HRA Article

New Year’s Irresolution

From The December 2011 HRA Journal

David Coffin and Eric Coffin

First off, we want to wish all of you a joyful holiday and a happy New Year.  We’ve been at a family wedding that was a pretty good start the holiday season for us but we’re back in the saddle again.

Just how happy the market’s New Year will be is still to be determined.   The past few months have shaken out a lot of traders as markets seemed to fall apart every time they looked ready to finally break out.   That pattern may continue but we think we could see higher highs after the New Year starts.  Traders seem closer to accepting that, while Euro politicians have no magic bullet, they probably won’t go out of their way to hold a gun to their own heads. 

Northern Europeans will get their way on austerity and Beijing will squeeze property speculators a little harder.  We do think the market will get through that eventually and that some contrarian thinking may be in order.  Not totally contrarian, mind you.  The company we re-visited this month has ounces in the ground and is drilling to expand them.   Likewise, most of the companies in the Updates that we’re more comfortable with have resources to build on, and the monetary resources to get the work done.  It’s not time yet to just toss the dice but we think many of the marked down names on the list will prove to be bargains.

A Euro summit that all knew had to generate some move away from the half done currency system appeared to have finally shifted things in the right direction.  All of the Eurozone members agreed and all but one of the EC members supported bringing in measures to make national government budgets subject to centralized oversight.  Basically, the Eurozone agreed to tighter fiscal integration.  The market response has been “yeah, right”.

This summiting is reminiscent of the show around the Canadian constitution in the 1970s and ’80s to change a document written in the 1860s without a domestic amending formula (it was an Act of the British parliament before de-colonizing was a concept.)  At the time Quebec's separatist government coined sovereignty-association for its wont. 

Quebec “sovereignists” in fact pointed to the nascent EU as model for what it wanted.  That blatantly ignored the point that the EC was about integration rather than disintegration.  Regardless, the Canadian constitution came home with an amending formula, after much ballyhoo and with Quebec sidelined.  A later attempt to include Quebec’s signature floundered in its final days when a single Cree member of the Manitoba legislature refused to vote and filibustered through the amending stale date.    

Who thinks the larger concerns of the Euro on the world stage over a Canadian system that functioned well enough as it was means more sensible treatment?  Neither do we.  Spain alone could spark protests by half a dozen groupings who will want change-before-change.  They will have to be heard, as will general populations. 

Relatively minor gripes from a global perspective might have forced a split of the Canadian union.  It’s in the nature of splitting up that it can get focused on irritants and “final straws”.   Forcing together on the other hand does require some serious push behind it.  Markets won’t be happy with Euroland until they see that.  Perhaps they are, finally. 

We do think this shift at the governmental level in Europe is an important step towards a more workable Euro system.  But more than half is still not a whole.  The UK will likely have company on the sidelines before any concrete formula is worked out, and the market will shudder again as this happens.  It had to happen to someone, and the reality is benching Britain is easier than punting weaker partners who would wreak havoc on German and French banks.  Now the rest of the pick and choose can happen.

Eventually something of greater market import will happen — the process of European integration will be accepted as necessarily prolonged, and the political hand wringing that comes with it as normal.  As this process normalizes it will become easier for the market to ignore it.  ‘It’ being the politics, not the economics. 

That market can’t ignore the debt forcing the integration.  How much of it still needs to be written off along the way isn't finalized, nor is how to do that.  European banks will have to merge with and borrow from unlikely sources before they are close to healed.  Consumer spending will continue to shrink, and to shrink the amount of capital that is willing to invest against future. 

This is no secret.  The real hold up is waiting for the bottom, and that is a psychological shift that’s usually only recognized when viewed in a rear view mirror.  We aren't there yet, but now that the notion of absolute consensus is gone a realistic process has begun.  That is worth viewing through contrarian glasses. 

Retrenchment

This is the point when we would like to say thrashing in the commodities space for the past while is normal.  Mostly, it just sucked.  It was a typical reaction to US$ strengthening as trades fled from the Euro.  It came at the end of a weak year and was exaggerated by that.  However, the damage it did to related equities looked overdone to us.

