Economic challenges ahead - emerging market growth demands resources
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Fred Sturm, CFA
Portfolio Manager
Ivy Global Natural Resources
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Ivy Global Natural Resources Fund – October 2011
Almost all global investment assets went through major price adjustments in the third quarter – one of the most challenging periods for natural resources in many years. Fred Sturm, portfolio manager for the Ivy Global Natural Resources Fund, says increased uncertainty about the economic outlook has added volatility to resource markets worldwide, but he thinks there are indicators that could point to a turnaround.
While the current market crisis is centered in Europe’s government debt problems, economic concerns also have begun to spill into emerging economies, including new discussions about growth risks in China. We think the slowdown in China is a successful response to specific policy initiatives to slow growth and reduce inflation pressures. The economic indicators that we track, including electricity consumption and year-over-year retail sales, simply do not support the idea of a hard landing there. The emerging markets more generally have both fiscal and monetary policy options available to stimulate activity as inflation pressures ease. In fact, we think inflation pressures are cresting now and expect more accommodative language about interest rates from central banks in those countries before year-end.
In aggregate, developing economies now represent close to half of the global economy, and we expect economic growth in this group at an annual rate of 6.0 to 6.5 percent, anchored by China. This underpins our estimate of global growth at about 3.5 percent. We remain undeterred in our belief that, over a multi-year period, resource sectors will benefit from a growing and industrializing world primarily driven by developing countries facing supply growth challenges. Where additional supply is constrained, we think resource businesses still should be able to generate reasonable profits, so we do not expect a sharp deterioration in global corporate profits.
Taking the long view on markets
Investment markets have had to digest a number of disappointing headlines in recent months, leading to the steep sell-off in the third quarter and rapid reductions in analysts’ expectations. Fast and sustained “waterfall” sell-offs are not the norm for these markets, but the shock of 2008 makes it extremely difficult for investors to be patient. Markets typically go through a bottoming phase that shakes out nervous investors, moving shares to stronger holders and setting up the next advance phase.
We think some market indicators are once again hinting this is under way, as we saw in 2002-03 and 2008-09. These tests and retests can be challenging and rapid price changes can cause investors to get whipsawed. But taking time to focus on long-term trends and fundamental valuations can provide useful guideposts. Based on our analysis, stock price valuations for the broad stock markets are reaching attractive levels, although not as cheap as 2008. While valuations speak to multi-year return potential, not to exact timing, we think market sentiment indicators also show we are closer to a low than a high.
Energy prices hurt by economic outlook
In the energy sector, concerns about the global economy caused the share prices of energy services companies and energy producers to decline by roughly 30 percent. We think markets have priced-in a Brent Crude oil price of about $80 per barrel, compared with the quarter-end spot price of $103. We believe prices below $80 are only sustainable if global growth drops to 2.5 percent or less – as noted, we do not expect that to happen.
In other words, much already has been discounted in financial markets. If energy prices do not decline for a sustained period, then we think the stocks are too cheap at current levels. In our view, oil prices still can drift as we work through a soft patch in the global economy and we have some resumption of crude oil production from Libya. However, what the world absolutely cannot afford is for Saudi Arabia to become destabilized, as has happened in Egypt and Libya. We believe Saudi Arabia will need higher budget revenues to maintain a positive economic environment and political stability, which could require $20 per barrel more than its previous $60 budget break-even level. Most other OPEC nations are in a tougher spot and want to defend a price closer to $90, which is a level we believe the world can afford over a normal business cycle. This leaves investors to decide whether oil prices are likely to stay below $80. If so, then energy shares are likely to decline further; if not, then values are attractive now. Our forecasts for global growth, tracking non-OPEC supply shortfalls, and recent inventory data suggest that energy prices are more at risk of drift than sharp decline.
In addition, there are indications that prospects for offshore energy development are actually turning higher as permit approvals in the Gulf of Mexico improve and global offshore development is set to increase. We think companies more geared to offshore drilling would be the direct beneficiaries, but the major oil producers also will benefit. We also think profit margins and unit growth onshore are likely to stall, but we expect solid cash generation unless there is a bigger decline in energy prices. We still believe natural gas prices in the U.S. are among the cheapest commodities relative to economic value. Over a three- to five-year window, we expect the gas-oil spread will narrow.
We have made the case in the past that coal production challenges in China and India will keep inventories tight for global seaborne coal. The outlook for metallurgical coal is harder to discern. This coal used in making steel is more difficult to find and mine, which is why prices have been elevated relative to costs of production. The concerns about global growth caused investors to sell down these companies during the quarter, and investors also have punished companies that pre-announced disappointing production rates. We think there is share price recovery potential for thermal coal companies, but they will need to deliver better production and synergy targets before significant rebounds can be sustained.
We met with solar power companies in China during the quarter and reviewed their operations. This is a sector that we feel has long-term opportunity from the perspective of diversifying energy sources and providing local energy production security. However, it still requires subsidy to be competitive and barriers to entry have not been high enough to discipline capacity. We expect China will step up its internal installation of solar, which could help offset some expected demand weakness in Europe.
Metals reflect economic weakness
Mining stocks were hard hit during the third quarter, reflecting investors’ views that economic weakness would translate into much lower metals prices. Copper declined 26 percent and leading producers sold off more. We believe that growth in copper supplies still will be muted and that increasing cost pressures now require long-term incentive pricing to be sustained near $2.75 per pound. The spot price closed September at $3.15, and bearish investors could point out that there is further downside risk if a global recession were to develop. However, we believe share prices now reflect long-term pricing at $2.25-$2.50, which is below our assessment of incentive pricing.
Our models that correlate gold with currency reserves suggest global gold prices could be 10 to 15 percent too high, notwithstanding global macroeconomic concerns. However, we still expect gold to remain in a primary uptrend and elevated until central bankers raise real interest rates – and we do not expect that to happen until at least 2013. Based on our expectations for working through the European sovereign debt and bank credit risks, we are more inclined to trim back exposure to gold than materially increase it during the fourth quarter.
The way forward
In summary, we think natural resource sectors have been oversold, which may provide potential opportunities for resource investors. We can’t forecast the timing, but we expect market conditions to improve in the near term – barring what we would consider to be further government policy blunders – and over the next three to five years. We do not expect a global recession and now think the world will “muddle through” its economic challenges if there are no sustained systemic shocks. As a result, our tag line remains, “It ain’t great, but it ain’t 2008.”
Among other things, we think this forecast requires central bankers and government leaders to provide sufficient liquidity for economic activity and to ensure the banking system is supported. If global investors believe the European banking system will be protected, then we think the result of Europe’s debt crisis primarily will be a period of moderate recession in the euro zone. We think China and the emerging markets will continue to lead global growth, although at a slightly slower rate; Canada will have moderate growth again in 2012; and the U.S. will avoid recession but post slow economic and job growth.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through October 12, 2011, and are subject to change due to market conditions or other factors.
Consider all factors. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in natural resources can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments; and the cost assumed by natural resource companies in complying with environmental and safety regulations. Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time. These and other risks are more fully described in the prospectus. Not all funds or fund classes may be offered at all broker/dealers.
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