A Pivotal Year?
From the HRA Journal: Issue 263
Gold took another drubbing after the December Fed meeting but its managed to fight its way back above the level it was trading at right before the meeting.
It’s still well below the levels it traded at before the US election. The Trump honeymoon isn’t over yet though NY markets are finding it tougher to make headway. The crowd at CNBC has been doing the “Dow 20K” cheer for a month now. The market still hasn’t breached that newsworthy but otherwise meaningless level but it’s very, very close.
Most of this issue lays out my thoughts about where markets may be headed this year so you’ll have plenty of ammunition if you want to make fun of me later. I’m generally fairly positive about this year, though it’s not likely to display low volatility. I think the resource bull market is alive and well but the path upward will be neither straight nor smooth.
The truth is that almost everything is purely or nearly purely sentiment driven right now. It’s all about what a Trump administration may do but the ultimate path of the markets will be based on what it does do. That is still very much up in the air. And that uncertainty doesn't even account for some important offshore elections in Europe and potential for missteps in China. The predictions in this issue are even more subject to change without notice than an average year!
January 8, 2017
In the wise words of eminent philosopher Yogi Berra “it’s tough to make predictions, especially about the future”. Nonetheless, anyone who distributes opinions about markets knows we’re expected to produce a set of predictions at the start of each year.
I’ve been doing this long enough to understand it’s mainly so readers can have something to tease me about for the remainder of the year. Nothing like a bit of hubris to keep a guy on his toes.
I’m starting off this issue with a chart of the Venture Exchange where many of the exploration stocks I follow reside. It's a flawed index but so are most others. It’s not a pure resource index. Indeed, the late November, early December bounce was all about weed stocks. Still, it’s a decent enough facsimile that gets my basic point across.
[Editor’s note: for the sake of consistency all charts in this editorial are January 1-December 31, 2016 even though we’re a few days later. More recent moves are referenced in the text.]
To hear some resource traders talk, you’d think 2016 was a disaster. Lighten up people!!
I’ll save you the trouble by doing the math. For the full year, the Venture index was up 46%. And its up another 3.5% since yearend. That’s what we call a bull market in the old country. It’s also a far larger gain than any major market index managed to achieve.
If you need a reminder of what bear markets look like, try looking at a previous year for the Venture. Any year from 2011 to 2015 will do. There. Feel better?
I’m not ignoring the fact the resource sector was in a pull back for the past four months. But the operative words are “pull back”, not “bear market”. We’re still in a bull market and I expect we see gains on a number of fronts in the resource space this year. It won't always be easy and it certainly won’t be even but I expect another pretty good year. With that bracing introduction done, let’s step back for now and talk about the broader outlook for markets and individual metals.
I’ll start with the chart below. It may seem off topic but I think it could be central to the gains we see, or don’t see in the US economy next year and, by extension, how US debt and equity markets perform. Those markets influence all others. We can’t ignore them even though we’re focused on resources.
The chart portrays median family income in the US, in nominal and real (inflation adjusted) terms going back to 2000. The recovery in median household income since the Great Recession has been awful. In real terms, its still below its peak in 2007.
The US is a consumer driven economy, something everyone running the place seems to have forgotten. If you want to see sustained 3-4% growth, as some investment banks on Wall St are predicting for 2017 and beyond, you’d better figure out how to generate larger increases in consumer spending. If you want to do that you need to see either rising incomes, higher disposable incomes or willingness to borrow against future income.
Will we see a surge in spending? Based on average wage growth since the Great Recession alone, no. There has been an upward shift in wages gains for hourly employees in the past couple of months. It’s too early to tell if this is a blip but its one of the more encouraging signs I’ve seen in the past year. Maybe we’ll finally see that accelerating wage growth Wall St keeps predicting but which never seems to arrive.
Another thing that may help is rising consumer confidence in the US. I’m skeptical about how closely tied confidence and spending truly are but the recent move does bring confidence back to levels of the mid-2000s. That was the last time consumers were willing to borrow heavily to spend. That didn’t end too well but maybe it will be different this time.
The other route to higher consumer spending could be a large middle class tax cut. While I think a repeat of the Reagan/Bush Jr. tax cut and spend scenario is no long-term solution, it could still generate a short-term spending surge.
I’m skeptical about Trump repaying the people who elected him. There are an awful lot of oligarchs in his cabinet. I think planned tax cuts will favor the rich and, even then, Trump could be in for a fight with his own party. Deficit hawks in the Republican caucus don’t like Trump’s budget proposals. The market is pricing in the rosiest scenario but this isn’t a done deal politically. The Tea Party wing didn’t sign on for trillion dollar deficits.
