Recession on the Horizon? Look at the Big Picture

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

Today the Bank of Japan (BoJ) rattled global markets by announcing its adoption of a negative interest rate policy intended to spur banks to lend and consumers to spend. The world’s third-largest economy, then, joins a handful of European countries who are experimenting with less-than-zero rates, among them Denmark, Austria, Switzerland and Sweden, which I’ve written about previously.

The BoJ’s move is just the latest to suggest that global central banks’ bag of tricks to stimulate growth is quickly running empty, and that the imbalance between monetary and fiscal policies continues to accelerate. Negative rates charge banks for parking excess cash and ultimately punish savers, yet make gold more attractive.

Already companies and individuals are more indebted than ever before.

Bloomberg reports that corporate leveraging around the world has reached an unprecedented, and arresting, $29 trillion. In 2015, debt reached three times earnings before interest, taxes, depreciation and amortization, a 12-year record. An estimated one third of these companies, meanwhile, are unable to generate enough returns on investment to cover the cost of credit.

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If this is a debt bubble, it only adds to speculation that we’re headed for a global recession. As I mentioned last week, several prominent voices, including George Soros and Marc Faber, believe recessionary forces are growing stronger, precipitated by struggling commodity prices and surging global debt.

It might be hard to remember after a nearly seven-year equity bull market, but we’ve been here before.

Credit Suisse looked at 14 recessionary pullbacks between 1929 and 2008 and found that the S&P 500 Index, after lasting an average 298 trading days, declined an average 33 percent. Some of these recessions, obviously, lasted longer and were more severe than others, such as the most recent one that lasted between 2007 and 2009.

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But each of these pullbacks, Credit Suisse notes, provided ample buying opportunities in U.S. equities. Rebounds following the recessions averaged 62 percent—80 percent following the 2007 financial crisis.

How to Invest When Stocks Make You Worry

Whether or not a recession is imminent, I believe it’s a good idea for investors to be prepared by having a well-diversified portfolio, including assets such as gold and municipal bonds. Gold has tended to have a low correlation with stocks, meaning that even when stocks were tumbling, it’s managed to retain its value well. The same can be said for short-term, high-quality munis, which have been shown to offer a greater amount of stability than some other types of securities, even during market downturns.

In 2015, munis, as represented by the Barclays Municipal Bond Index, were actually the top fixed-income asset class, beating both Treasuries and corporate debt. They also outperformed S&P 500 Index stocks, returning more than double what equities delivered.

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Muni fund inflows gained momentum in the second half of 2015 as global stock markets began to show signs of trouble, and so far this year, investors are piling into munis at a rate of about $1 billion per week.

The last couple of decades were among the most volatile, with the tech bubble and financial crisis challenging markets. Out of more than 31,000 equity and bond funds during this 21-year period, only 0.12 percent of the total number, made up almost completely of municipal and short-term bond funds, managed to delivered positive returns on a consistent basis. Learn more about the $3.7 trillion muni market!

Did Russia Just Blink?

Several forecasts this week suggest oil prices are unlikely to recover in 2016—and might fall even further.

Morgan Stanley says crude could reach $20 per barrel as the U.S. dollar strengthens. The U.S. Energy Information Administration (EIA) predicts that we might not see supply and demand start to rebalance and prices recover until late 2017. And the World Bank lowered its 2016 forecast for crude oil prices, from $51 per barrel on average to $37 per barrel. The downward revision is based on a number of factors, including sooner-than-expected oil exports from Iran, a mild winter in the Northern Hemisphere and, most significantly, continued imbalance between global supply and demand. U.S. producers have been much more resilient than expected to lower oil prices.

But talk that meaningful production cuts are on the horizon led oil higher this week, helping it achieve its first three-day winning streak of the new year. In the global production staring contest, it appears as if Russia blinked first, as it just expressed an interest in reaching terms with the Organization of Petroleum Exporting Countries (OPEC) on output cuts.

