Global Markets Rally on Stimulus

So the central bank answer is to keep rates low, depreciate their currencies, and print money to try to stimulate economies. To date, it would be difficult to call these efforts a success. In the US, the economy appears to have stagnated again, with business activity, new job creation, and overall GDP growth stalling or moving backwards. Only consumer spending has shown signs of life recently, and with spending rising faster than wage gains, it is neither helpful nor sustainable.

In Europe, to date, we have heard far more words on stimulus (“whatever it takes”) than seen action. The way is now clear, however, after German political and judicial roadblocks have been removed.

What is clear is that there is an overwhelming desire among the political elite to keep the euro experiment together, though taxpayers and electorates in many countries are beginning to weary of the cost and lack of progress.

And the progress has been slow, with renewed problems raising their head. Moody’s has warned of a Spanish bond downgrade to junk, while reports indicate that the Greek situation may yet be worse than even revised estimates. So we can anticipate some action from Europe soon.

Despite the lack of progress on dealing with the debt crisis, the economy is showing signs of stabilizing particularly in Germany and core Europe (with purchasing managers and business climate surveys in Germany, France and Belgian moving up). The periphery remains weak, however, so this will not be sufficient to stop further easing and stimulus.

Emerging economies are losing some momentum, yet growth – at 5.6% estimated for 2012 – remains well above that for the OECD countries, while the fundamentals in most remain stronger, with government finances, personal savings, and bank balance sheets all in better shape. These countries, therefore, hurt mostly by external factors (the slowdown in exports due to weaker demand from Europe and the US) have more latitude to inject stimulus without disruptions to the domestic economy.

Pressure on Asian Currencies

All major countries are attempting to drive down their currencies, or at least stop them from appreciating. Since the Fed has taken the lead in stimulus measures, the dollar has taken it on the chin. The dollar had appreciated for much of the year, as the Fed’s balance sheet flattened and Europe remained in disarray. But with Europe promising to get its act in order and the Fed getting ready to expand its balance sheet (print more money), the dollar fell.

Central banks around the world, particularly in the newly developed countries whose banks have the large dollar reserves, are continuing to diversify out of the dollar. Dollar reserves at the People’s Bank of China are now down to barely 50% of total reserves. Yet where does this money go? The Euro is fragile and the yen overvalued. A little went into smaller currencies like the Swiss franc (but no more with the Swiss bank’s commitment to link the franc to the Euro), or the Australian dollar. But that’s a minor currency. The dilemma is the same for private global investors. The pressure is on the Asian currencies; the Chinese yuan has risen to its highest level since the new currency system was introduced in 1994.

Stocks Face Headwinds after Stimulus Rally

In our last Review, I wrote of “the possibility of a strong rally sparked by global stimulus while, particularly in the US, the risk of declining markets exists for later in the year.” I wrote that we would use rallies to exit some stocks.

And so it has been, with the strong stimulus-induced rally already possibly running out of steam. (And we have been raising cash in the last week or two.) Like junkies, investors need ever-more stimulus to keep going, and each additional injection has diminishing returns.

On the positive side, valuations are not stretched; indeed, they are not so overvalued versus their long-term average as are bonds or even commodities. There are reasons for the varying valuations, but the question is how long they may last. In addition, there is the prospect on continuing monetary stimulus (notwithstanding the caveats above). And retail investors remain on the sidelines, with withdrawals from US stock funds continuing as of September 19th, the latest numbers, thus providing a source of further stock buying.

On the other side of the ledger, however are several potentially negative influences, particularly for the US market and particularly in the near term: a stalling recovery; upcoming elections (and the uncertainty markets dislike); prospects for higher taxes (including capital gains tax); weaker corporate earnings (following several earnings warnings). On balance, therefore, we are cautious in the near term, using this rally – as we suggested last quarter – to raise cash.

Valuations are better around the globe. In Europe, value stocks are selling at record discounts to book value, even after excluding the obviously risky financials. In Asia, the risk-reward is probably better than elsewhere, including cheaper Europe, despite some deterioration (relatively speaking) in the macroeconomic environment.

So we are using the rally to sell fully valued and more marginal positions, focusing on discounted asset plays as well as dividend payers in the U.S. and Asia.

Commodities Recover on Stimulus

A slowdown in economic activity is obviously negative for resources in general, but global GDP remains positive, driven by still-high Chinese growth. With GDP growth at 8% while year-on-year inflation is under 2%, China’s real growth remains very strong and that is reflected in a pick-up in commodity imports.

There has been concerned expressed about the build up in China’s inventories in various resources, but we are somewhat more sanguine on this. To be sure, there have been dramatic build ups in stockpiles, particularly in aluminum and copper, but we have seen this movie before. Chinese stockpiles have been particularly volatile and serve only to exaggerate the price swings in commodity prices rather than affect them long term.

