Are You Limited by Linear Thinking?

 

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

Is your portfolio limited by linear thinking? We believe so.

Many linear thinkers believe that to solve a problem, you need to follow a simple, logical path, a step-by-step sequence involving two variables. One and one is always two. Here’s a diagram depicting the progression.

When it comes to solving today’s social, political and economic ills, linear thinkers believe the solution is more regulation and government intervention. To wit: the thousands of pages piling up from the solutions of Sarbanes-Oxley, the Volcker Rule and Dodd-Frank.

There’s a danger with this line of thinking because life is much more complex. Government policies are necessary for a level playing field for businesses, but they require a nonlinear way of thinking. Consider how scientists, mathematicians, psychologists and meteorologists have had tremendous success when they step outside the stiff boundaries required by linear thinking. Nonlinear math equations and systems have been used to explain weight loss, the spread of happiness, strength of metals and hurricanes. Millions of Americans’ lives have been improved by a deeper level of understanding of these issues.

This nonlinear line of thinking needs to be adopted by policymakers. As we enter a critical period in the U.S. election cycle, Americans deserve thoughtful regulations that maintain the spirit found within the Declaration of Independence. These are lofty, but attainable goals, as long as we have leaders who are brave enough to fully consider how their actions affect job creation, social stability, economic prosperity, trust, and free markets.

Prohibition is an obvious example of extreme regulation in American history. With all the good intentions of improving the lives of Americans by eliminating the perceived source of corruption, crime and poverty, politicians outlawed the making, transporting and selling of alcohol. Politicians did not anticipate the extent of unintended consequences, as the illegal commodity only encouraged bootlegging, speakeasies and the mafia.

If you’re older than 21, raise your glass to the repeal in 1933 and the more practical and balanced approach that followed, as states chose their own drinking ages until the 1980s, when the need to reduce drunk driving fatalities led to the National Minimum Drinking Age Act of 1984.

Investors today are the unintended victims of the linear thinking that has permeated through today’s government policies. A friend of mine shared his parents’ experience with me that many retired workers can relate to. After years of working hard and prudently saving for retirement, my friend’s parents felt that their nest egg was large enough to retire and live off the interest. At the time, their accumulated savings of $500,000 was invested in long-term Treasury bonds yielding roughly 6 percent. The annual interest of $30,000 satisfied their needs.

Fast forward to this year, when 30-year and 10-year government yields have been so manipulated by the Federal Reserve that the rates have been reduced to near-record lows. This knocks the interest income on the retirees’ half a million dollar nest egg to only $5,000 per year.

By regulating yields, the Fed had the good intention of allowing people to borrow money at low cost to stimulate the economy, but the unintended consequence was a huge tax on retired people, forcing many to go back to work to supplement today’s meager earnings.

Think Nonlinearly: A Time to be Resourceful

Don’t be limited by linear thinking in your portfolio. As an alternative to low yielding Treasury bonds, consider resources stocks that pay dividends. We’ve found that most materials, utilities and energy stocks in the S&P 500 Index pay a dividend higher than the 10-year Treasury: Materials and utilities companies yield an average of 2.3 percent and 4.1 percent, respectively, while energy stocks pay an average yield of 2.2 percent.

Nonlinear thinkers have historically benefitted from the inclusion of natural resources as part of a balanced portfolio. Financial Planning found that, when included in a diversified portfolio and rebalanced annually, of natural resources funds with 10 year returns, the Global Resources Fund added the most return.

 

Index Summary

• The major market indices were mixed this week. The Dow Jones Industrial Average fell 0.84 percent. The S&P 500 Stock Index dropped 0.55 percent, while the Nasdaq Composite gained 0.08 percent.
• Barra Growth outperformed Barra Value as Barra Growth fell 0.09 percent while Barra Value declined 1.11 percent. The Russell 2000 closed the week with a gain of 1.08 percent.
• The Hang Seng Composite posted a gain of 2.24 percent; Taiwan rose 0.99 percent, while the KOSPI rose 0.23 percent.
• The 10-year Treasury bond yield fell 10 basis points for the week, to 1.55 percent.

