Extreme Divergence Between Coal Rocks and Stocks Unwarranted

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

The Dow Jones Industrial Average experienced its worst quarter since the beginning of 2009. The S&P 500 Index fell 14 percent during the third quarter, with the materials sector as the worst performer, falling 25 percent. Many base metal commodities saw double digit declines, but not surprisingly, gold increased 8 percent over the quarter. It appears that fear of a “2008 repeat” drove investors from stocks despite positive long-term fundamentals.

Coal was relatively flat for the quarter, but what’s interesting is that coal companies were severely discounted. Over the last two years, coal stocks and the commodity have closely tracked each other, until this summer, when worries about a global slowdown caused coal stocks to fall off a cliff, not once, but twice, in August and again in early September. This extreme divergence between coal companies and the commodity seems unwarranted when the long-term drivers of coal remain supportive.

We discussed coal in May in Coal Use in China Shines Light on Growth, and highlighted how the price of coal was supported by strong demand from reconstruction projects in Japan along with reduced supply from floods in Australia, Indonesia, South Africa and Colombia. As the largest consumer of coal in the world, China was expected to continue to demand a significant amount of coal over the long term.

This long-term driver hasn’t changed, even with China’s concentration on controlling inflation this year. Coal inventory levels at China’s top loading port have dropped, hitting a new low at the end of September, reports Macquarie Research. In mid-September, the Daqin Railway was under maintenance for a few weeks, causing reduced deliveries, which put further pressure on the country’s inventory. As the world’s largest coal transport railway, the Daqin line transports coal from northern China to Zinhuangdao for shipping to manufacturing centers in the south and the east.

Throughout the world, coal demand is expected to rise significantly over the next 25 years. According to the U.S. Energy Information Administration’s (EIA) recent International Energy Outlook 2011, total coal demand will be driven largely by the non-OECD economies, which are primarily emerging markets. Specifically, the Asian non-OECD countries are projected to account for nearly all of the increase from 2008 through 2035, with China averaging 5.7 percent each year and India averaging 5.5 percent per year, says the EIA.

Today’s worries about a global slowdown shouldn’t impact China’s consumption levels for many commodities. In fact, a worldwide slowdown may spur additional demand from China. Macquarie explains that China’s government tends to “de-synchronize” the country compared with the rest of the world, creating an inverse relationship. This means that when the world is growing, China becomes so concerned about rising costs and inflation, that it moves quickly to slow growth.

Conversely, when world demand for commodities slows, China ramps up its infrastructure projects and scoops up unwanted commodities. In China-The Great Stabilizer, I showed a Macquarie chart indicating how China’s demand for many base metals has run counter to world demand over the last 10 years. Most recently, in 2008, the de-synchronization took place when China first moved to slow growth to combat increasing inflation. As the global crisis caused a significant slowdown, “authorities moved quickly to substantially ease monetary and fiscal policy,” says Macquarie. Due to its long-term planning, China can start and stop infrastructure projects at will.

In addition, Macquarie says that potential growth of the country generally outpaces its energy and resources capacity.

The recent dramatic decline in coal stocks has been driven by concerns of a global slowdown, but with equities already down 40 percent from their July highs, we feel this negative sentiment is already priced in. Given the encouraging long-term fundamentals, along with the fact that the underlying commodity has roughly stayed the same over the past few months, it appears that fear is the driver. This is often when opportunity knocks.

John Derrick, director of research, contributed to this commentary.

 

Index Summary

• The major market indices were mixed this week. The Dow Jones Industrial Average gained 1.32 percent. The S&P 500 Stock Index declined 0.44 percent, while the Nasdaq Composite fell 2.73 percent.
• Barra Growth underperformed Barra Value as Barra Value finished 0.70 percent higher while Barra Growth decreased 1.42 percent. The Russell 2000 closed the week with a loss of 1.27 percent.
• The Hang Seng Composite Index finished lower by 1.22 percent, Taiwan gained 2.54 percent, and the KOSPI increased 4.25 percent.
• The 10-year Treasury bond yield closed 8 basis points higher at 1.92 percent.

