Markets remained upbeat, spurred on by the first rate cut by the Central Bank of China since 2008. The S&P and DOW have held onto this week’s gains while key European indices were all in positive territory.
The eagerly awaited testimony before Congress from Fed Chairman however disappointed markets, but was still insightful in our view. Bernanke kept his cards fairly close to his chest saying that the central bank will ‘need to assess the economy before deciding if more stimulus is needed’. He did speak emphatically speak about the US Governments need to keep fiscally stimulating the economy, and this essentially means that the US has no choice but to keep increasing their national debt. Ultimately this will all mean more fiat currency creation in the longer term and higher rates of inflation.
Due to the lack of any decisive noises on quantitative easing, the gold price fell. However as recent unemployment figures illustrate the US can ill afford to take QE off the table in our view. The prospects for such a move still remain very high and consequently, we don’t anticipate much more downside as the gold price continues to consolidate after last week’s breakout.
US market continue to hold recent gains
After a strong start to the day with DJI hitting an intraday high of 12540, selling pressure intensified following Bernanke’s testimony to finish up 46 pts.
Bernanke’s congressional testimony and decision to ‘leave his printing press at home’ may have underwhelmed those expecting a firmer indication of stimulative intentions. However we thought it was telling that he acknowledged that these remain a firm option. From Ben’s perspective his oft-repeated mantra holds: “the Fed remains ready to act…”. Some further clues here may be given at the next FOMC meeting on June 19-20. We continue to believe the Fed will act swiftly and with vigour should further signs of the economic recovery faltering emerge. Mr Bernanke’s main focus continues to be the economy and the labour market.
Significantly, Mr Bernanke made clear he is well aware of the external risks posed to the US economy. ‘The situation in Europe poses significant risks to the financial system and economy and must be monitored closely.” The simple fact that is the world’s economies are heavily inter-connected and the Fed can ill afford to ignore these. The widening of the ‘risk net’ therefore increases the possibility of further stimulative measures in our view, particularly given the weakening labour market and the rise in the unemployment rate back to 8.2%.
And another pointer came from senior member of the Fed only a few hours before the Chairman’s testimony. Federal Reserve Vice-Chair, Janet Yellen, laid out the case for more QE at the Boston Economic Club yesterday. As number two at the Fed, her views carry great weight with Bernanke; and she is an advocate of aggressive moves to support the recovery.
While the release of the Beige Book painted a somewhat brighter picture of the US economy the US recovery remains far from conclusive . Indeed, we would not be surprised if the Fed takes a more decisive line at the next FOMC meeting after assessing the effects of recent job market reports and economic developments, along with further data between now and then.
The statements from the Fed do nothing to dispel, and indeed reinforce our view, outlined in yesterday’s daily that market participants are betting on a binary outcome.
Markets are polarised between the 2 contrasting views that either Europe will fall apart and therefore an economic depression will ensue, or governments (including the US) get their act together and work through the issues. Either way, at some point there is going to be much more printing of fiat currency in the future in our opinion and ultimately this will prove positive for equities. If we manage to avert a a crisis in Europe, then equity markets will stage a powerful rally. Particularly as valuations today are the cheapest in decades and interest rates are structurally too low as it relates to the pricing of risk.
Given this scenario we will continue to focus on the fundamentals, and adhere to our strategy and not get too caught up in the emotion and continue to focus on finding the quality bargains with a “bottom up” selective approach.
Market sentiment was also helped by China’s surprise 25 basis point rate cut – the first in four years. Benchmark lending and deposit rates were cut to 6.31 and 3.25 percent respectively. With May economic data due this weekend, this suggests that inflation is easing and growth is slowing by more than previously thought.
We believe the move reinforces what we have been saying in recent weeks that a pullback to more sustainable levels of growth in China is welcome, and that the government and central bank will do what they can to ensure it is a softer than expected rather than hard landing. We can expect more from the Bank of China.
This is positive for global markets, and the resource sector. China also has a vested interest in stimulating domestic consumption which has long lagged the export driven side of its growth story.
We believe the latest move by China also suggests that central banks globally are “lining up on the same page”. Already this week the RBA has cut rates. The move by China could signal momentum is gaining in a co-ordinated international policy stance towards global growth, the like of which we have not witnessed since the GFC. As we see it this is the great inherent danger now facing the bears and the shorts.
Certainly central banks are keeping the bias towards easing, or at least remaining ‘loose’. The Europeans have already showed their intentions this week. ECB president Mario Draghi acknowledged that the bank has ‘left the door wide open for a rate cut in July’.
Overnight we saw the Bank of England follow the ECB’s lead yesterday, leaving rates unchanged at 0.50%. Similar to the FED the BoE has left its quantitative easing programme on hold but is keeping its options open in this regard. However in the UK there are some signs that the economy which is technically still in recession, is improving. The Markit/CIPS PMI showed the UK’s service sector grew at a steady pace last month, with a reading of 53.3 – higher than the 52.2 forecast.