Domestic Equity Market

 

The S&P 500 Index fell 0.55 percent this week, driven lower by a disappointing employment report on Friday. Defensive areas tended to outperform such as consumer staples and telecommunications services, along with select retail names in the consumer discretionary sector.

Strengths

• The consumer staples sector rose 0.54 percent this week as defensive tobacco stocks rose along with names such as Wal-Mart, Constellation Brands and Monster Beverage.
• The consumer discretionary sector was also able to eke out a small gain this week as discount stores such as Ross Stores and Family Dollar tended to do well. Homebuilders were also among the best performers for the week continuing a recent trend.
• The best individual stock performer this week was Netflix which rose 19.6 percent as the company announced that subscribers streamed more than 1 billion hours of video in June.

Weaknesses

• The industrials sector lagged as heavyweights such as General Electric, Emerson Electric and Joy Global all fell by more than 2.5 percent this week. 

• The financial sector also lagged with Bank of America and JP Morgan both falling by more than 5 percent.
• Fossil, Inc. was the worst performer this week, falling by more than 10 percent on fears that excessive discounting and promotions at the company’s retail stores indicate soft demand.

Opportunity

• A barrage of government policy actions out this week with rate cuts from the European Central Bank (ECB) and Bank of China, along with more quantitative easing from the Bank of England, appears likely to propel the recent rally in risky assets even further.

Threat

• While policymakers in Europe have made strides to stabilize the situation, many risks remain and the situation remains very fluid.
• China has now cut interest rates for the second time in a month, which likely indicates the conditions on the ground remain challenging.

 

The Economy and Bond Market

 

Treasury yields headed lower this week on disappointing economic reports and global central bank easing. Two key economic data points bookended the week, with a very weak reading from the ISM Manufacturing Index on Monday, followed by a subpar employment report on Friday. On Thursday we had what appeared to be coordinated global central bank policy easing with the ECB and the Bank of China cutting interest rates by 25 basis points, along with the Bank of England adding £50 billion to their quantitative easing program. As can be seen in the chart below, the yield on the 10-year treasury fell to the lowest level in more than a month.

Strengths

• Economic data is weak globally, forcing central banks to act which is sparking a bond rally and pushing down yields.
• Domestic auto sales remain a bright spot for the economy with GM, Ford and Chrysler all posting strong sales growth in June.
• Factory orders for May rose 0.7 percent, beating expectations.

Weaknesses

• June nonfarm payrolls were weaker than expected, rising by a meager 80,000, little changed over the past few months.
• The ISM Manufacturing Index fell to the lowest level since July 2009 and indicated contracting manufacturing in June. 
• European bond yields remain elevated even after central bank intervention and the EU summit the week before.

Opportunity

• The Federal Reserve reaffirmed its commitment to an ultra-low interest rate policy through 2014 and additional monetary easing is possible in the near future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.
• China has obviously become more concerned about the economy and has eased twice in the past month.

 

Gold Market

For the week, spot gold closed at $1,583.75 down $13.65 per ounce, or 0.85 percent.  Gold stocks, as measured by the NYSE Arca Gold Miners Index, fell 0.70 percent. The U.S. Trade-Weighted Dollar Index surged 2.03 percent for the week.

Strengths

• Turkish banks are shoring up their reserve base by pouring their technical expertise and marketing resources into offering their customers gold deposit accounts. For cultural reasons gold is big business in Turkey which has had experience with bouts of high inflation over the past century.  Customers can deposit their gold in the bank and can make withdrawals from their accounts in gold bars or the lira currency.  In addition, gold accumulation accounts can be set up where the customer makes monthly purchases of gold. In September 2011, the central bank increased the ration of lira reserves that could be held in the form of gold from 0 to 10 percent, raising it further to 20 percent in March 2012 and 25 percent last month.  This had the effect of significantly increasing the banks’ desire for taking in gold deposits.
• China’s Ministry of Industry and Information Technology released data that showed the country’s gold output for the year so far, rose 6.59 percent year-over-year to 140.7 tons.  However this suggests that the world’s largest producer’s pace of increase in output over the last five months could be declining, although it is still too early to call a trend.  Monthly production data for April and May showed a slowdown in production from the first 3 months of the year.
• One of Greece’s largest construction companies, Ellaktor SA, noted after its annual meeting that with the Halkidiki Mines obtaining a gold mining license, this was very positive and will likely result in the implementation of a significant investment plan in the coming years.  Ellaktor anticipates the friendly takeover of European Goldfields by Eldorado Gold Corporation should result in some significant new business for the company and speaks well of the permitting process going forward for Eldorado. 

