Commentary

Risk aversion was the key phrase in the latter stages of the last quarter. Markets sold off in reaction to a number of political and financial issues taking place around the world. The noise from government upheavals in the Middle East, the Greek central bank bailout, and U.S. debt problems all sent investors running for the sidelines. We could see this flight to safety, not only in the sell-off in the equity markets, but also in the flow of funds out of certain areas. Large caps vastly outperformed smaller capitalized companies. We also saw capital flowing out of resource companies that had assets internationally back into those who operated in North America. As usual, many of these issues are noise that will pass with time, and the markets will return to focus on global growth and corporate earnings.

The fact that the U.S. could default on its debt obligations by early August sent shivers through the markets. The government has until that time to agree to raise their debt ceiling, in other words, the amount they are allowed to borrow. I can’t foresee a situation where this won’t happen, however the Republican Party will extract their pound of flesh to allow it. Of longer concern is how the ratings agencies react to the agreement reached, and whether they lower the U.S. investment rating. No discussion of natural resources is complete without examining the impact of China, now the dominant consumer of many commodities. What concerns investors is the impact of inflation on China. Premier Wen Jiabao has stated that price stability is a top priority, and has raised interest rates five times in the last nine months to achieve this. The increases have had moderate success to date so we may see further tightening this year. Although the markets were hampered by fears of a slowdown in China, their second quarter GDP came in at 9.5%, above expectations. Industrial production growth in June came in at a robust 15.1% year over year. These numbers seem to have quelled fears of a “hard landing” in China. It is the continued modernization of the interior of the country, and the government mandate to build ten million units of affordable housing this year alone, that give us comfort that Chinese demand for commodities will continue.

One factor that was prevalent in the last resource cycle that has started to reappear is cost escalation. Capital costs on new projects are rising once again as input prices such as steel are rising, and companies are finding shortages of skilled labour. Corporations are also seeing escalating operating costs as energy prices increase, unions seek higher wages, and governments are seeking higher royalties and taxes so they can also benefit from rising commodity prices. In the last boom, companies found it difficult to make a decent economic return, so many projects were put on the back burner, leading to supplies being unable to keep up to emerging market demand.

The price of gold traded at all-time highs during the quarter, above $1,550 U.S. per ounce. Investors were buying the metal as a safe haven investment on the back of the political turmoil in the Middle East and North Africa, as well as continuing debt issues with a number of European central banks, primarily Greece. In the short term, the price of gold will remain elevated, as it will take time for the world’s geopolitical and financial issues to stabilize. Although the metal performed well, gold equities lagged quite dramatically, with the TSX Global Gold index down 8% on the quarter. Although gold reacts positively to political issues, equities can be negatively affected by them. Many resource companies operate in countries that are less politically stable, and these shares suffered the most. We have also seen a trend towards dramatically higher gold production costs, which cut into profitability.

Tensions in the Middle East and North Africa also sent the price of West Texas oil climbing. It hit $115 U.S. per barrel when civil war hit Libya, a sizable oil producer. Oil did drop back below $100 as there were signs of political calming and fears of a slowing global economy. The big fear is if these uprisings were to spread to a major oil producer like Saudi Arabia, and the impact of any ensuing oil disruptions. A major concern with a large spike in the price of energy is the ramifications towards global growth. We believe that oil hitting $150 per barrel in the last cycle was a major contributor to the global economic slowdown. OPEC at their most recent meeting did not change their production levels. They feel that the world is well supplied with oil and that speculative forces have been driving prices higher.

Although equity markets corrected in the back half of the quarter, we are still believers in a longer-term bull market in commodities. After two very strong years coming out of the global recession a mid-market slowdown is not surprising. We take comfort in an extended rally due to the strong growth coming out of the emerging markets, as well as some of the supply bottlenecks from the last cycle starting to reappear.

Craig Porter