What Areas of the Market Will Remain in the Limelight?
By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors
The current bull market has been five years in the making. Since the bottom on March 9, 2009, the S&P 500 Index has grown an incredible 174 percent. With this spectacular performance, investors are asking if U.S. companies will stay in the limelight or if it is time to draw the curtain on equities.
While I am in Los Angeles at a leadership event for CEOs from around the world, I asked John Derrick, CFA, director of research, to shed some light on the subject.
Index Summary
- Major market indices finished higher this week. The Dow Jones Industrial Average rose 1.36 percent. The S&P 500 Stock Index gained 1.26 percent, while the Nasdaq Composite advanced 1.05 percent. The Russell 2000 small capitalization index rose by 1.58 percent this week.
- The Hang Seng Composite rose 0.89 percent; Taiwan gained 0.44 percent while the KOSPI advanced 1.13 percent.
- The 10-year Treasury bond yield fell 8 basis points this week to 2.65 percent.
Domestic Equity Market
The S&P 500 Index rose to new highs this week. The market was led by cyclical areas primarily driven by confidence in expected growth prospects. Defensive areas such as telecommunication services and utilities were down for the week even as treasury yields rallied and ended the week lower.
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Strengths
- The consumer discretion sector was the leader this week as retailers were strong. Target, Kohls and Best Buy were among the best performers this week. All three companies reported earnings that were ahead of expectations.
- The materials sector was also strong this week, with chemical companies generally leading the way. FMC Corp, PPG Industries, Dow Chemical and Eastman Chemical were all among the best performers on expectations of better pricing and a recovery in the agricultural chemical space.
- Newfield Exploration was the best performer in the S&P 500 this week rising 14.13 percent. The company released quarterly earnings results which were ahead of expectation on operation efficiency, and the company is nearing completion of a significant foreign asset sale which the market took positively.
Weaknesses
- The utilities and telecom services sectors underperformed. Performance was mixed, but it was a “risk on” week for the market and defensive areas generally underperformed.
- The technology sector was also a laggard in a strong market as Autodesk, Juniper Networks and Micron Technology were down for the week.
- Cliffs Natural Resources was the worst performer in the S&P 500 this week, falling 8.83 percent. Falling iron ore prices and fears that China demand will falter were the primary drivers of the share price drop.
Opportunities
- The current macro environment remains positive as economic data remains robust enough to give investors confidence in an economic recovery, but not too strong as to force the Federal Reserve to aggressively change course in the near term.
- Money flows are likely to find their way into domestic U.S. equities and out of bonds and emerging markets.
- The improving economic situation could possibly drive equity prices well into 2014.
Threats
- A short-term market consolidation period after such strong performance over the past six months cannot be ruled out.
- Higher interest rates are a threat for the whole economy. The Fed must walk a fine line and there is potential for policy error.
- A lot of good news is potentially priced into the market and the economy will need to deliver to maintain the positive momentum.
The Economy and Bond Market
Treasury bond yields rallied this week on mixed U.S. economic data and weaker Chinese property data. The market is also struggling with disentangling the weather effects from the recent figures, which have generally been weaker-than-expected, adding another layer to the complexity of the analysis. New home sales were strong and hit the highest levels since 2008, creating some excitement around housing as a catalyst for the economy in 2014.
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Strengths
- New home sales were strong and hit the highest levels since 2008.
- The S&P/Case-Shiller 20-City Composite Home Price Index rose 13.42 percent year-over-year and has already had a positive impact on the economy through a wealth effect and by spurring activity.
- German GDP rose 1.4 percent on an annual basis in the fourth quarter, ahead of expectations, while the Ifo Institute’s business confidence index rose to the highest level since July 2011. This all bodes well for Europe’s largest economy.
Weaknesses
- Chinese property prices fell in January, and combined with government efforts to curb the housing market, created concerns about Chinese growth prospects.
- Consumer confidence fell modestly in February as expectations fell relative to last month.