 

Domestic Equity Market

 

The domestic stock market as measured by the S&P 500 Index was slightly lower this week by 0.44 percent. The figure below shows the performance of each sector in the index for the week. Six sectors increased and four declined. The best-performing sector for the week was telecommunication services which increased 1.80 percent. Other top-three sectors were financials and health care. Materials was the worst performer, down 3.21 percent. Other bottom-three performers were consumer discretionary and technology.

Within the telecommunication services sector, the best-performing stock was American Tower, up 2.89 percent. Other top-three performers were Verizon Communications, and AT&T.

Strengths

• The property & casualty insurance group outperformed, rising 5 percent, led by the group’s largest member, Berkshire Hathaway, Inc. The firm announced a share buy-back. Valuations of group members in general were raised by the announced agreement of the acquisition of Harleysville Group, by Nationwide Mutual Insurance Co. for $60 per share in cash, a 90 percent premium over the closing price prior to the announcement.
• The life & health insurance group gained 5 percent, led by group members AFLAC, Prudential Financial, Inc., and MetLife. The Harleysville Group acquisition described above also appeared to raise valuations in the life & health insurance group.
• The electronic manufacturing services group outperformed, up 4 percent, led by Jabil Circuit, Inc. The contract manufacturer of electronics reported quarterly revenue and earnings above the consensus estimate, and it raised its earnings guidance for the current quarter.

Weaknesses

• The casinos & gaming group was the worst performer, down 11 percent, led by its largest member, Wynn Resorts. The weakness was likely caused by investor concern over macro issues.
• The fertilizer & agricultural chemicals group underperformed, losing 10 percent, led down by Mosaic Co. and CF Industries Holdings. The U.S. Department of Agriculture released corn inventory data which was larger than expected.
• The oil & gas drilling group declined 8 percent. Oil service-related groups have been weak on investor concern that oil exploration and production companies might cut back expenditure budgets when faced with a possible economic slow-down.

Opportunities

• There may be an opportunity for gain in merger & acquisition (M&A) transactions in 2011. Corporate liquidity is high, thereby providing the means to pursue acquisitions.

Threats

• A mid-cycle slowdown in the domestic economy would be negative for stocks.
• An escalation of concerns over sovereign debt obligations in Europe would be negative for stocks.

 

The Economy and Bond Market

 

Bond yields rose this week as the financial markets gyrated and the focus remained on whether Greece would receive the next round of funding that is scheduled for October. The markets remain very volatile with bonds trading roughly inverse with equities.

In a sea of negativity, we did receive some encouraging news on Friday as the Chicago Purchasing Managers Index (PMI) unexpectedly rose to 60.4 in September; a decline had been expected. This bodes well for the closely watched ISM Manufacturing Index that is scheduled for release on Monday, and if the results are better than expected, that would likely boost economic sentiment.

Strengths

• After much deliberation and debate Germany approved a stronger European bailout fund and allowed policymakers more time to deal with the Greek debt situation.
• The Chicago PMI exhibited surprising strength and is a ray of hope for the manufacturing sector.
• Weekly initial jobless claims fell below 400,000 for the first time since early August and is at least moving in the right direction.

Weaknesses

• The housing market remains grim as new home sales in August hit a six-month low, August pending home sales hit a four-month low, and prices remain below a year ago.
• The Conference Board’s Consumer Confidence Index remains at very low levels and the “jobs hard to get” component hit the highest level since 1983.
• International economic data is also signaling a slowdown as Japanese retail sales fell 2.6 percent in August.

Opportunities

• With the economy weak and concerns brewing about an additional financial crisis, the Federal Reserve will remain accommodative for some time and bonds appear well supported in the current environment.

Threats

• The threat of a more significant global economic slowdown than many expected just a couple of months ago has increased sharply.

 

Gold Market

 

For the week, spot gold closed at $1,623.97, down $32.83 per ounce, or 1.98 percent. Gold stocks, as measured by the NYSE Arca Golds BUGS Index, fell 2.21 percent. The U.S. Trade-Weighted Dollar Index rose 0.33 percent for the week.