The mood was also somewhat brighter in Europe as well overnight. Strong demand for Spain’s sale of €2.1bn of medium and long-term bonds proving the door to international bond markets remains ajar. However, after the European close Fitch surprised no one in downgrading Spain from A to BBB.
It is clear to us that the risks in Europe are not going to go away, but we continue to believe that much of the bad news is priced in. However that does not stop investors reacting strongly to what central bankers and goverments have to say. And whilst this headline or soundbite driven trading continues, nervousness and volatility will remain.
In Europe, Merkel has consistently maintained the solution will involve “more Europe, not less”, meaning not just currency union, but also fiscal union, joint budgetary policy and ultimately political union. But realistically nothing of substance is likely to emerge prior to EU summit at the end of the month – the risk being whether it will yield a masterplan or merely an agenda for further inetgration. There is also the G20 summit in Mexico – where Merkel is expected to come under further pressure – coinciding with the Greek election on June 17th. In short: June promises to be a busy and quite possibly pivotal month.
Like Bernanke, Merkel is a cerebral, cool and rational thinker, who will not be rushed or panicked into decisions. It is fair to assume plans are currently being formulated – if not already in place – on both sides of the pond. As Leonard Cohen once said: “First we take Manhattan, then we take Berlin”
GOLD
Given the lack of definitive commitment to further quantitative easing measure by Ben Bernanke overnight it was no surprise to see the gold price give back some recent gains. However as we have remarked above we still believe the only real uncertainty with respect to further stimulative measures is timing. The tepid nature and the ever present risks in Europe (acknowledged by the Fed Chairman) mean that the likelihood of additional money printing is high. And if things derail it will be most certainly used as a backstop.
We expect the gold price could now well undergo a period of consolidation, at least until the next Fed Meeting. Technically it has been encouraging to see the gold price hold above the recent breakout level.
Gold is still consolidating following the recent breakout.
UK gold stocks
In last night’s UK equities report, we covered our preferred UK gold stocks and have reproduced the report below.
UK gold stock investors saw a long awaited bounce after returning from the extended bank holiday on Wednesday. This followed weak US jobs growth in May, announced on 1st June, which boosted gold as it increases the chance of further quantitative easing. Gold stock valuations aren’t expensive and look to have further upside.
Gold stocks haven’t proven to be golden for investors recently as they have weakened on the stock market sell-off. This is as even if the gold price holds up gold stocks will tend to fall back with equities in general at least in the short-term.
Furthermore, gold has also proven to be weak recently as strong US jobs data has seen investors discount the prospects of further quantitative easing in the US. In weak market conditions investors also often sell the metal as it remains a source of liquidity.
Meanwhile, the largest consumer of gold in 2011, India, has seen a weakening currency make the commodity more expensive which has weakened demand. Thus a weak gold price and weak equity markets have both pushed gold stocks down.
The weak jobs growth in the US in May, however, has seen gold rebound as the prospects for near-term quantitative easing in the US have increased. Meanwhile, China looks set to become the biggest consumer of gold this year – the country cut interest rates this week for the first time since early 2009 – and emerging market central banks remain keen to diversify away from dollars.
Gold Price over 17 months
For gold shares the gold price is the key driver which explains the bounce in gold stocks following the gold price bounce. We remain optimistic on the gold price and so view the current weakness as an opportune time to top-up on the sector. The above graphic shows that gold bounced but fell back slightly today on comments from the Fed Chairman.
In a nut shell the gold price is underpinned by China and India’s economic growth as the countries are the top two consumers. This supports jewellery demand while global investment demand is driven by dollar weakness and economic instability which looks set to continue.
The supply side for gold is seeing strength in some areas such as China and Russian output. However, many regions are mature such as South Africa and new large mine discoveries are sparse. On balance supply looks to be relatively constrained.
UK portfolio gold stocks
The UK Fat Prophets portfolio has six gold stocks which are by order of market value Randgold Resources, African Barrick Gold, Petropavlovsk, Centamin Egypt, Highland gold Mining and Avocet Mining. Many of these stocks look to have recently hit bargain basement levels which explains the strong bounce on Wednesday.
Randgold rose 7.6%, African Barrick jumped 14.5%, Petropavlovsk rose 10%, Centamin was up 11%, Highland gold up 5.2% and Avocet up 10.3%. This follows gold closing at US$1,568 on Thursday and then closing at US$1,637 on Tuesday – an increase of 4.4%. The price has since weakened marginally to around US$1,600 on cautious comments from Ben Bernanke on more QE.
Of the six gold miners in the portfolio all were rated buy at our last review with the exception of Randgold which has been such a strong long-term performer that are rating has moved to hold. The gold stocks have seen greatly varying fortunes but are all likely to perform well if gold shows strength.
We do note though that critics of gold stocks often point to the general failure to meet output targets, cost inflation and the more aggressive tax stance from host countries. Nevertheless gold stocks look inexpensive enough to offset these factors with P/E ratios at long-term lows.