- Durable goods orders fell 1 percent in January, which was better-than-expected, but the prior month was revised lower and continues a recent string of lackluster manufacturing reports.
Opportunities
- The Federal Reserve member commentary this week more-or-less confirmed that tapering would proceed as planned.
- The International Monetary (IMF) released a report recently highlighting the deflation risk in Europe. It is exactly this type of thinking that could spur additional easing policies from the European Central Bank.
- There are many moving parts to the taper decision and although the Fed began the process, it is very possible that tapering could be delayed if the economy stumbles.
Threats
- Several emerging market countries are raising interest rates at an aggressive pace to either deal with inflation or a weak currency. It could be the beginning of a new global interest rate cycle for higher rates.
- Trade and/or currency “wars” cannot be ruled out which may cause unintended consequences and volatility in the financial markets.
- China remains a wildcard for economic recovery and the economy has shown some cracks in recent months. This is similar to how last year started and China found its footing, something similar needs to happen this time around.
Gold Market
For the week, spot gold closed at $1,326.44, up $2.16 per ounce, or 0.16 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, fell 2.62 percent. The U.S. Trade-Weighted Dollar Index slipped 0.59 percent for the week.
Strengths
- Gold is heading for a second month of gains, the longest such run since August. Bullion has gained more than 10 percent this year, rebounding from the biggest annual decline in more than three decades, even as the U.S. Federal Reserve announced a reduction in asset purchases at its past two meetings. The rally in gold is apparently halting the 13-month outflow from the biggest exchange-traded fund backed by the metal. Assets in the SPDR Gold Trust are poised for the first monthly inflow since December 2012.
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- Gold demand apparently remains very strong. China’s January Hong Kong gold imports soared 326 percent year-over-year. The Hong Kong region exported a net of 83.6 tonnes of gold to the Chinese mainland in January, down slightly from December exports of 91.9 tonnes. Exports from Hong Kong to China last year in January were very low at 19.6 tonnes. Macquarie notes that Russia was the biggest buyer of gold last year, purchasing 77 tonnes of the metal. Kazakhstan added 28 tonnes, Azerbaijan 20 tonnes, South Korea 20 tonnes, and Nepal 12 tonnes for a total estimated central bank addition of 185 tonnes.
- The mining industry in Canada has seen a significant increase in M&A activity. Investment bankers report more than $3 billion in mergers and acquisitions in less than two months this year vs. $2.6 billion in the first quarter of 2013 and $4.8 billion for the full year. On the other hand, according to Bloomberg’s review of financial statements across 1,300 mine operators, 49 percent of Canadian-domiciled companies have less than three months of cash, 62 percent have less than six months and 74 percent less than 12 months, which is highest percentage ever recorded, likely a catalyst to get a deal done.
Weaknesses
- Recently, Shanghai gold premiums have moved from a slight discount to flat, partially ameliorating concerns over China’s import appetite.
- Silver Lake announced it was placing its second operation, Murchison, on care and maintenance. Silver Lake has had three successive significant misses on guidance, none of which it has addressed.
- Goldcorp’s chief executive says he is prepared to kill the hostile bid for Canadian rival Osisko Mining Corporation if it becomes too complicated or expensive. CEO Chuck Jeannes in his interview said that if it happens “that would be a very bad day for Osisko shareholders. They would probably see their stock drop by 20 percent overnight.”
Opportunities
- For those investors that have thought bitcoins might be a viable alternative to gold, they have something new to consider. Mt. Gox, once the world’s largest bitcoin exchange, filed for bankruptcy after the company lost 750,000 bitcoins belonging to users and 100,000 of its own. The company blamed weak computer systems for the theft of bitcoins, focusing attention on the digital currency’s risk. For digital currencies, security measures may leave a lot to be desired in comparison to the security one has of physical gold being locked in a bank vault.
