What's the Answer to Unprecedented Policies and Ultralow Rates?

What's the Answer to Unprecedented Policies and Ultralow Rates?

By Frank Holmes

CEO and Chief Investment Officer

U.S. Global Investors

An unexpected change of heart happened this week that you might not have heard about. After years of resisting any path other than its rigorous course, Germany announced it is backing off from pure austerity and is now planning to spend billions of euros to stimulate the economies of Europe.

Germany, which had been the economic rock of Europe, was facing fissures in its economy as well as an upcoming election season.

With pressure building, Finance Minister Wolfgang Schäuble and Chancellor Angela Merkel are now “willing to abandon ironclad tenets of their current bailout philosophy,” says Spiegel Online.

Berlin’s about-face seemed to be underreported, but the news is significant to global growth. Many countries around the world have been trying to charge ahead, implementing stimulative easing and monetary policies to strengthen their economies, yet Europe was still a drag.

Just look at the unemployment rate in the Europe area, which recently rose to 12.2 percent, a new record, according to Business Insider.

Weeks ago, when a student discovered a mistake in the famous report of Harvard professors Carmen Reinhart and Ken Rogoff, I said that calling this data into question provides a platform for Germany and the European Union to lessen austerity measures and delay the inevitable. It appears that Schäuble and Merkel have taken their first step onto the stage of unprecedented monetary policies.

From March 2009 when the first round of quantitative easing began, central banks have cut interest rates a total of 515 times and injected $12 trillion into markets, says Bank of America Merrill Lynch (BoA-ML). As a result, U.S. stock investors saw the market take off an astounding 166 percent since the first shot of liquidity.

However, contrary to what you may think, the U.S. is not the best performing market in the world. Take a look at the chart below, which ranks the top 10 equity markets’ total return over these past four years. Stocks in Indonesia grew 372 percent, Turkey rose 286 percent and Mexico has climbed 211 percent. Even Singapore, Korea and Australia climbed more than the U.S. stocks.

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In addition to all the global liquidity sloshing around, central banks have also “crushed bond yields to the point that almost 50 percent of all global government bond market cap currently trades below 1 percent,” according to BoA-ML.

In a great illustration of today’s low yield environment, the research firm compared the yields across debt markets from 2007 and 2008 to today. In June 2007, Treasuries were yielding more than 4.5 percent; today, they are sitting just above 0.5 percent. Even the riskier high-yield corporate bonds, which climbed to a high of 23 percent in December 2008, have fallen to about 5 percent.

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Even though market pundits talk about elevated rates on the horizon, we believe significantly higher rates that would move the needle for an income investor is a ways off. This means low yields will be significant for awhile.

So what’s the answer to unprecedented central bank policies that have been driving stocks higher and ultralow rates? I believe investors need to stick to a strategy that includes dividend-paying stocks that offer the opportunity for both income and growth.

Index Summary

• Major market indices closed lower this week. The Dow Jones Industrial Average fell 1.23 percent. The S&P 500 Stock Index moved lower by 1.14 percent, while the Nasdaq Composite lost 0.09 percent. The Russell 2000 small capitalization index fell 0.01 percent this week.
• The Hang Seng Composite fell 0.63 percent; Taiwan rose 0.55 percent while the KOSPI rose 1.40 percent.
• The 10-year Treasury bond yield rose 12 basis points this week to 2.13 percent.

Domestic Equity Market

The S&P 500 finished down for the second week in a row, falling 1.14 percent. The traditionally defensive groups continue to be hit the hardest with dividend paying stocks being sold across the board as treasury yields begin to rise. We highlighted the beginning of this rotation about a month ago as cyclicals began their outperformance.

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Strengths

• The technology sector was the leader this week with a diverse set of companies experiencing gains. First Solar, Applied Materials and EMC Corp. were the best performers and all rose by more than 4.5 percent.
• The financial sector was the second best performer, led by Morgan Stanley, CME Group and MetLife. Insurance companies and the large banks generally performed this week as higher interest rates at this point are still viewed as positive developments.
• Newmont Mining was the best performer in the S&P 500 this week gaining 7.23 percent. Broadly speaking gold stocks rallied this week as the dollar weakened and downside volatility returned to the market.