Moreover, though Chinese copper stockpiles have built up again since the spring to multi-year highs, inventories are low in other parts of the world; LME stockpiles are down to just five days use, while global stockpiles-to-use are at their lowest level in over three years.

In addition to global growth, easy money, low interest rates, and a decline in the dollar also all help commodities. Apart from the macroeconomic environment, the supply side of the equation is very favorable for many commodities, notably copper, though less so for nickel, aluminum and iron ore (not to say we are negative on the price from current levels).

With higher capital costs, several projects have been put on hold from two major projects for Barrick (one gold and one gold-copper), to the expansion of BHP’s large gold-copper-uranium Olympic Dam project, among others. There is also a notable lack of enthusiasm for investing in new projects in South Africa. Thus supply is being pressured as demand arguably is beginning to turn back up.

We should constantly remind ourselves, however, that commodities tend to move in very long cycles; so far, this cycle is less than two-thirds the previous shortest cycle. Given that this cycle is driven by the industrialization in a country with one-fifth of the world’s population, it would be perverse if this cycle were to be shorter than other historical cycles. We remain positive on the sector absent dramatic social upheaval in China, a global recession, or significant tightening of money around the world.

One more factor that would have a profound, if short-term effect on resources, is the growing tension in the Middle East and particularly the clear and growing warnings from Israel concerning Iran’s nuclear program. Any strike on Iran, and the likely response (including closing of the Strait of Hormuz and US response to that) would clearly boost gold and oil, though not necessarily other resources.

Gold the Clear Winner

Gold is the main beneficiary of stimulus, and the sustained beneficiary. In May, gold had dropped to its lowest levels since June of last year as the dollar moved up and prospects for stimulus were dampened by both the US and European monetary authorities. But that was temporary. Soon, gold started rallying in expectations of additional stimulus, and kept on going when it came.

The fundamentals remain positive. Central banks of newly developed and developing countries – those with the largest reserves and lowest gold weighting – continue to buy and importantly, lend price support on the downside. Individuals around the world continue to turn to gold as a defense against depreciating currencies. These factors offset the recent declines in buying from India and China, the two largest gold markets. Purchases of physical gold ETFs continue to increase, clear evidence of the net buying.

At the same time, the supply of gold is not increasing much. This year, global production is expected to increase by less than 1%, but it remains lower than it was a decade ago, at the onset of this bull market. Given the record prices, this is astonishing. Renewed concern about South Africa’s production – albeit no longer the dominant player it once was – shows the difficulty in increasing production.

Significantly, Japanese pension funds have started buying gold; in a Zero Interest Rate environment, gold becomes more attractive, and we expect pension funds around the world, those that are permitted, to start buying gold in increasing numbers.

While we remain very positive on gold for the medium and long term, we would not be surprised by a very short-term correction after such a rally. August and September are traditionally strong months for gold, while there is usually a pullback in October, before a resumption in November picking up at the end of the year. So such a price retreat in the immediate term will not cause too much concern, though we are taking some gains in the gold stocks before this correction. We fully expect new highs by early next year, if not this.

Gold Stocks Outperform, At Last

The gold stocks were, earlier in the summer, at their lowest valuations ever; we argued this in our last Review, and we took advantage of this to become fully invested in the sector, including increasing our weighting to the major producers which typically move first. These low valuation levels account for the strong rally we have seen in the gold stocks, which have over the last couple of months demonstrated their vaulted outperformance to bullion.

The juniors have been more selective, with very strong moves in some, while others continue to languish or even decline further. For the most part, this disparity in moves has been justified by the fundamentals, as those stocks with weak fundamentals – and particularly those low on cash, fell.

In the last couple of weeks, we have been taking profits in some of the seniors and will look to add to selected juniors, particularly on weakness in coming weeks.

In sum, we are not convinced the global stock market rally will continue at least in the near term. Gold, however, is more likely to sustain gains from this expansion in the money supply. Given that we had moved to almost fully invested position over the summer in anticipation of a global stock market rally induced by further stimulus, we are now looking to raise some cash, both from broad global markets as well as senior gold stocks. We remain well exposed to strong global companies, growth in Asia, and better-quality gold stocks, which we expect to do very well in coming quarters and years, while we will look for pullbacks in these areas to buy more from the cash we have raised in recent weeks.

Adrian Day will present an expert view and a free education workshop on  Friday, Nov. 16, and participate in a "Bulls and Bears" keynote panel on Saturday, Nov. 17, during the San Francisco Hard Assets Investment Conference.