africa could disrupt oil supplies and add another blow to global prospects. The World Bank cut its outlook for global growth in 2012 to 2.5 percent and 3.1 percent in 2013, down from 3.6 percent for both years.

 

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