 

Strengths

• AngloGold’s chief executive announced this week that the company will be investing $250 million each year in Brazil through to 2016 to raise its Brazilian output of the precious metal by two thirds. Relative to its Latin American neighbors, Brazil has not targeted the mining sector as an “enhanced” revenue opportunity for the government.
• While gold mining in Australia is the country’s third-largest resource export, the minority-led government said that broadening the controversial profits-based tax on coal and iron ore miners was not going to be expanded to include the gold industry. The 30 percent tax on mining profits is estimated to generate $8.2 billion in its first two years from July 1, 2012, helping the budget return to surplus which is laden with unfunded government pension benefits. The tax legislation was designed to shift government liabilities to China via a resource tax on exports which are primarily heading to the Chinese market.
• Don Coxe, a global portfolio strategist, highlighted as his investment recommendations to maintain heavy weighting in precious metals, particularly through gold mining companies. He pointed out that gold mines are the cheapest relative to bullion that the market has ever seen.

Weaknesses

• Senior gold mining companies, while down about 2 percent for the week, outpaced the junior gold and silver mining companies which were down 5 percent. While we had one acquisition announced in the gold space last week, there was only one new acquisition proposed by the close of the this week by a Chinese company for a copper company in the Democratic Republic of Congo.
• Peruvian President Ollanta Humala signed into law higher mining taxes and royalties, while Cabinet Chief Salomon Lerner told a news conference that the Humala Administration has no plans to ask other industries to pay more taxes. Miners will now pay 1 to 12 percent royalties of operating profits, in addition to a windfall profits tax ranging from 2 to 8.4 percent of net profits, with the goal of increasing tax revenue during the mining boom years. Previous to this, miners were paying royalties between 1 and 3 percent. However, new labor actions this week in Peru may signal that unions are still not satisfied and we may have not seen the end of this hot issue yet.
• Mineweb reported that the Shanghai Gold Exchange will raise trading margins for gold and silver forward contracts from September 30 temporarily to prevent default risks, ahead of the week-long national holiday. Gold and forward-contract margins would be increased from 15 percent to 20 percent and from 18 percent to 22 percent, respectively. Daily upward and downward trade limits would be raised to 18 percent from 12 percent. Margin requirements would return to original levels on October 11 should there not be any breach on the upward or downward limits on the first day of trading on October 10.

Opportunities

• Jeff Nichols, Managing Director of American Precious Metals Advisors, has said that the “summer run-up in the gold price was too far too fast” but continues to feel that fundamentals still support much higher prices ahead. Nichols noted that from the September 6 all-time high of $1,923 per ounce, to the September 23 gold price of $1,628 per ounce, we have only seen a decline of 15 percent, which is well within normal corrections for the precious metal. He pointed out it is not unusual for gold prices to correct by 10, 15 or 20 percent after a run-up similar to what we have recently experienced.
• Gold traded down, touching the 150-day moving average on Thursday, and bouncing off that to close on Friday with an uptick. Gold now appears to be returning to the upward pattern that we have seen steadily over the past five years. In light of the fact that the European and U.S. debt problems are not going to be sorted out next Monday, gold should find renewed support at these levels.
• In addition, gold mining stocks have fallen back. European-based funds in the resource space are thought to be experiencing redemptions, which may be part of the issue, as junior-tiered mining companies have been pushed lower due to a distressed seller being in the market.

Threats

• Professor Dick Stacey of the School of Mining Engineering at the University of Wits in South Africa emphasized that there is a fall off in South African mining research. Twenty years ago, there were 600 to 800 people involved in full-time mining research in South Africa. “If there are 40, it’s a lot,” he said. He went on to say that despite an absolute demand for rock mechanics in mining, there is a major Western shortage. This is poised to further worsen as well.
• Roubini Global Economics published a piece questioning whether or not the Indian and Chinese festivals will provide support for the plummeting gold prices. Gold fell 16.7 percent between August 25 and September 26. The decline was attributed to profit-taking to cover losses in other asset classes, Chicago Merchant Exchange (CME) margin hikes, disappointment in the Fed’s Operation-Twist-like bond restructuring program and concern around further rounds of quantitative easing not materializing.
• Michael Sata was sworn in as President of Zambia in a tightly contested election. Mr. Sata has promised to re-introduce the windfall mining tax and to promote policies that will bring greater benefit to poor people. Currently mining in Zambia, Africa’s top producer of copper, contributes 11 percent of GDP and the country aims to double the contribution by 2015.