Like Saudi Arabia, Nigeria, Iraq and Venezuela, Russia greatly depends on oil exports, the revenue from which makes up about half of its government’s total revenue. The country averaged 10.5 million barrels a day in 2014, making it the world’s third-largest oil producer after the U.S. and Saudi Arabia. Coupled with Western sanctions for its involvement in Ukraine, low prices have wreaked havoc on Russia’s economy, which contracted 3.7 percent in 2015 and is expected to fall another 1 percent this year. The ruble, which closely tracks the decline in Brent oil, has lost approximately half its value against the U.S. dollar in the last two years.

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Reaching a production cap deal with OPEC, whose members are collectively responsible for about 40 percent of the world’s output, would help rebalance supply and demand and firm up prices.

Oil has historically bottomed in the month of January, and it appears that last week was a bottom. It remains under pressure, but we could see oil climb to between $38 and $40 per barrel over the next three months.

In the longer term, things look more constructive. Oil will continue to be the world’s most important source of energy for at least the next couple of decades, according to a new report from ExxonMobil. We should expect to see a 25 percent increase in energy demand by 2040, which is like adding another North and South America.

Looking at transportation fuels, natural gas demand is expected to grow the most—300 percent between 2014 and 2040. Jet fuel should climb 55 percent as air travel demand increases in emerging and developing markets.

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China Still a Long-Term Growth Story

By 2040, the world population should surge to nine billion, with a greater percentage of people than ever before demanding affordable, reliable energy for their homes and businesses.

Even though its demand for materials and commodities has cooled in the last year, China should continue to see huge consumption growth in durable goods for many years to come as its GDP per capita expands.

Back in October, Credit Suisse reported that the size of China’s middle class had, for the first time, overtaken the size of the American middle class, 109 million adults compared to 92 million. As this group increases in number, so too rises the demand for durable goods, vehicles, energy and other things we expect to find in a middle class lifestyle.

In a report this week, McKinsey & Company’s Gordon Orr urges readers to focus on the absolute scale of China’s economy, not just slowing growth.

“No matter what rate the country grows at in 2016,” Orr writes, “its share of the global economy and of many specific sectors will be larger than ever.”

For forward-looking global investors, that’s optimistic news indeed. 

Index Summary

• The major market indices finished up this week.  The Dow Jones Industrial Average gained 2.23 percent. The S&P 500 Stock Index rose 1.75 percent, while the Nasdaq Composite climbed 0.50 percent. The Russell 2000 small capitalization index gained 1.44 percent this week.
• The Hang Seng Composite gained 2.49 percent this week; while Taiwan was up 4.18 percent and the KOSPI rose 1.74 percent.
• The 10-year Treasury bond yield fell 12 basis points to 1.93 percent.

Domestic Equity Market

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Strengths

• Telecommunications was the best performing sector, increasing by 4.32 percent vs an overall gain of 1.60 percent for the S&P 500.
• Consol Energy was the best performing stock for the week, increasing 28.90 percent. The company reported better than expected 2015 fourth-quarter revenue results.
• Earnings season is in full swing. Thus far, nearly 73 percent of the companies reporting in the S&P 500 Index have beaten expectations, and 47.4 percent of companies reporting have beaten revenue forecasts as well, according to research from Zack’s Investment Research. It’s worth noting that expectations heading into earnings season were quite low.

Weaknesses

• Health care was the worst performing sector for the week, falling 1.86 percent vs an overall gain of 1.60 percent for the S&P 500.
• Alliance Data Systems was the worst performing stock for the week, falling 19.83 percent. The company’s fourth quarter 2015 results missed analyst’s estimates.
• Caterpillar says it plans to close five plants and trim about 670 jobs in Illinois and several other states, in the latest phase of a larger cost-cutting campaign announced last year.

Opportunities

• Defense orders are moving higher, which is supportive of ongoing earnings growth.
• While the S&P telecommunications service sector faces challenges to grow revenue, the focus on profit margins should be sufficient to create value. Chronic competitive pressures have eased following consolidation efforts, enough to drive meaningful pricing power gains.
• Household product stocks are gathering momentum and this trend should persist as profit margins slowly improve. The industry has undergone a forced retrenchment as a consequence of the strong U.S. dollar, which sapped top-line growth. However, both commodity input and labor costs are contracting, providing much needed profit margin relief.