- With the stronger gold performance this year we are seeing some analysts revising their price predictions higher. For example, UBS analyst Edel Tully has revised her gold one-month average forecast price from $1,180 to $1,280, and her three-month gold price prediction stands now at $1,350 vs. $1,100. Also, RBCCM’s Toronto-based analytical team has revised its long-term gold and silver price assumptions to $1,400 and $23.50, respectively. The higher the price goes, the more likely commodity forecasters will start adjusting their price targets higher.
- NGEx Resources’ preliminary results from Los Helados suggest that a large-scale block caving operation with the potential to mine 75,000 - 100,000 tonnes per day as a technically feasible development option, would allow early mining of the higher grade core of the Los Helados deposit with a cut-off grade of .6 percent copper equivalent.
Threats
- The Democratic Republic of Congo’s government and local miners failed to agree on mining code. Talks have been extended for another week to try to overcome differences over proposed tax changes in a draft mining code. Prolonged discussions over the new code may have a chilling effect on Randgold and Banro, both with operating mines located in the Democratic Republic of Congo.
- Rosa Abrantes-Metz, a professor at Stern’s School of Business, and Albert Metz, a managing director at Moody’s Investors Service, conducted a study on gold fixing and found signs of collusive behavior that need to be investigated. The gold fixing study revealed unusual trading patterns around 3:00 pm in London, during the time when the five biggest gold dealers actively work together to manipulate the benchmark. This likely is a bigger problem for the banks involved in the price fix, but could lead to more transparent markets for customers.
- The world’s biggest macro hedge fund says Canada has a tough decade ahead of it, with Ray Dalio’s Bridgewater Associates saying in its well-read daily note that the country’s economy is just beginning a tough period of rebalancing. While this could be negative for the country as a whole, further currency weakness would likely be a positive for the gold miners which sell their production benchmarked to a U.S. dollar gold price.
Energy and Natural Resources Market
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Strengths
- West Texas Intermediate crude oil gained 5 percent in February and closed above $100 a barrel for a twelfth-straight day on strong weather-related demand and a weaker U.S. dollar.
- The price of nickel posted its biggest monthly gain in more than a year as a result of speculation that supplies will tighten as Indonesia, the world’s top exporter, maintains a ban on unrefined ore shipments.
- Vale opened its Totten Mine in Ontario’s Sudbury Basin, its first base metal mine in the area in more than 40 years. The construction of the mine, which will produce copper, nickel and precious metals over the next 20 years, took more than seven years with a budget of more than $700 million.
Weaknesses
- Natural gas futures headed for the biggest weekly drop in 17 years in New York, as the March contract expired and a government report showed U.S. stockpiles of the heating fuel declined less than estimated this week.
- The Steel Index (TSI) 62 percent spot iron ore prices have dropped back to $119.10 per tonne ($119.10/t) mid-week, the lowest level since July 2013.
- Thermal coal spot prices are currently at their lowest level since last September, with the DES ARA Index and Newcastle benchmark at $76.25/t and $77.30/t as of last Friday. We believe that the main cause of the fall in price has been demand weakness in both the Atlantic and Pacific basins.
Opportunities
- Solar developers around the world will install record capacity this year as a thriving Chinese market drives growth, a Bloomberg survey showed, as manufacturers in the $102 billion industry began to return to profit. About 44.5 gigawatts will be added globally, a 20.9 percent increase on last year’s new installations, according to the average estimate of nine analysts and companies. That is equal to the output of about 10 atomic reactors.
- Cameco Corp., Canada’s largest uranium producer, welcomed a commitment by Japan to nuclear power almost three years after the meltdown of three reactors at the Fukushima Dai-Ichi nuclear power plant. Prime Minister Shinzo Abe is seeking the restart of the nation’s 48 reactors, all of which are idled for safety checks.