Weaknesses

• ISI’s Weekly Economic Report listed 197 simulative policy initiatives announced around the world in the past 10 months which have yet to create a self-sustaining recovery.  David Rosenberg of Gluskin Sheff noted recently that profits are contracting for the first time in three years and corporate guidance is decisively negative.  The ratio of negative to positive pre-announcements has actually risen to 3.5x--the highest since the third quarter of 2001. 
• Harmony Gold suffered a minor setback when a judge in South Africa ruled that even though Harmony had sold one of its gold mining operations to a company that later went bankrupt it was still responsible for any environmental liabilities even though those liabilities had been transferred to the new owner.
• Pan American Silver’s Navidad project in Argentina was essentially rendered uneconomic under a newly proposed law in the province of Chubut in Argentina.  Much like the Ecuadorian plan laid out by its government for the development of the Fruta del Norta deposit, the government wants what is essentially greater than 50 percent of the economic profits.

Opportunities

• Stifel Nicolous Canada, in a recent gold industry update, noted that China gold imports from Hong Kong, a proxy for gold buying activity in the country, decreased to 2.4 million ounces in May (from 3.3 million ounces in April).  Although May imports decreased significantly on a month-over-month basis, they are still up seven-fold year-over-year, and we expect them to increase as we enter into the seasonally strong August to December period for gold prices (Indian weddings, Christmas and Chinese New Year). We believe gold imports will continue to surge based on our thesis of increasing appetite for gold as newly wealthy Chinese citizens seek to diversify domestic economic and political risk through hard assets. We would not be surprised by more gold purchases by the Chinese government for diversification from the U.S. dollar and now in particular, the Euro.  The environment, (negative real interest rates worldwide including planned, sustained low-interest rates in the U.S. through 2014, ballooning sovereign debts, and Europe debt problems) remains positive for gold prices.  We continue to believe that gold prices could increase to $2,000 per ounce by 2013. 
• Martin Murenbeeld pointed out in his weekly piece that gold continued to make headway as a financial asset: It appears that the Federal Deposit Insurance Corporation (FDIC) may have taken up the discussion along with the Bank for International Settlements (BIS) to reclassify gold as a risk-free asset for bank capital adequacy ratios.  This would essentially zero risk-weight gold along with cash and direct claims on the U.S. government.  Slowly but surely gold is reentering the financial arena in an official capacity. 
• In an interesting slant, Kazakhstan is planning to add a third gold refinery by year-end 2013 so it will have enough capacity to ensure the Central Asian country can refine all the gold the country produces for supply to the central bank and will not need to ship some of its gold out of the country for refining by Switzerland.  Not only does Kazakhstan not want to place its gold at risk by being outside of it control, the country plans to raise its share of gold in its gold and foreign currency reserves to 20 percent from 14-15 percent.  Officials further elaborated they were cutting their exposure to the euro in favor of gold.