I don’t assume US growth will accelerate much this year. We’ve had a nice bump in the second half of 2016 which might bring growth for the year to2.5 %. Keeping that momentum going will be trickier. IF a pro growth platform is enacted AND Trump doesn't start a trade war we might see things pick up in the second half of 2017. That’s a lot of “ifs” and I’m not changing my target of 2.5% growth—and potentially less-until I see legislation enacted.
Wall St “surged” post election, though its gain for the year was only 10%. Gains were concentrated in energy and financials. Wall St expects lower tax rates, larger rate spreads and less regulation will help banks.
The expectation of looser regulation and lower taxes underpins Wall St. upgrading its estimate of 2017 profits for the S&P. That’s nice but I suggest you look at the chart below to help keep your enthusiasm in check.
Wall St. expects an increase of almost 15% profits for S&P Index companies this year. The problem is that Wall St ALWAYS expects a surge in profits. The chart shows expected profits 12 months forward against actual profits as reported. Its clear from the chart that Wall St. always overestimates profit levels going forward and has wildly overestimated them for the past couple of years.
Trumpmania notwithstanding I’m not willing to buy into that forecast until I see actual reported profits increasing faster than they have.
An added reason for caution about profit is the level of the US Dollar. The Chart above shows the $USD index marching to a 15-year high on the back of a hawkish Fed statement last month. The Fed was expected to raise rates in December and twice more in 2017. The dot plots released with the December statement indicate three rate increases this year. The USD was already moving higher but had another leg up post-Fed.
Dollar sentiment is still bullish, though I think it may ease for reasons given below. I’ve seen predictions calling for USD Index levels as high as 120 this year. If the USD reaches 120 you’d better be hedged because things could go very wrong. We’re already at levels that will hurt SPX earnings. And that’s before whatever trade problems the US has when president-elect Trump finishes setting off Twitter bombs.
I realize there are many who love the fact Trump is taking a hard line on trade. Maybe that will save a few jobs in the US. I hope so, but its going to come at a cost. There’s no way the US will be able to impose unilateral tariffs without retaliation.
Trump is enjoying being the big dog, but keep in mind the US runs current account deficits of almost half a trillion a year. Some of that is trade deficit that Trump is vowing to reduce but a big chunk of the current account deficit is, effectively, the US borrowing the savings of others to support spending (public and private) that exceeds income.
The US has run current account deficits for years and its never had a problem borrowing money on the best possible terms. I don’t expect it to run into big problems any time soon, but an aggressive trade stance won’t make it easier.
We’re seeing several of the world’s major central banks selling Treasuries. They aren’t doing it for political reasons. They have their own problems to deal with. Financial flows could easily turn against the US, especially if some of the most sluggish economic blocks like the EU find their feet and the US starts trade wars.
Another metric to monitor is emerging market volatility. Collapsing EM currencies are already driving inflation and bond yields higher in several frontier markets. Remember that the swoon we went through in late 2015-early 2016 started in China and secondary EMs. I don’t see an obvious near term flashpoint but you rarely do in advance. Keep an eye out for crashes on obscure markets that could spook traders at home.
NY markets reached another plateau but have been stalled there for most of the past month. I think another catalyst will be needed to drive the 10-15% gains most are calling for. I’m not convinced that catalyst will arrive. The simple truth is that the recent moves are all sentiment driven. Sentiment can move markets a long way but traders will need more concrete evidence at some point. What a Trump administration manages to accomplish in the first half of 2017 will largely determine how the year ends. That’s still a mystery.
I’ll be surprised if the SPX manages more than a 5% gain from here in 2017 and a lower close would not surprise me unless we see constructive changes on the policy front. Tweets can only carry a market so far.
The gold chart below shows gold’s drubbing since the US election and Fed meeting. It also shows bullion gaining ground at year end, erasing it’s losses since the Fed meeting. Gold has displayed good relative strength on days the USD was moving higher lately. This might be a blip, but could also mark a change in the tone of the market.
The reason for that change in tone, I think, is captured by the two charts below. For the first time in a couple of years we’re seeing widespread evidence that inflation is starting to pick up. The charts are from the US and EU but similar charts from China, Britain and several other regions show more dramatic moves.
The moves in inflation are caused by a combination of currency depreciation and increases in raw material prices. In the US, the price pressure, such as it is, is still wholesale—it’s coming up in things like PMI surveys but hasn’t shown itself in the CPI yet.
The stronger US dollar is hurting US exporters but should slow the inflation trend in the US. Currency weakness in other areas like China and Britain is pushing up inflation in those regions. Its even impacting the EU which officials are probably thrilled about after recent deflation scares.
