Gold News

3 Assets to Review for 2016

Gold, oil and airlines deserve attention this New Year...

TODAY I'd like to look ahead to 2016 by pinpointing three asset classes that I believe hold opportunities for investors, writes Frank Holmes on his blog at US Global Investors.

Going forward, gold prices will largely be affected by US monetary policy. The Federal Reserve began its interest rate-normalization process with a small but significant 0.25% increase, and unless the Fed has reason to mark time or reverse course in 2016, rates should continue to rise steadily.

This will bump up not just the US Dollar – which historically shares an inverse relationship with gold, since it's priced in Dollars – but also real interest rates. As I've discussed many times before, real rates have a huge effect on the yellow metal.

Real interest rates are what you get when you deduct the rate of inflation from the 10-year Treasury yield. For example, if Treasury yields were at 2% and inflation was also at 2%, you wouldn't really be earning anything. But if inflation was at 3%, you'd see negative real rates.

When gold hit its all-time high of $1900 per ounce in August 2011, real interest rates were sitting at negative 3%. In other words, if you bought the 10-year, you essentially lost 3% a year on your "safe" Treasury investment. Since gold doesn't cost anything to hold, it became more attractive, and the metal's price soared.

But today, the US has virtually no inflation – the November reading was 0.5% – so real rates are running at less than 2%.

Across the Atlantic, many investors are now realizing that Europe's quantitative easing (QE) programs have failed to improve market performance in any substantial way. Earnings per share growth estimates in the European stock market have not budged. The lack of real growth in this market is a compelling argument for global investors to own gold for the long term.

Low interest rates, higher taxes and tariffs and more labyrinthine global regulations since 2011 are all contributing to the global slowdown. Neither QE3 in Europe nor QE3 in the US has led to a marked improvement in growth. What markets need now to ignite growth are fewer taxes, tariffs and regulations and smarter fiscal policies.

The chart below, courtesy of Evercore ISI, helps to illustrate some of the challenges we've faced in 2015 in terms of the investments we manage. Growth remains scarce globally. M2 money supply in the US also looks dim.

Looking forward, we're hopeful that these two indicators – global trade volume and money supply – will turn up. Both are necessary to improve commodity and emerging market investments.

On the upside, gold demand in China remains strong. It's important to remember that more than 90% of demand comes from outside the US, in China and India in particular. Precious metals commentator Lawrie Williams reports that Chinese gold withdrawals from the Shanghai Gold Exchange (SGE) crossed above 51 tonnes for the week ended December 18.

Already Chinese demand is higher than the previous annual record set in 2013, and if total withdrawals for 2015 climb above 2,500 tonnes, as Lawrie expects, this will be "equivalent to around 80% of total global annual new mined gold production." We expect demand to rise even more as we approach the Chinese New Year – historically a key driver for gold's Love Trade – which falls on February 8 in 2016.

BCA Research meantime believes oil markets will rebalance in 2016, not because of a price collapse but because production will continue to slide and consumption, grow. Most of these adjustments are being made in nonmembers of the Organization of Petroleum Exporting Countries (OPEC). In the US alone, over 600,000 barrels per day have fallen out of the market as the rig count falls.

Russia, however, is unwilling to cut its production in a bid to compete with OPEC. In November, the country hit a post-Soviet record of 10.8 million barrels produced per day. And even more oil is expected to come out of Iran in 2016 once international sanctions are lifted.

For these reasons, Moody's recently trimmed its 2016 oil forecast. West Texas Intermediate (WTI) crude will average $40 per barrel, down from $48, according to the ratings agency. The projection for Brent was slashed even more significantly, from $53 to $43.

To put this in perspective, oil averaged $55 per barrel in 2015, compared to $85 in 2014.

In all likelihood, then, oil prices probably need to remain lower for longer in order to rebalance the market.

Finally, last month I shared the latest report from the International Air Transport Association (IATA), which states that global airlines will post record net profits of $33 billion for 2015. Because fuel prices are expected to stay low, airlines could very well hit another record at the end of 2016 – $36.3 billion, according to the IATA.

Savings from lower fuel prices are partially to thank for these profits. Goldman Sachs points out, however, that we shouldn't expect prices to fall at the same magnitude as they did in 2014 and 2015.

As a result of lower fuel prices and airlines' improved discipline in capacity growth and capex spending, the group is poised to see increased operating margins in the coming years, according to Morgan Stanley.

In short, operating margin tells you what percentage of every Dollar made the company keeps as revenue before taxes. The higher the operating margin, the better off the company is.

Ancillary revenue is also contributing more to airlines' bottom line. Such revenue comes from non-ticket fees such as baggage and handling, cancellations, seat upgrades, meals and the like. According to ancillary revenue expert IdeaWorks, the total global amount generated from these fees is estimated to rise to a whopping $59.2 billion in 2015, up from $49.9 billion in 2014. That accounts for 7.8% of global airline revenue, an improvement from the 6.7% in 2014.

The increased revenue is helping to boost domestic airlines' free cash flow. Bank of America Merrill Lynch has forecast that airlines will see the highest free cash flow in years, one of the best indications of a company's ability to generate cash.

As we reflect back on 2015, it's important to remember that everything happens in cycles – from the presidential election cycle to the gold seasonality cycle and even to weather patterns. Similarly, every asset class has its own DNA of volatility.

By recognizing these cycles and patterns, it becomes easier to manage your expectations and become more proactive than reactive.

Frank Holmes is chief executive officer and chief investment officer of US Global Investors Inc., a registered investment adviser managing approximately $4.8 billion in 13 no-load mutual funds and for other advisory clients. A Toronto native, he bought a controlling interest in US Global Investors in 1989, after an accomplished career in Canada's capital markets. His specialized knowledge gives him expertise in resource-based industries and money management.

See the full archive of Frank Holmes.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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