 

Energy and Natural Resources Market

 

Strengths

• The Global Resources Fund performed well this week due to its defensive positioning in the portfolio.
• On a relative basis, asset allocation and stock selection among food and grain processors helped to limit downside risk to the fund. Additionally, weighting in senior precious metals also played a role in limiting a decline.
• Despite a sell-off in copper prices and poor sentiment towards mining stocks this week, M&A remains active. Minmetals Resources agreed to buy Anvil Mining for $1.3 billion cash, gaining three copper mines in the Democratic Republic of Congo, which may produce 60,000 metric tons of copper cathode annually from next year.

Weaknesses

• Copper fell almost 5 percent to a 13-month low on Wednesday, plummeting from ongoing European fears. Copper’s drop came despite a 21 percent jump in Chinese imports in August. Gold had dropped almost 2 percent and wheat 5 percent.
• Freeport McMoRan Copper and Gold continues to experience ongoing strikes at two of their properties. Mining Weekly reported that up to 1500 workers in Indonesia’s Freeport remote Papua province protested outside a government office on Thursday, while workers went on strike that same day at the Peruvian Cerro Verde mine. This is third stoppage at Freeport this month. The company still maintains that the labor concerns have had no effect on output. Freeport’s shares were at a 15-month low as it weathers these two strikes.
• Crude oil is headed for its largest quarterly drop in 15 months over concerns of global economic slowdown.
• HSBC highlighted that September data signaled continued stagnation of China’s manufacturing sector. After adjusting for seasonal variation, the HSBC Purchasing Managers Index held steady at 49.9 in September. Moreover, the index averaged its lowest quarterly reading since the first quarter of 2009. Despite manufacturing production in China continuing to rise during September, panelists attributed the subdued increase in production to fewer intakes of new business and decreased demand conditions.

Opportunities

• The Don Coxe Strategy Journal recommended an investment strategy of maintaining heavy weighting in agricultural stocks. Despite having high volatility, the endogenous risk in their earnings is well below those of most cyclical stocks – commodities and otherwise. He also recommended retaining strong exposure to U.S. oil producers operating on land. The spread between West Texas Intermediate and Brent oil, and U.S. and European natural gas prices, remains. Coxe says that at the moment, energy is the most conspicuous competitive advantage the U.S. possesses.
• The CEO of Anglo American gave an upbeat statement this week regarding current and forward-looking demand conditions. The company stated that demand from China continues to be robust and that it doesn’t expect any of its clients to cancel orders for the next 18 months to two years in their nickel and iron ore businesses.

Threats

• Should we continue to see excessive volatility in the markets, we could potentially experience a global sell-off. Worldwide negative sentiment remains present, as ongoing concerns surrounding the global sovereign debt issues, leading investors to lose confidence in global policymakers.
• After recently swearing in Michael Sata as Zambia’s new president, the new Mines Minister Wilbur Simusa reportedly said that the tax the country is receiving from Africa’s top copper producers is not enough and may need to be reconsidered. Reuters highlighted that copper mining is Zambia’s economic mainstay and any plans to increase the tax could hurt the industry target of doubling annual copper output to 1.5 million tons by 2015.

 

Emerging Markets

 

Strengths

• In China, industrial companies’ profit rose 28.2 percent in the first eight months from a year ago. Net income climbed to 3.2 trillion yuan ($500 billion), the National Bureau of Statistics of China said this week.
• Korea has sufficient foreign-exchange reserves to cope with a potential financial crisis even if European investors take their money out of the country, central bank Governor Kim Choong Soo said.
• Indonesia has foreign reserves of $120 billion, while foreign debt funding is about $30 billion, according to CLSA research. The reserves should provide Indonesia enough liquidity in the event that foreigners withdraw their money as a result of an escalation of the European sovereign debt crisis.
• China’s hog herds are “firmly bouncing back,” with the total number of pigs rising for six months and the number of breeding sows rising for four months, according to the Ministry of Agriculture in Beijing. The pork price increase was the largest contributor to rising inflation in China. Also this week, China Premier Wen Jiabao said China food prices are stabilizing.
• Korea’s industrial production rose 4.8 percent in August from a year ago after rising 4 percent the previous month, but it declined 1.9 percent sequentially month-over-month.
• Exports in India have been steadily growing and are on course to reach the government’s target of $300 billion for the current fiscal year, driven by increased government support to exporters to tap into new markets in Latin America and Africa.
• Turkey is three times more efficient in using energy than China, Russia, or South Africa, according to Credit Suisse. Also, Central European countries (the Czech Republic, Hungary and Poland) made the most incremental improvement over the last decade.