- Hebei, the largest steel-producing province in China, is targeting 60 million tonnes of capacity closures by 2017. If implemented, this would have a huge impact on steel capacity utilization rates and steel margins. Recently, the government demolished 15 blast furnaces as part of the drive to reduce capacity and improve environmental performance. The level of detail in the targets for closure suggests there is an imperative to achieve the closure targets this time.
Threat
- China’s steel industry will not see a quick end to its troubles, as overcapacity has reached staggering proportions and structural adjustments to the economy have complicated the sector's situation, according to CISA. China has 300 million tonnes of surplus steel output capacity, which is twice the output of the European Union in 2013.
- The Democratic Republic of Congo and mining firms fail to agree on the new mining code. As a result, the government extended talks by a week to overcome differences on proposed tax changes in the mining code.
Emerging Markets
Strengths
- Through Wednesday, February 26, both the Philippines and Indonesia have seen three consecutive weeks of net-equity fund inflows. Investors started to differentiate among emerging markets and turned more constructive toward those with improving economic fundamentals.
- Confidence in emerging market (EM) equities continues to build, as tapering concerns appear overdone. Fundamentals in the Asian members of the “Fragile Five” have improved. The Brazilian real, Turkish lira and South African rand gained more than 3 percent in the past month. Export purchasing managers’ indexes (PMIs) in Taiwan and Korea are signaling strengthening domestic market (DM) demand.
- MENA’s outperformance has been significant; 60 percent for MENA banks versus the MSCI Emerging Markets Financials Index over the last 12 months. The entry of the United Arab Emirates (UAE) and Qatar to the MSCI EM Index in May has been a significant driver, but the broader MENA region has also benefited, foreign exchange (FX) pegs, current account surpluses, a robust/downgrade-free gross domestic product (GDP), and high dividend yields.
Weaknesses
- Singapore’s industrial production growth in January expanded by a much lower-than-expected 3.9 percent year-over-year, a slowdown from December’s 6.4 percent pace, and driven by weakness in transport engineering and electronics.
- The Ukraine hryvnia breached the psychological level of 10.0 per U.S. dollar, setting a new record low. Weakness in the Ukraine’s currency came as no surprise given the shaky economic situation and considerable headwinds on the external front. CNBC cited a National Bank of Ukraine (NBU) official as saying that the monetary authorities would abandon forex interventions.
- Not only is the U.S. showing weak import demand, but so is the eurozone. The growth rate of the eurozone’s import volumes remained negative through November 2013, the twentieth-consecutive month of contraction.
Opportunities
- Citi emerging market strategist set year-end target for Turkish equities at 15 percent above current levels. At only 8.3 times forward earnings, Turkish equities are already at the lower end of the ten-year range, a compelling entry point.
- Yandex has announced a partnership with Google over online display advertising sales via the Real-Time-Bidding (RTB) system. The partnership is likely to result in improvements in ad quality and increased display adverting sales for both Yandex and the Russian ad market.
- Further proliferation of mobile devices and the roll-out of the 4G wireless network in China may continue to change consumer behavior in everyday living, according to Goldman Sachs. Indeed, mobile payment, group purchases and advertising have the potential to double China’s online-to-offline market size in the next two years, according to iResearch. This megatrend should benefit leading Internet software and services companies.
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Threats
- While recent weakness in the Chinese renminbi was arguably engineered by the Chinese central bank to discourage cross-border carry trade arbitragers and manage hot money flows, the worsening prospect of the Chinese currency might weigh on sentiment toward the banking and property sectors in the near term.
- Russia’s involvement in the Crimea dispute may have major consequences for Russian gas exports into the Ukraine and the European Union, and the entire Russian economy, already near stagnation. A recession would result in further pressure on the ruble and the macro-sensitive domestic names among financials and consumers, as well as Gazprom.
- The risk themes for the year have not changed much. China, growth and flows remain the most important concerns. The recent slowdown in some Chinese numbers, the tightening in local credit conditions and the recent move in the currency, all underscore an economy that is in the process of adjustment.
© US Global Investors