Bond traders have taken notice as you can see from the second chart above. The EU five-year swap rate has quietly moved from 1.3% to 1.8% since September. The ECB, Bank of China and Bank of England are all behind the curve on this. I don’t see any of them trying to get in front of an inflation move. They have other problems to deal with.
The US optimism I referenced earlier may translate to the corporate level and encourage companies to raise prices. Most have been loathe to do that since the Great Recession.
If we see even moderate increases in consumer level inflation that would be a good set up for gold and other precious metals particularly and other commodities generally. Most metals and energy commodities had good years in 2016 and I expect a repeat, with caveats for individual metals as noted below.
I think odds are good that we see a continuation or return to a negative real rate environment moving through 2017 depending on the region. While I was finishing this “megatorial” last month’s Fed meeting minutes were released. They show an FOMC that is more hesitant than last month’s dot plots and press conference made them sound. For very understandable reasons. I think that hesitancy, plus recent better economic readings from the EU and China, will put a ceiling on the USD and a floor under precious metals.
Note the speculative positioning chart for gold above. As of the last CoT report the net long position was 91,000 contracts, and it probably fell further based on changes to holdings of gold ETFs. Gold got oversold and under-owned as we exited 2016. Another reason to expect gains now that a bottom appears to be in.
The Fed has done everything in its power and, going forward, the trajectory of the US economy and markets will depend on fiscal policy. That is the purview of the political class, not the Fed.
The FOMC has to sit back and see what the politicians propose and legislate. Until they see that they really don’t know how far to push interest rates or any other monetary policy. We’re all in the dark, waiting on the Donald. I repeat again; we can’t expect fiscal changes in a high debt, rising interest rate environment to have the impact they did in the 1980’s. Trump isn’t Regan. Don’t expect lightening to strike twice.
All the base metals had decent years in 2016 though individual performance varied widely. The below shows the Goldman Sachs Spot Commodity Index for the year. This index has a heavy energy weighting but is one of the longer running commodity indices around.
After bottoming in January, the GNX put in a strong performance, entering a bull market on a year over year basis in the past few weeks. After years of pain on the commodity front I think the bull market is real but its still got some real hurdles to over come.
As you are no doubt already aware, zinc is the base metal I have the most comfort with. It was also the best performer during 2016, reaching a 10-year high in December before pulling back slightly.
Zinc is currently in supply deficit. Warehouse inventories have been falling though there have been occasional large additions from sources unknown. It’s believed there are still fairy large inventories of finished metal in China though these are being worked through as well.
There is little doubt the market for concentrates are quite tight. Smelters are reported to be offering to process clean concentrates for as little as $50/tonne. That leaves no profit margin. Offers like that would only be made if smelters were desperate for feed.
There are two larger mines slated to start production in 2018. This could help close the supply gap briefly but with no other large mine start ups on the horizon the deficit is projected to get steadily worse.
The two big unknowns for the zinc market are small mine production in China and the restart of 500,000 tonnes of idled capacity by Glencore. Chinese traders obviously think the Chinese government is serious about closing heavily polluting small mines and smelters across the base metal space. Speculative buying in China is partially driven by this belief, especially in the copper, iron ore and coal markets. There hasn’t been much evidence of increased Chinese zinc production yet.
Glencore is keeping everyone in the dark but management said recently they will only restart operations gradually and only if they think it won’t harm the zinc price. Zinc prices have moved far enough that Glencore’s zinc unit should be generating much higher profits even with reduced output. I don’t see Glencore rushing to restart and it will take several months even when they do decide to do it.
I don’t think zinc’s move is over. As long as the world economy continues to stabilize there is potential for another price run this year. I won’t be surprised to see a zinc price above $1.50/pound before 2017 ends. If Glencore does hold off restarting capacity, we could see prices above that level for a longer period than we did during zinc’s run in the mid-2000’s.
I was more hesitant about copper for 2016 because of potential incoming supply. Copper sees more speculative trading than any other base metal. As is so often the case with mining, several development projects are moving more slowly to production than originally anticipated. This should reduce potential supply
overhang in the next couple of years but may not eliminate it.
It’s not always easy to separate purely speculative buying (that can reverse at any time) from buying by legitimate consumers. There is little doubt the move in copper through November was mainly speculative buying in China. I was skeptical of the November move for that reason.
After hitting a high of $2.80, copper has settled back to the $2.50 level. This seems reasonable though we don’t know yet if all the November buying has been unwound. Warehouse inventories ended the year higher than they started. That trend underlies my continued caution when it comes to copper prices.
