Gold News

Commodity Cycle Turns

Maybe 'super' too...

SINCE the commodities supercycle began unwinding 10 years ago, many investors have been waiting for the right conditions to trigger mean reversion and lift prices, writes Frank Holmes at US Global Investors.

I believe those conditions are either firmly in place right now or, at the very least, in their early stages. Among them are factors I've discussed at length elsewhere – a weaker US Dollar, a steadily flattening yield curve, heightened market volatility, overvalued US stocks, expectations of higher inflation, trade war jitters, geopolitical risks and more.

In addition, nearly 60% of money managers surveyed by Bank of America Merrill Lynch believe 2018 could be the peak year for stocks. A recent J.P.Morgan survey found that three-quarters of ultra-high net worth individuals forecast a US recession in the next two years.

All of this makes the investment case for commodities, gold, and energy more compelling than at any other time in recent memory.

Exhibit A is the chart below, which I've shared before but recently updated with new data.

Relative to equities, commodities are as cheap right now as they've been in decades. This is literally a once-in-a-generation opportunity that investors with a long-term view should seriously consider.

For perspective, had you invested in a fund tracking the S&P GSCI or an equivalent commodities index in 2000, you would have seen a compound annual growth rate (CAGR) of around 10% for the next 10 years, according to Bloomberg data.

We all know that past performance is no guarantee of future results, but I'm not alone in my bullishness. In a note last week, analysts at Goldman Sachs wrote that "the strategic case for owning commodities has rarely been stronger." The bank recommends an overweight position, estimating that commodities will yield at least 10% over the next 12 months, with most of the gains being made by crude oil and aluminum.

Whereas crude traders are responding primarily to concerns that output could be disrupted by intensifying conflict in the Middle East, specifically oil producer Syria, aluminum prices have skyrocketed following the imposition of fresh US sanctions against a number of Russian firms. Among them is United Company RUSAL, the world's second-largest aluminum company, responsible for producing as much as 6% of global supply.

Since its low of $26 per barrel in February 2016, the price of West Texas Intermediate (WTI) crude has surged nearly fivefold and is currently at its highest level in more than three years.

Last month, oil jumped nearly 3% on reports that US inventories had fallen more than expected, suggesting the global glut continues to recede, then rising to test resistance at $70, a level we haven't seen since November 2014.

But prices retreated again after President Donald Trump blasted the Opec oil cartel on Twitter, proving once again how quants comb through social media at lightning speed and use sentiment analysis to inform their trades.

"With record amounts of Oil all over the place, including the fully loaded ships at sea, Oil prices are artificially Very High! No good and will not be accepted!" the President said.

Opec and Russia are planning to work more closely together to limit output for a number of years, possibly as many as 10 or 20. Such an agreement would help support oil prices – Saudi Arabia, in particular, seeks higher prices to take Saudi Aramco, the world's largest energy company, public – but it's likely American shale producers would ramp up production to fill the void. The US is now the number two oil producer in the world, having overtaken Saudi Arabia late last year.

Aluminum is likewise enjoying a strong rally, jumping sharply more than 23% since the White House announced sanctions against select Russian firms and oligarchs in response to the Eastern European country's alleged interference during the 2016 presidential election. In nine of the past 11 trading days through mid-April the metal posted positive gains, surging nearly 6% on one day alone.

Aluminum soared to $2,715 per metric tonne, the highest we've seen since April 2011. The rally may have further to run, writes Goldman Sachs, which forecasts a price range of between $2,800 and $3,000 this year.

Australian-British multinational Rio Tinto and Melbourne-based BHP, two of the world's top aluminum producers, were both upgraded to "BUY" by CLSA, partly in response to rising aluminum prices but also because they maintain strong balance sheets and are expected to generate favorable free cash flow (FCF) this year.

Also bolstering the commodities investment story is China's massive ongoing "Belt and Road" megaproject, also known as the Silk Road Economic Belt.

In a note last month, CLSA reminded us that the infrastructure initiative is still in its infancy, expected to be completed by 2049. It will cut through as many as 68 countries across Asia and Europe, affecting an estimated 62% of the world's population. China has already spent approximately $180 billion to complete various projects, but many billions more will go toward building roads, ports, dams, high-speed rail, airports and more – all to "enhance regional connectivity," as President Xi Jinping put it, and strengthen China's economic clout.

To give you some scale as to how monumental and historic this undertaking truly is, the graphic below, courtesy of BHP, compares the development to the US Marshall Plan, then one of the most expensive projects in human history. The Belt and Road initiative could eventually cost 12 times as much or more, with total spending estimates ranging between $4 trillion and $8 trillion.

Estimates of how much energy and natural resources will be needed during the development phase vary wildly, but I think it's fair to assume that demand will continue to be supported for some time.

Gold ended last week down, but I still believe gold could hit $1500 an ounce this year on rising consumer and producer prices, which I think are understated. This is more than apparent when you compare the official US consumer price index (CPI) and alternative measures such as the New York Fed's Underlying Inflation Gauge (UIG). And as Dr.Ed Yardeni points out in a recent blog post, the word "inflation" appeared as many as 106 times during the latest Federal Open Market Committee (FOMC) meeting, a sign that Fed members could be getting more and more concerned about mounting inflationary pressures.

Recent reports also suggest gold production is slowing, which could help support prices long-term. Exploration budgets have been declining pretty steadily since 2012 after the price of gold peaked, and fewer and fewer large-deposit mines are being discovered.

Last month the China Gold Association announced that the country, the largest producer of gold, produced 98 metric tonnes in the March quarter, down some 3% from the same period last year. This comes after total Chinese output in 2017 fell 6% year-over-year to 426 tonnes. Granted, miners have been pressured by Beijing to curtail production as part of the government's enforcement of tougher environmental protection policies, but the decline in output is part of a downward trend we're seeing across the board, especially among major producers.

Take a look at the declining quarterly output of Barrick Gold, the world's largest gold miner. According to its preliminary results for the first quarter, Barrick produced a total of 1.05 million ounces from its 10 projects. That's only a 2% decrease from the same quarter last year, but a far cry from where it was seven years ago.

While some investors might view the lower output as disappointing, others no doubt see it as a reminder that gold is a finite resource, one of the many reasons why it's remained so highly valued for centuries. As I've written before, the low-hanging fruit has likely already been picked, making the task of mining the yellow metal more difficult as well as expensive. Supply isn't growing nearly as fast as it once did.

And yet demand continues to climb. Not only do the peoples of India, China, Turkey and other countries have a strong cultural affinity to gold – an obsession that will only intensify as incomes rise – but the metal still plays a vital role as a portfolio diversifier in times of economic and political uncertainty.

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.

Follow Us

Facebook Youtube Twitter LinkedIn

 

 

scri

Market Fundamentals