• Turkstat reported that the Turkish economy added 2.2 million new jobs in the first eight months of this year.

Weaknesses

• Korea’s consumer confidence index fell to a five-month low of 99 in August, down from July’s reading of 102.
• Investors are worried about China’s shadow-banking loans, due to intensified news that many small- and medium-sized enterprise (SME) debtors are bankrupt, and therefore bank shares are under pressure. A China International Capital Corporation Limited (CICC) bank analyst estimated private lending went up 38 percent to RMB 3.8 trillion in total loans outstanding in the first half this year, and he further estimates that non-public loan (NPL) increases from small enterprises would reach RMB150 billion, 0.46 percent of corporate loans, not as bad as many media reported.
• Economic growth in South Africa slowed significantly in the second quarter of 2011, to 1.3 percent from 4.5 percent in the first quarter. This can be largely attributed to the ongoing sovereign debt crisis in Europe and an overall negative global economic outlook. Currently, unemployment is just above 25 percent of the labor force.

Opportunities

• Merrill Lynch expects record 2010 construction permits in Turkey to translate into a significant increase in demand for kitchen appliances. Typically, construction permits lead house deliveries and white goods sales by 12 to 18 months.

• As railway investments decline, China’s next bright spot in fixed asset investment is water conservancy investment. The Chinese government is said to invest Rmb 4 trillion in the next five years in water and environment infrastructures. This chart shows the water conservancy investment has increased in recent years after being neglected for the last 10 years, after frequent droughts, floods and food shortages in recent years. In the twelfth five-year plan, water infrastructure investment is expected to be at a cumulative average growth rate (CAGR) of 23 percent, according to CLSA China strategist Andy Rothman.

• According to The Beijing Axis, the global balance of power is shifting into the hands of rapidly industrializing emerging growth giants, especially Brazil, Russia, India, China and South Africa. Today, these countries are fuelling the global recovery with their huge demand requirements, high growth multiples and vast deployment of capital. The report also highlighted that these emerging powers are becoming more present in securing a foothold in Africa’s vast and rich resources.
• Bloomberg reported that Bovespa, the operator of Latin America’s largest securities exchange, is planning to start a bond trading platform by the middle of next year. Marcelo Maziero, Bovespa’s head of product and customer development said, “We are developing a platform. We are accelerating the fixed-income side, so it gets to the same level as stocks.”

Threats

• In China, SMEs are very much underdogs when it comes to bank lending; therefore, they borrow from shadow banks, i.e., private loans and entrusted loans, to expand their growth. With the economy slowing down and loan price going up (see chart shown below), many of them are leveraged at a wrong time. Many SMEs are now financially stressed.

• The La Nina storm is threatening record South American crops. Rabobank International reported that La Nina runs the risk of bringing dry weather to parts of South America, threatening record crop production on the continent. Analysts have speculated that because weather forecasts indicate that La Nina conditions are expected to strengthen, this would likely have a negative impact on corn planted area and yields. Corn production is expected to rise 12 percent this year and soybean output may gain 1 percent.
• Colombia’s policymakers will probably leave borrowing costs unchanged for a second straight month and end a dollar-purchase program as slowing inflation allows them to gauge the impact of the European debt crisis on global growth, Bloomberg reported. Currency “intervention isn’t needed at these levels,” head analyst at Banco de Bogota SA Camilo Perez said, “What is the general driver in markets now is risk aversion and that means a weaker peso.” We continue to see emerging markets leaving their rates unchanged in response to global economic uncertainty.

 

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