Threats

• The industrials sector stands out as having operating margins well above its historic average, along with an elevated price/sales ratio.
• Aerospace new orders are very soft, arguing the commercial aerospace cycle is on the downswing. That implies lower plane deliveries and future profit margin pressure, as evidenced by Boeing’s earnings miss.
• The plunge in capital markets stocks does not seem like a buying opportunity. Corporate sector credit quality is quickly deteriorating and ratings agencies are adding fuel to the fire as bond downgrades are briskly outpacing upgrades. The message is that capital formation will continue to slow as the cost of credit climbs. As a result, profit prospects should continue to erode.

January 28, 2016 Will Oil Markets Rebalance in 2016?	January 25, 2016 Where Are Commodities Headed? Watch This Indicator	January 19, 2016 Frank Holmes Tells Kitco: Silver Is Strong, Gold Is Doing Well

The Economy and Bond Market

Strengths

• According to Bank of America Merrill Lynch, headwinds from an appreciating U.S. dollar, transitioning Chinese economy, and inventory overhang are weighing on growth. The impact of this slowdown has been seen in industrial sector data. However, leading indicators of economic activity suggest only a slowdown, not a downturn or recession.
• Consumer confidence strengthened to 98.1 in January, beating expectations of 96.5. This was up from 96.3 in December.
• New home sales surged 10.8 percent month-over-month (MoM) in December to 544,000 SAAR, reaching the strongest level since February 2015. The S&P Case-Shiller national home price index strengthened by 0.9 percent MoM for the second consecutive month in November, boosting the year-over-year rate to 5.35 percent from 5.06 percent in October.

Weaknesses

• The January FOMC statement nudged the Federal Reserve in the dovish direction of the markets, particularly by reinserting language that they would “closely monitor global economic and financial developments.” However, as expected, the Fed did not give a strong signal that they would wait to hike as the market has priced in. In fact, the FOMC explicitly added language to indicate they were still “assessing their implications” for the outlook, suggesting that they want to retain the option for a March hike, but not strongly lean in one direction or the other.
• The U.S. economy grew at a modest 0.7 percent annual rate in the fourth quarter of 2015, reflecting the impact of a strong U.S. dollar, tepid global demand and an inventory glut. Growth slowed from a 2 percent pace in the year’s third quarter.
• Durable goods orders collapsed -5.1 percent MoM in December, coming in well below expectations of -0.7 percent. November was also revised down to -0.5 percent from 0.0 percent.

Opportunities

• Prices for crude oil rebounded late in the week on rumors of a meeting between OPEC and Russia to discuss a production cut of around 5 percent. As yet, no meeting has been officially announced. 
• Two key metrics that drive the FOMC deliberations, core PCE inflation and payrolls, will be released Monday and Friday, respectively. A failure of inflation to accelerate along with weakness in the labor market would increase the probability of a more extended wait-and-see policy stance. This could hold the Fed from continuing to raise rates even as tightening financial conditions pose growing risks to domestic and global growth.
• The Bank of Japan (BoJ) surprised markets by dropping the policy rate to -0.1 percent. A negative interest rate policy could spur the Japanese stock market higher as investors search for yield.

Threats

• The Fed’s rate increase could ultimately prove to have been ill-timed. Unlike in previous cycles, the rate hike coincides with the beginning of corporate deleveraging.

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• Risks to global growth are on the downside. Purchasing manager surveys of both the U.S. and China will be released on Monday and Wednesday.
• A slower pace of rate hikes would mean a temporary reprieve from yield curve flattening. BCA’s U.S. bond team has been recommending the 2/10 curve flattener, but advises to step away for now.

Gold Market

This week spot gold closed at $1,117.77, up $19.77 per ounce, or 1.80 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, jumped 8.85 percent. Junior miners underperformed seniors for the week as the S&P/TSX Venture Index traded up 3.28 percent. The U.S. Trade-Weighted Dollar Index finished essentially flat for the past week.

Strengths

• The best-performing precious metal for the week was platinum, up 4.80 percent. The World Platinum Investment Council forecasts that platinum is to remain in deficit through the next six years.
• Bullion for immediate delivery rallied 5 percent in January, according to Bloomberg, the best gain in a year as seen in the chart below. Following the $15 trillion rout in global equity markets since May, the precious metals’ lure has reawakened. Bloomberg also points out that investors bought gold through exchange-traded funds for the past seven days straight, the longest stretch in a year.