Weaknesses

• The telecommunication sector was the worst performer this week, as interest rate sensitive areas of the market sold off sharply.
• The consumer staples sector also underperformed largely for similar reasons mentioned above.
• Cliffs Natural Resources was the worst performer in the S&P 500 this week declining 11.44 percent as iron ore prices accelerated their recent price decline this week.

Opportunity

• Germany pulled an about face and is now comfortable with less European fiscal austerity and is even offering to support its southern neighbors.
• Lower food and energy prices globally are helping to keep a lid on inflation, a blessing for global central bankers pondering further accommodation of monetary policy.

Threat

• A market consolidation could continue in the near term, as the S&P 500 kept trending higher beyond its all time record for a month defying the proverbial “Sell in May” seasonal pattern.
• The U.S. dollar is lingering around its three-year high, which may translate into lower earnings for S&P 500 companies going forward since around 50 percent of S&P 500 earnings are made from overseas.

The Economy and Bond Market

Treasury yields moved sharply higher this week as the bond sell off that began early this month continued. Fears of the Federal Reserve “tapering” (reducing QE and the first step on a long road toward tightening monetary policy) continued and investors are focusing on the potential end in a multi decade bull market for bonds.

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Strengths

• Consumer confidence rose to a five-year high as both current and future expectations improved. The University of Michigan’s Confidence Index also rose in May.
• Existing home values rose 10.9 percent in the twelve months ending in March, the biggest gain since 2006.
• The Chicago Purchasing Manager Index rose to the highest level in a year and well into expansion territory, which bodes well for next week’s national ISM report.

Weaknesses

• The total number of mortgage applications, according to the Mortgage Bankers Association, filed in the U.S. last week fell 8.8 percent from the prior week. This was the third week in a row of large declines in mortgage activity due to rising interest rates.
• Personal income and spending in April came in below expectations as income was flat and spending was down.
• Brazil unexpectedly raised interest rates by 50 basis points this week to fight inflation even with weaker than expected economic growth.

Opportunity

• The Fed continues to remain committed to an extremely accommodative policy.
• Key global central bankers are still in easing mode such as the European Central Bank (ECB), Bank of England and the Bank of Japan. The Bank of Japan, in particular, is aggressively easing currently and the ECB recently cut interest rates.

Threat

• Inflation in some corners of the globe is getting the attention of policy makers and may be an early indicator for the rest of the world.
• Trade and/or currency wars cannot be ruled out which may cause unintended consequences and volatility in the financial markets.

Gold Market

For the week, spot gold closed at $1,387.92, down $6.86 per ounce, or .09 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 7.21 percent. The U.S. Trade-Weighted Dollar Index lost 0.45 percent for the week.

Strengths

• A week of weak U.S. economic data eased fears that the Federal Reserve would engage in any sort of tapering program for its monthly $85 billion bond buying program. Furthermore, gold climbed as the dollar index weakened. The rise in spot gold also helped attract attention from generalists and hedge funds that are driving the rise in gold-backed exchange-traded fund holdings for the first time in three weeks.
• Russia is profiting from the weakness in gold prices and has expanded its gold reserves for a seventh straight month in April. Russian bullion holdings are now the seventh largest by country, after they increased to 990 tons. However, sovereign buyers are not the only ones benefiting from the price action created by excessive sell-off last month. In Singapore, home to large communities of Chinese and Indian immigrants, unprecedented physical demand for the metal has drawn down inventories and made supply scarce. Premiums for immediate delivery rose to $7 per ounce, setting new highs. Premiums in other Asian countries have eased after gold prices bounced off the two-year lows but remain well above their averages.
• Klondex Mines released more recent exploration results this week. All five drill holes intercepted mineralization at its Fire Creek gold project in Nevada. The new mineralization continues to highlight the potential for new discoveries in the unexplored areas of the Fire Creek property. In Bulgaria, home to Dundee Precious Metals’ Chelopech mine, Parliament has elected a new prime minister, ending a three-month stalemate following the resignation of the previous government amid escalating anti-austerity protests. The new government’s task of promoting economic growth should bode well for companies like Dundee.