Threats

• After substantial pressure from Congress, the SEC said it would meet on August 22 to publically vote on two sets of rules, which are arguably the most controversial under the 2010 Dodd-Frank Wall Street reform law. The conflict minerals rule would require companies to disclose whether they use tantalum, tin, gold or tungsten from the Democratic Republic of the Congo.  The other rule would require oil, gas and mining companies to disclose payments they make to the governments.  The delays have been fueled by a bitter dispute between human rights groups who say the rules will help reduce corruption and companies who say they will be too costly and difficult to implement.  As proposed, companies would need to identify if any conflict minerals are used in their products and trace back the origins of said minerals through their supply chain, which would be very costly to implement.
• The president of Nicaragua will propose changes to the country’s mining laws as part of a package of constitutional reforms to be presented to Congress for debate on July 16. The proposed mining law change says “the state reserves the right to acquire up to 40 percent of all extraction businesses.  The state will be able to become a shareholder in all companies that extract natural resources.” Guatemala’s mining chamber is pushing for the government to scrap the plan, claiming it will hurt mining development in the Central American country.  But a top presidential adviser who helped draft the reform, said the government was moving forward with the plan, which had so far received more support than criticism.
• Market Cutifani, CEO of AngloGold Ashanti, commented that Australia’s tax policies are more of a worry to his company than calls within South Africa’s ruling party to nationalize mines and impose more duties. “It’s clear at the senior-levels of the ANC there is no appetite for nationalization.” Essentially, the South Africans understand there will be no mines if the economics don’t work.  Cutifani pointed out that recent Australian tax policies have been draconian toward the mining industry.  As of July 1, iron ore and coal companies in Australia making more than AUD$75 million in annual profits must pay an additional 30 percent “Minerals Resource Rent Tax” An AUD$23 per ton carbon tax on emissions also took effect the same day and applies to all businesses.  Even a single six pack of beer in the grocery store will run you upwards of AUD$25.

 

Energy and Natural Resources Market

Strengths

• Brent crude continued to advance after a proposed bill in Iran threatened to block off oil transportation through the Strait of Hormuz. This would prevent tankers from delivering oil to countries that have imposed sanctions against Iran.
• U.S. auto sales were solid in June at 14.1 million Seasonally Adjusted Annual Rate (SAAR), above expectations and better than the 13.8 million units in May. Autos remain one of the more solid parts of the commodity demand equation, with even troubled economies like Europe meeting fairly pessimistic expectations rather than deteriorating again.
• South Korea is planning to increase spending on industrial metals by 9.4 percent for 2012. Hyundai car exports were up 7.7 percent compared to last June, and continued sales growth is expected. South Korea’s demand for metal shows promise and it will definitely look to take advantage of these low commodity prices (the LMEX index, which tracks copper, aluminum, lead, tin, zinc, and nickel, has dropped 21 percent in the past year).  
• Corn prices jumped to a nine-month high close of $7.68 per bushel this week and have surged more than 39 percent since June 1, as a crop-damaging drought in the U.S. Midwest shows no signs of abating. The crop’s condition deteriorated for the fourth straight week as of July 1, with 48 percent of corn rated good or excellent, the worst for that date since 1988, the U.S. Department of Agriculture said earlier in the week.  
• Wheat futures also have gained 34 percent since June 1 to a 13-month high close of $8.22 this week on news that dry weather has damaged the Russian wheat crop and exports will be lower than expected.

Weaknesses

• Iron ore hit a three-week low over concerns about China’s slowing growth, and Brazilian iron ore exports saw a 17 percent drop in value for the month of June. China’s Purchasing Managers Index (PMI) was released at 50.2 for the month of June, beating expectations but still showing signs of deteriorating expansion. China consumes more iron ore than any other nation, and this backward demand will be reflected in the prices of many of these industrial commodities.
• Oil futures on the New York Mercantile Exchange dropped as the dollar gained value against the euro. This came after Mario Draghi, President of the European Central Bank, stated that economic risks remain prevalent despite interest rate cuts.
• Low natural gas prices continue to take market share from coal for power generation. Coal production in the U.S. declined 9.2 percent in June from last year’s levels, according to government data. Output totaled 80.5 million short tons in June, and year-to-date production was about 504 million, 6.2 percent lower than the same period in 2011, according to a report by the U.S. Energy Department. U.S. producers have cut thermal-coal production in response to lower consumption by power generators with output down by about 1 million tons a week compared with a year ago, Deutsche Bank AG said in a report this week.