Reviewing portfolio stocks and Randgold trades on a P/E of 17X for the current year, African Barrick sits at 11X, Petropavlovsk trades at 4.8X, Centamin at 5.6X, Highland Gold at 4.48X and Avocet at 12.3X. The dividend yields are generally low but Avocet has a yield of 3.3% and Petropavlosk and African Barrick offer 2.5%.
On the balance sheet front at the end of March African Barrick Gold stands out with net cash of US$581m, Centamin had liquid assets of US$175m and no debt and Randgold had cash of US$457m. Meanwhile Avocet saw debt reduced to US$23m which is set against cash of US$100m.
At Highland Gold Mining the group had US$126.7m cash at the end of 2011 and a debt free balance sheet. Petropavlovsk is the only group which stands out with net debt up 360% to US$787m at the end of last year. The company is set to see debt fall, however, as lower capital expenditure kicks in and gold output increases.
Broadly the gold miners have strong balance sheets and many have cheap P/E ratios and all are targeting gold output growth. Clearly there are lots of stock specific factors with Centamin Egypt being affected by weak sentiment towards Egypt – second round Presidential elections are due in a week.
Meanwhile Petropavlovsk and Highland gold focus on Russia and have not performed to expectations on the output front. However, Petropavlovsk looks to be back on track on the output front and Highland Gold’s weakness looks in part to be due to the sale of a stake by Barrick Gold.
For relatively low risk investors Avocet Mining looks to be a strong investment with the group having a clearly defined growth strategy and a strong dividend yield. The group is expecting to produced 160,000 ounces this year and then hopes to see this increase by 50% by 2014 on expansion at its existing mine.
Avocet is also hoping for phase 2 expansion at the key Inata mine to start-up in 2014 and also is looking for the start-up of its second key project in Guinea in 2014. All told Avocet is looking for output to exceed 500,000 by 2015 which is growth of over 200% in three years.
Randgold meanwhile is looking to increase output from 696,023 ounces in 2011 to double to over 1.4m ounces by 2016. The group stands out for its expectation that it can lower cash costs/oz over the period.
Centamin Egypt is another group with clear growth plans with output set to come in around 25% up on 2011 during the current year at around 250,000 ounces. The group is targeting a rage of 500,000 ounces in the medium term. A strong cash position and growth plans makes the stock stand out.
The other gold miners are more coy on the production front with African Barrick previously having a target of 1m oz per year but output in 2011 down 2% to 688,278 ounces. Highland gold saw output fall in 2011 but is looking to return to growth this year while Petropavlovsk saw output up 24% in 2011.
Summary and valuation
Some of the gold miners now look to be priced for failure with Centamin Egypt, for example, pricing in a high probability of mine nationalisation. Broadly, though, the operational side looks to be getting back on track while any negative economic data will support the case for more QE and therefore boost the gold price.
Investors are best advised to take a portfolio approach and we have all the stocks rated as buy except Randgold Resources. However, Avocet Mining does stand out for its strong growth plans, good cash position and supportive dividend yield. African Barrick Gold meanwhile is a medium risk play as it gets back on track in Tanzania.
At the higher risk end of the spectrum Centamin is partly a play on the politics of Egypt but its strong growth plans and financial position also make it attractive with high quality fundamentals. Meanwhile Petropavlosk and Highland Gold look cheap on P/E ratios of under 5X earnings.
Accordingly, our gold stocks will remain firmly held in the Fat Prophets portfolio. We re-iterate our buy recommendations on African Barrick Gold, Petropavlovsk, Centamin Egypt, Highland gold Mining and Avocet Mining.
BHP Billiton will keep spending throughout the cycle
In a speech to a business forum in Perth yesterday, BHP chief Marius Kloppers lectured his audience on the importance of long-term thinking.
He said: “It is quite often the case that an investment decision in a particular commodity will be made in a part of the business cycle that results in a low price environment for that particular commodity, but the investment is made nevertheless in recognition of the expected future demand and prices.”
The market has been speculating that BHP may delay more or more of its expansion projects, including the Port Hedland Outer Harbour expansion (US$10b), the Olympic Dam expansion (US$30b) and the Jansen Potash project in Canada.
It’s widely known that BHP has an agenda to spend up to US$80b over the next five years, but sliding commodity prices and easing Chinese demand are slowing BHP’s cash flow.
We are convinced that BHP will eventually complete all three plus the myriad of other projects on its radar.
He added “BHP’s challenge is to balance the long-term demand outlook with short-term economic developments,”
We espoused this view in our Australasian Mining report back in April of this year. (If you do not already receive this report, please call 0203 130 4676 for further details)
Mr Kloppers sent out a challenge to the Government to consider the longer term impact on investment in Australia of factors such as royalties, taxes, flexibility and productivity that determine the worth and viability of these projects.
We certainly agree with the synopsis painted by the BHP chief.
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