Weaknesses

• Short sellers in the gold futures market increased their position for the sixth consecutive week lifting the total short position to a new record 14.6 million ounces. Geoff Candy, a Mineweb contributor, notes that despite the extreme bearish attitude by traders toward the yellow metal, analysts believe it could be a good thing for gold. The reason why lies in the fact that heavily oversold positions with record levels of short positions are very unlikely to fall any further. At such a juncture, the margin calls have been made, those bearish on the metal have already sold off or taken short positions, while long term holders of the metal buy the dips. The option for a negative catalyst is virtually non-existent, while the occurrence of a positive catalyst – out of which there are many – could trigger a revaluation that would be intensified by the record number of short covering.
• In a recent interview, Peter Leon of Webber Wentzel noted the mining sector in South Africa is in urgent need of strong leadership, from labor, the miners, and government. The country’s un-addressed social inequality is largely to blame for the seemingly-continuous labor strikes and the demands for unaffordable wage increases. Amid spiraling costs and declining commodity prices, labor instability has certainly become a nationwide problem for the resource dependent economy. The government’s increased involvement has yet to bring a realistic solution to the table, while investors bear the cost.
• Last Friday a Chilean regulatory agency ordered Barrick Gold to halt its $8.5 billion Pascua Lama Project and fined the company $16 million, alleging serious violations of water management at the site. Chile’s environmental regulator was cited this week stating it will likely take at least a year or two for Barrick to reactivate the project given the time required to build the anti-water pollution infrastructure needed.

Opportunities

• This week we dusted off one of our favorite statistical analysis tools at U.S. Global. We study the time certain assets spend above or below their 200 day moving average after crossing the “golden cross” or the “death cross” as it help us understand the assets’ relative strength and complements our other mean reversion models. The study reinforced our belief that gold is in uncharted oversold territory and has to revert upwards, even on a purely statistical analysis. Over the last ten years, when gold meets its “death cross” it spends 71 calendar days on average before reaching a “golden cross”. More importantly, gold falls on average a maximum of 5.7 percent before it troughs. Since gold’s last “death cross” on February 19 this year, 101 calendar days have passed, and gold has fallen a maximum of 19 percent. With these numbers in mind it is evident why we believe gold is due for a correction towards its “golden cross.”
• The price action in the mining sector is starting to show signs of a technical bottom and it is highly likely that we will see additional choppiness before the market finalizes the transition back to a solid uptrend. Market participants seem to be buying more than selling and the current price appreciation is testing resistance levels established in April and early May.
• The index still has more work to do before the trend has changed, but we haven’t seen price action like this for quite some time.

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• According to a recent Deutsche Bank Research study, central banks of countries covering roughly 27 percent of global GDP have cut rates in recent weeks, highlighting once again the ongoing accommodative bias. Perhaps the most meaningful of these cuts was the 25 basis point slash to the refi rate in the eurozone in early May. To ratify its commitment to increasing liquidity in the system, the German government put aside its intransigent commitment to austerity this week in light of new record unemployment numbers across the continent. Some see the willingness to lend as a potential shock to restart the eurozone economies, however, the reality of the members’ unsustainable deficits will be continue to be ominous and the necessity to diversify into real assets such as gold will be more undeniable.

Threats

• On Thursday, first quarter GDP growth for the U.S. was revised down to 2.4 percent from the previous 2.5 percent. Not a terrible revision by any means, especially given most of the growth components were unchanged from the previous reading. However, details emerged showing after-tax corporate profits decreased 1.9 percent for the quarter. The disappointing number was the first negative reading since the first quarter of 2012 and highlights the big concern in the markets today of stocks grinding higher on the face of stagnated earnings growth. The negative reading is not only a blow to the overly enthusiastic buying seen in the market, but also a worrisome indicator of global economic growth where the U.S. has been the poster child of the developed world.
• On a similar note, David Rosenberg of Gluskin Sheff, cited in his daily note four reasons why investors should be concerned with the current state of the U.S. equity market. Firstly, he argues that the current trailing P/E multiple of 16x appears overly-expanded at levels similar to those that triggered the market correction in April 2010. Secondly, market bullishness hit the 70 percent mark, a level not reached since the exuberance of the 2007 summer. In addition, leverage has reversed its decline with margin debt rising 1.3 percent for the month of April. Lastly, speculative long positions for the S&P have reached near record highs. There may be reason to believe the market is overstretched, yet with the current monetary expansion not expected to be tapered soon, the market may have more upside before it corrects.
• The Reserve Bank of India continue its frontal attack on gold following its futile attempts to reduce imports by increasing the tariffs paid by importers on two separate occasions this year. The RBI has now banned banks from lending against gold coins weighing more than 50 grams per customer, or for that matter any units of gold exchange-traded funds and gold mutual funds. In addition, the central bank said non-bank financial institutions should not give loans for the purchase of gold in any form. As with the previous attempts at over regulating and forcing demand lower in the bullion market, the RBI will quickly find out these policies are meant to backfire in a country where gold plays a crucial cultural role.