Opportunities

• Iron ore mining in the Karnataka state of India is said to resume operations this month after being banned for the past year over environmental concerns. However, the iron ore can only be exported once domestic consumption has been met, and it must be at a price higher than auction offering. 
• Six blocks of land are being auctioned off by the government of Afghanistan for exploration, and Exxon Mobil is one of the companies that have shown interest. Studies conducted by agencies such as the United States Geological Survey have indicated that there may around 1 billion barrels of oil and natural gas to be found in the region.

 

• Botswana reduced minimum company tax by 3 percent in hopes of attracting more non-mineral based investment and exploration projects.

 

• Reuters reported that BHP could tighten global copper supplystarting in late 2013 if it postpones work on its single-biggest project, the $30 billion expansion of the Olympic Dam mine in Australia. This dam is the fourth-largest known copper deposit and largest uranium source in the world.

 

• The crude oil market may tighten on supply problems in Norway. Statoil ASA said it is likely to shut production on the Norwegian continental shelf as employers locked out striking platform workers after mediation talks failed. This lock out would halt the nation’s entire offshore production to the total of about 2 million barrels a day.

Threats

• China’s demand for West African crude oil weakened as it purchased about 12 percent less supply for July than in June. Brent crude prices may be affected if this continues as China is the top energy consumer in the world.
• Just as CaNickel Mining Ltd suspended operations at its Brucko Lake Mine due to low nickel prices, Eramet is planning to increase output 12 percent by 2015 at one of its plants with expectations of meeting a higher demand from China and India. However, growth and demand have been slowing recently, and this may be counter productive if we want to see gains in global nickel prices anytime soon.

 

Emerging Markets

 

Strengths

• China cut interest rates again this Thursday, effective Friday, July 6. The one-year benchmark lending rate was cut by 31 basis points to 6 percent, and the one-year benchmark deposit rate was cut by 25 basis points to 3 percent. In the meantime, the People’s Bank of China (PBOC) lowered the floor of lending rates to 70 percent of the benchmark rates from 80 percent, which was just lowered from 90 percent in the previous rate cut. It’s another asymmetric cut, but much less asymmetric than the previous cut.
• According to China International Capital Corporation, of the 16 cities it monitors, housing sales volume increased last week by 33 percent week-over-week, and 15 percent month-over-month. Year-to-date, average sales volume has risen 18 percent. Also in the housing market, Shanghai existing home sales surged 20 percent in June to a 17-month high of 19,300 units, Shanghai Daily reported, citing Century 21.
• Brazil’s inflation rate in June fell to the lowest level in nearly two years by rising 0.08 percent from a month earlier.

Weaknesses

• Macau’s gambling revenue for June rose 12.2 percent to 23.3 billion patacas, versus market expectations of 15.3 percent.
• January to May profits at large and medium-sized Chinese iron and steel companies fell 94 percent year-over-year to Rmb 2.53 billion, the economic Information Daily reports.
• The Guangzhou government unveiled a purchase limit on some mid- and small-sized passenger vehicles license plates from July 1, with a yearly quota of 120,000 units or 10,000 units a month.
• Turkey, the fastest-growing economy after China and Argentina, saw its GDP shrink 0.4 percent (up 3.2 percent year-over-year) in the first quarter from the previous three months, promoting the market to believe an interest rate cut by its central bank. 

Opportunities

• With further rate cuts, mortgage rates are lowered again. Particularly, PBOC has encouraged banks to lend to first-time home buyers. The best mortgage rate is a 30 percent discount to the benchmark rate. The chart below shows a downtrend in the ratio between monthly mortgage payments to income, showing improvement in housing affordability.

Threats

• Even with another rate cut within a month by China’s central bank, the market is still muted in Hong Kong and China. The best explanation might be the lack of liquidity in the banking system due to the lower Loan to Deposit (LTD) ratio, currently at 75 percent, and high bank requirement reserve ratio (RRR), currently at 20 percent. The market consensus is for China to cut RRR or reduce LTD soon. Also adverse to the economy is the weak loan demand this year, which might be improved by starting infrastructure projects and increasing consumption spending assisted by fiscal policy.

 

 

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