I’m not bearish and I think a good copper discovery would get plenty of attention. I don’t expect higher prices this year though, unless there is evidence that additional mine start ups are getting pushed even further back or growth in China accelerates this year. I think copper prices will be broadly stable with a slight downward bias.
Nickel should have a good year given the supply headwinds its facing. An increasingly anti-mining government in Indonesia has been choking off supply and an erratic government in the Philippines may not allow for expansion there to offset it. We may even see Indonesia follow through on threats to cut Freeports export licences which would be supportive of copper prices.
While nickel seems certain to be in supply deficit it’s still not a balanced market. Warehouse inventories continue to be quite high by historic standards. There is also more uncertainty about the level of above ground inventory. Its widely believed that Chinese end users were stockpiling nickel, particularly “pig nickel” buyers that hold product that can be upgraded by stainless steel producers.
There are no reliable figures on how much inventory there is outside bonded warehouses but even nickel bulls admit its probably a lot. Even if Indonesian production is shut down its going to take at least 2-3 years to work down official stocks, and who knows how long for hidden ones.
All that said, nickel is in primary supply deficit and current prices are not going to induce new production. I’m not expecting big things in 2017 from nickel but I agree at some point, there is high probably of a large run up in price. That is reason enough for me to keep a watch for new discoveries. High quality nickel discoveries are rare. If I see one, I’ll be on it because the rarity alone can drive a lot of speculative buying even if the nickel price hasn’t lifted off.
Oil prices finally moved higher towards the end of 2016 in the wake of a new OPEC agreement to (sort of) limit output. Current pricing above $50 takes a lot of pressure off of shale producers. This may make further prices increases difficult if US based production starts to trend up again.
Oil prices are widely expected to climb back over $60 this year, thanks to the recent OPEC agreement. Oil’s not my area of expertise. The bullish narrative may work out but OPEC is not a group famous for sticking to quotas.
We’re not really dealing with a supply shortfall here. In order to keep moving higher the oil market needs everyone to live up to their promises not to increase production. Above ground inventories are still pretty high and even bullish oil traders could be easily spooked. They’ve been caught out several times in the past two years. I would expect sellers to have a hair trigger at the slightest indication the OPEC deal isn’t holding.
My view on oil for 2017 is neutral but I have a downward bias. I’ve seen OPEC deals fall apart or end up being meaningless because members break their quotas. With the fiscal pressure on so many OPEC member nations the pressure to produce above quota will be particularly high this time. I won’t be surprised if worldwide production mysteriously ends up higher than forecast sometime this year. If that happens oil could slip below $50 again.
Uranium stocks have enjoyed a major revival since Christmas. Suddenly, we’re seeing all sorts of “the bottom is in” and “this is the next bull market” articles. Be very careful about jumping on this bandwagon.
At the most basic level I agree with this latest incarnation of the uranium bulls. The recent dip to $18/lb on spot prices, above, might be the bottom. Certainly, you’re not going to see new production if prices don’t recover significantly.
That’s the good news. The bad news is that there is still a huge overhang of above ground inventory. Traders got excited about Trump talking up increasing the nuclear arsenal. That’s an idiotic idea and meaningless in terms of uranium demand anyway. The US, and probably Russia too, has enough enriched uranium on hand to build plenty of new warheads.
The late 2016 dip in prices did draw out some buying from bargain hunting utilities. That will need to continue before we see meaningfully higher prices.
I noted last year that, at some point, we’ll see meaningful restocking by utilities but with spot prices so low there is absolutely no sense of urgency. Reactor restarts have been slower than expected in Japan and large scale demand increases from China and India are still a few years away.
There is a lot of excitement surrounding uranium stocks right now but I’ve seen this before at the start of a year. 2-3 times in the last five years actually and uranium prices continued to fall. I think we may have finally seen the bottom but I’m not convinced the price can move much higher in the short term. If you’re interested in uranium stocks I think some patience is in order. Don’t chase them here.
We’ve started the year with a bounce in the gold price that helped generate an even larger bounce in gold stocks, both senior and junior. I think the relative strength of the equities is encouraging as the stocks often lead the metals.
The positive divergence of gold equities relative to bullion does mean that we’ll need to see further gains in gold and silver prices to underpin gains in precious metals equities. That is particularly important for the producers. Explorers as a group can gain on positive sentiment for the sector, even without gains in bullion. That’s one reason I’ve been favoring earlier stage companies.