Energy and Natural Resources Market

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Strengths

• World industrial production, a key determinant of metals demand, was 0.6 percent higher in March 2013, latest data from Dutch research group CPB shows, with strong gains in all regions except Africa and the Middle East. Output was just 1.7 percent higher year-over-year, but that reflects a very weak July-Sep 2012. Since then output has risen 2.2 percent in six months.
• With consecutive records in the reported ten day steel production rates in China over mid and late April, it looks like April should be a record month for steel production in China. This has come at the same time as a very healthy 67Mt imports went into China in April (third highest on record).
• The U.S. land rig count was up 5 rigs from the prior week, while the offshore rig count was up 4 rigs (+8 percent). Accordingly, the overall U.S. rig count was up 9 rigs (+1 percent) from last week to 1,771 rigs, which compares to a 7 rig decrease in the prior week.

Weaknesses

• Global coal producers cut back. Australian miners recently announced measures to streamline operations, reduce costs, and cut output in response to low prices.
• The combination of overcapacity and weakness in steel demand outside China continues to bear down on steel prices, as illustrated by the latest SteelBenchmarker data from World Steel Dynamics. WSD’s HRC export price fell $7/tonne to $546/tonne and is now at its lowest level since the end of November 2012, while the domestic US HRC price is at its lowest level since November 2010 at $637/tonne.
• China crude steel output slips in mid-May from an all-time high. China daily steel output for mid-10 days of May slipped marginally (0.3 percent) to 2.185 million tons per day vs. 2.193 million tons per day in first 10 days of May. This latest figure annualizes to approximately 798 million tons per year vs. output of an estimated 709 million tons in 2012. (CISA)

Opportunities

• Vale wins approval to exploit an iron ore deposit in the Brazilian state of Minas Gerais as it seeks to replace dwindling output. The permit allows estimated 20 million metric tons of iron ore production a year on reserves of 64.9 million tons.
• South Africa may take unspecified "interventions" in the gold and platinum sectors, as part of a state plan to maintain the viability of the industries, said the Mines Minister, although no details were provide on what the interventions might involve. Also, the government will not tolerate anarchy or wildcat strikes at the country’s mines as annual wage negotiations in the industry get underway, according to the Mineral Resources Minister.

Threats

• With the release of the weaker-than-expected business confidence in China, concerns are increasing with respect to deteriorating fundamentals as we approach the mid-year summer slowdown period. Copper in particular remains vulnerable to underperform versus the rest of the complex.
• Latest LME open interest data signals new short positions being established over the last week or so in some of the main metals markets traded on the exchange. On a one-month view the data points to a combination of long liquidation and short covering in most cases. Aluminium appears most bearish while there may be some cautious optimism emerging in lead.