Selling is normal this time of year, but we expect it would have been more measured had Euro flight not taken place.  We respect the concern, but it’s not as though it’s a new issue.  Even if concern about the structure underlying the Euro is cause to shift away from it, there was no cause for that large a commodities move against the Dollar buying.  Unless you think global demand is sinking.

Market turbulence aside, the weak early year recoveries in the US and Europe have continued.  Uneven at times and never the stuff of legend, but none the less positive though Europe seems destined to austerity itself back into recession.  Continued and in fact prolonged Western weakness is the smart money bet until the heavy buildup of debt is considerably paid down.  At the same time, there is also a lot of cash on the sidelines getting weak returns.  There are also structural imbalances in the balance of trade that need work, but as Germany and Japan attest there is still room for wealthy and productive economies to export.

Growth is appearing to accelerate in the US, though slowly.  The EU is trickier since it appears northern Europeans will get their way and force substantial austerity on the spendthrift South.  This does have to happen but it’s going to cut growth in the EU for some time to come. It may have been wiser to be more Keynesian about it but Germany simply will not allow the adjustment to be about more spending.  Austerity is the price for their financial support and that will mean weak or no growth in the EU for a while.

The other issue over the year for commodities has been slowing growth in China and India.  This has however been against rising inflation in the former and persistent high inflation in the latter.

China backed away from stimulus and restricted lending to housing in particular.  Its problem has been wage-push in manufacturing and more recently from soft commodities as coastal industrial workers moved to higher end pantries.  Many will point to excess money supply as the root cause of inflation.  It is usually just this sort of wage push addition to household cash that that is the source of that extra money flow. 

Prices have begun to moderate in China.  This will have shaved a few percent off of growth, but China is still in a very healthy growth spurt and increasingly able to import goods as well as materials for re-export. 

Just how quickly this will translate into a moderating of restrictive measures is next year’s question.  However, since next year will see turnover of much of the top leadership we expect stimulus measures to be in place to go with the guard changing.  With protests over corruption and indifference to local concerns rising, even those leading in a one party state have to pull the prosperity levers at election time.

India’s GDP expansion has moderated from 9.4% in early 2010 to 6.9% in Q3 of this year, and there are forecasting for some further shrinkage.   The mining and food sectors both shrank, which was partly a matter of price rather than output.  Manufacturing growth also slowed considerably.  However, investment grew by 30% y/y.  This is despite the Reserve (central) Bank pushing up interest rates to try and deal with inflation.

In November India’s inflation rate was running at 9%, which though high is still down from the double digits it had seen.  The interest rate gains are fighting a Rupee that has fallen 20% since midyear and pushed the cost of imported oil and other goods.  The high interest rate policy must be helping stem inflation given that, and is in turn dampening growth.  However, the economy is still early in its economic take-off and there is no evidence the growth spurt is faltering.  Keeping it going will also require dismantling of some of India’s famous red tape that decreases efficiency and capital formation in nearly every sector. India has good political management at the very top but lots of incompetence in the middle, and plenty of corruption and politically self-serving foolishness too.  Democracy has its drawbacks and one of the biggest is that politics can and often does get in the way of sensible decisions and Mumbai has suffered some of the same gridlock as Washington lately.

Markets have swung between hope and despair for several months now.  We are not expecting an outbreak of euphoria but we think markets will find some new normal as more Euro countries sign on to fiscal discipline and amounts get added to rescue funds.  Better than feared numbers out of the US should help calm some nerves too.  The combination may be enough to allow markets to lift.  If Europe actually pulls together a workable new treaty that would be good for the Euro and for the US$ gold price.

Q1 is traditionally good for resource stocks.  There is too much trepidation to expect a large rally but a lift as year-end selling is exhausted isn’t too much to expect.   Continued decent economic numbers from North America and some signs that Beijing and Mumbai are taking the foot off the economic brake could build on that.  

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HRA is your key to uncovering and profiting from extraordinary resource shares by getting ahead of the crowd. At HRA, we look for companies with the potential to at least double over one or two years based on asset growth and development of metals deposits for production or take over by larger companies.  HRA also uncovers high risk/ high potential exploration plays, the kind of "swing for the fences" trade that can yield returns of hundreds or even thousands of percent.  You choose your comfort zone and which type of company you want to follow.

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