The turn in the commodity complex as a whole does finally seem like a real one. That may be the most encouraging sign as we enter 2017. Most broad commodity indexes are heavily weighted to energy. I’ve noted some potential oil market concerns and the same concerns apply to coal. A lot of the buying is sentiment driven and that can turn on a dime. That doesn’t mean it will, but if it does we might not get much warning.
Sentiment is really the key driver behind the whole market right now. Traders think there has been a sea change and that we're on the cusp of a secular bear market in bonds. At the same time, we’re seeing large retail inflows into equity markets based on optimism about reduced regulation and taxation and higher growth rates, especially in the US.
I tend to agree with the market’s view on bonds though I don’t know how quickly a full-blown bear market will develop. That is a critical question. Markets are balancing acts. Its quite possible for equities to advance while bonds fall, as long as companies are generating profit growth that exceeds rising bond yields.
I think Trump will be able to pass some sort of legislation that allows companies to bring overseas cash home. That will help underpin markets in NY. Not because companies will invest the money intelligently. Because they will use if for share buybacks and dividends just like they did when Bush the Younger passed similar legislation.
Other aspects of the Trump agenda, like infrastructure spending, will take much longer to appear and are likely to underwhelm. Expectations are so high right now I can’t conceive of them being met. I think some disappointment is inevitable. That will be the first test of the Trump rally and it shouldn’t be long in coming. How the market gets through the inevitable letdown from the election sugar rush could determine the overall tone for the year.
One of the biggest surprises in the past couple of months isn’t centered in the US. For me, signs of acceleration in the economies of China, Britain and the EU are more heartening. Things went well for most metals in 2016. We need to see growth in China and the EU to underpin further gains this year. Everyone is obsessed with the US but Asia and Europe are far more important when it comes to marginal demand for metals.
China, as always is the more opaque market and the scarier one. Its debt markets always seem to be just a step away from disaster lately. China has defied the skeptics for years. Hopefully it continues to.
The early year gains for metals and weakness for the USD in 2016 were partially driven by convergence in growth rates between the US and other economic blocks. As we ended the year traders again assume we’re about to see divergence again, with US growth far outstripping gains elsewhere.
Traders may be right about that. The US definitely has the more dynamic economy that has the most potential to accelerate. What we don’t know yet is whether the US can lift off in an era of rising yields. That is a theory that has yet to be tested. A lot of the growth in consumer spending is debt driven—autos and housing specifically. Sentiment is important but so are carrying costs. Consumers need to be able to afford the debt loads.
If recent inflation moves aren’t just a currency driven statistical blip we could see stronger growth and strong bullion and base metal prices, something similar to the mid-2000’s. That outcome is most likely if other economic blocks continue to strengthen. That outcome would also help keep a lid on the USD.
I expect a more cautious Fed than the market does. An argument can certainly be made for another rate hike near term but the FOMC might want to see Trump’s legislative platform and Congress’s reaction to it before they get too proactive.
Overall, I’m positive about the potential for the sector this year. That said, its impossible to overstate how large the “tail risks” are as we move through 2017.
I can’t imagine a US administration with more potential to create Black Swans than the one about to take office. The markets are extremely optimistic right now but we shouldn’t underestimate the potential for Trump to screw up on a galactic scale. We’ll need to be on our toes this year and prepared to harvest profits along the way, as always.
The good news, if you can call it that, is that major policy missteps, if they occur, are likely to be positive for precious metals. If the new administration threads the needle and we see broadly higher growth the advantage will go to base metals.
I’ll continue to seek out new opportunities for you based on exploration success and resource growth in both base and precious metals. We’ll play it by ear and alter the balance between the two major subsectors in the junior space as we see how this potentially pivotal year develops. Best of luck to us all for 2017!
The HRA–Journal and HRA-Special Delivery are independent publications produced and distributed by Stockwork Consulting Ltd, which is committed to providing timely and factual analysis of junior mining, resource, and other venture capital companies. Companies are chosen on the basis of a speculative potential for significant upside gains resulting from asset-based expansion. These are generally high-risk securities, and opinions contained herein are time and market sensitive. No statement or expression of opinion, or any other matter herein, directly or indirectly, is an offer, solicitation or recommendation to buy or sell any securities mentioned. While we believe all sources of information to be factual and reliable we in no way represent or guarantee the accuracy thereof, nor of the statements made herein. We do not receive or request compensation in any form in order to feature companies in these publications. We may, or may not, own securities and/or options to acquire securities of the companies mentioned herein. This document is protected by the copyright laws of Canada and the U.S. and may not be reproduced in any form for other than for personal use without the prior written consent of the publisher. This document may be quoted, in context, provided proper credit is given.
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