Emerging Markets

Strengths

• China’s industrial profits rose 11.4 percent year-over-year in the period of January through April; profits rose 9.3 percent to RMB 437 billion in April. With double-digit profits increasing, the current H-shares valuation is attractive.
• During an environmental study meeting of the Politburo Standing Committee of the Communist Party of China, president Xi Jinping said that China cannot sustain economic growth without protection of environment. It is clear that environmental protection is moving to the forefront of policy decisions.
• Wenzhou, Zhejiang province dropped 0.09 percent on non-performing loans for April-end; this is from a month earlier to 3.92 percent. Outstanding bad loans fell 685m yuan from the end of March, Shanghai Securities News reported, citing the city’s banking regulator.
• China has allowed the U.S. Public Company Accounting Oversight Board access to documents from Chinese accounting forms related to U.S.-listed Chinese companies.
• Hong Kong’s April retail sales rose 20.7 percent year-over-year by value, versus the market estimate of 14.5 percent.
• The Philippines’ GDP growth came in at 7.8 percent year-over-year for the first quarter of 2013, sailing past consensus estimates of 6.2 percent. Construction activity was up 33 percent year-over-year, slightly faster than the fourth quarter of 2012’s 30-percent pace. Private construction grew 31 percent, riding the property pre-selling boom of recent years. Public construction spending surged 46 percent, consistent with the government’s infrastructure thrust. Note that the growth has come without the big-ticket, public-private partnership (PPP) projects. The government expects to increase infrastructure spending from just 2.5 percent of GDP currently, to as much as 5 percent by 2016 (including PPP), implying a sustained 30-40 percent compound annual growth rate (CAGR).
• The Bank of Thailand, the central bank, cut benchmark interest rates by 25 basis points to 2.5 percent.
• Indonesian infrastructure construction spending grew 23 percent CAGR during the 2007-2012 periods. The government plans 17 percent growth in infrastructure spending for 2013, to 2.2 percent of GDP. This trend will continue to make up the lost decade in infrastructure investment between the 1998 Asian financial crisis, and the completion of banking sector restructuring in 2004-2005.
• Taiwan unveiled 13 measures in a new economic stimulus plan, which includes cash-for-clunkers, capital gains tax revisions, incentives for private investments, and government funds for start-ups.
• Following the weak first-quarter economic data published last week, the Chilean economy appears to have regained its footing in April. Retail sales for the month soared by 11.2 percent from a year earlier, while the manufacturing index grew by 3.4 percent for the month beating analysts’ forecasts of a 2.9 percent rise. The rising domestic demand statistics are comforting for a country with large exposure to commodity exports amid weak global commodity prices.

Weaknesses

• Chinese premier Li Keqiang said China will grow its GDP at 7 percent, doubling GDP per-capita by year 2020 from the 2010 level. This is lower than the 7.5 percent GDP growth target set at the beginning of the year.
• The People’s Bank of China (PBOC), the nation’s central bank, will not rashly cut interest rates on concerns of inflation, Shanghai Securities News reported. It cited Wang Guogang, head of the Institute of Finance and Banking at the Chinese Academy of Social Sciences, as a think-tank for the Chinese government.
• The Bank of Thailand’s (BOT) private consumption index was up 1.7 percent year-over-year, but was down 0.5 percent month-over-month. The private investment index was down 1.1 percent year-over-year, and down 1.6 percent month-over-month in April, tracking the lackluster manufacturing index that was down 3.8 percent year-over-year and down 5.1 percent month-over-month. April exports were revised down to 2.9 percent versus consensus of 5.3 percent and 4.55 percent in March.
• Brazil’s GDP grew 1.9 percent year-over-year in the first quarter of 2013, trailing analysts’ forecasts of a 2.3 percent growth. More significantly, the number is far from President Rousseff’s growth estimates at the beginning of the year, which called for 3 percent growth for 2013. The rate disappointed despite strong domestic consumption and investment, as the trade balance deteriorated with falling exports and rising imports. Earlier this month, April exports data showed that despite fears of falling demand from China, exports to the Far East nation grew by 5.9 percent, while the falling demand came from lower oil shipments to the U.S.

Opportunities

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• As shown in the graph above, the Philippines has all stars aligned in favor of their economy, including growing overseas workers’ remittance, booming business process outsourcing, increased consumer spending, and demand for infrastructure investments. Investors have done very well investing in the Philippines’ stock market due to growing corporate sales and earnings.
• Vice President Joe Biden’s six-day tour of Trinidad and Tobago, Colombia, and Brazil is certainly a welcome development for a region that has seen little political interest from Obama’s administration as it focuses on its Transatlantic and Trans-Pacific trade partnerships. The visit already resulted in new trade agreements amounting to $500 billion between the U.S. and Brazil, with a focus on energy exploration and biofuels that should mitigate the negative impacts on Brazil’s trade of diminished oil exports to the U.S.

Threats

• Thailand has seen weak economic numbers recently from private consumption to exports. All of the policy catalysts after Prime Minister Yingluck was elected have already materialized. The market is looking for new drivers in the short term, though the economy still is solid, particularly in tourist and urbanization areas. The market corrected 2 percent in May.
• Mexico posted a large $1.23 billion trade deficit for the month of April against analysts’ forecasts of a small $190 million surplus. The deficit came as the pace of imports beat the slower increase in exports, led by a slip in petroleum exports. The news is unsettling for two reasons; first, the same type of deterioration in the trade balance weighed heavily on Brazil’s first-quarter GDP growth disappointment, and secondly, Mexico’s GDP growth for the first quarter was already weak, coming in far below previous readings.

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