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• According to Bloomberg News, China’s imports of gold from Hong Kong jumped 67 percent in December to the highest level in more than two years on the back of market turmoil and anticipation of further weakening in the nation’s currency. In addition, Barclays forecasts that the People’s Bank of China (PBOC) will buy 215 tonnes of the precious metal this year, as the country “seeks to diversify its reserves.”

Weaknesses

• The worst-performing precious metal for the week was palladium, still up 0.37 percent. Total ETF holdings for both platinum and palladium declined this past week, but nearly twice as many ounces of palladium were liquidated compared to platinum.
• Eldorado Gold plans to write down the value of its assets up to $1.6 billion, reports the Canadian press this week, with a majority of concerns related directly to its mining operations in Greece. Aureus Mining has also run into some trouble with its plans for the New Liberty mine in Liberia. The company has deferred declaring commercial production following last-minute plant problems.
• The top forecaster from OCBC, Barnabas Gan, says gold is “shiny today,” but will be “dull tomorrow,” according to a Bloomberg article. Gan sees the precious metal at $950 by the end of 2016. In a similar statement, Richard Jerram with the Bank of Singapore thinks gold’s stellar start to the year won’t last as the U.S. jacks up interest rates.

Opportunities

• In the final quarter of 2015, total gold supply dropped 7 percent, according to data from Thomson Reuters, due to an estimated 4 percent drop in global mine output. Based on prior long-term price declines for the gold, Bloomberg reports that gold production may drop more than 20 percent in the next five to 10 years.
• RBC Capital Markets released its Global Gold Outlook this week. In the report, the group cites five themes that are new or look positive for the gold price: 1) Gold has been resilient in the face of a strong U.S. dollar, 2) The gold price has been in a corrective phase since late 2011, 3) A bimodal global economy is benefitting non-U.S. dollar holders of gold, 4) Central banks are now net buyers, and 5) Gold ETF positions have grown.
• Orex Minerals announced that its assay results for the first hole of the 2015-2016 diamond-drilling program on the Sandra Escobar Project hit 61 meters from surface-grading 359 grams per tonne of silver. According to the company’s president, Gary Cope: “This is an excellent high-grade and thick drilling result… and although it is early in the program, silver has been detected in outcrops over a strike length of 700 meters.”

Threats

• According to Freeport-McMoRan, one of the world’s biggest gold mines, continues to operate after its export permit expired without receiving renewal. The Indonesian government has asked for a $530 million deposit on a new smelter in return for renewing the permit. A similar gloomy outlook was announced last Friday by Moody’s – the group put 55 mining and metals companies on review for downgrades to their credit ratings, citing “slowing growth in China.”
• This year investors are paying almost twice the average premium to own the most-recently auctioned 10-year notes, according to data compiled by Barclays. Bloomberg reports that part of the cracks in the bond market can be explained by turmoil in the financial markets, which have boosted demand for haven assets. The article goes on, however, to state “beyond those issues lie deeper concerns about the very structure of the U.S. bond market, and whether post-crisis rules intended to present another financial catastrophe have ultimately left it broken.” It seems the cure killed the patient!
• Gary Cohn, president of Goldman Sachs Group, says that Treasury yields will likely rise, according to Bloomberg, while Morgan Stanley is predicting just the opposite. Treasuries are heading toward their biggest monthly gain in a year, earnings 1.5 percent in January. Tumbling oil and equity prices are driving investors to the “relative safety of government debt”—and gold.

January 25, 2016 Comparisons to 2008 Spark Gold’s Fear Trade	January 21, 2016 How Airlines Are Spending Their Record Profits	January 19, 2016 One Weird Trick to Forecast Commodity Trends

Energy and Natural Resources Market

Strengths

• Investors are pouring money into commodity funds at the fastest pace in at least a year. Bloomberg data shows that inflows into commodity ETFs surged by $3 billion in January, backed by additions into energy and precious metals.
• The best performing sector for the week was the TSX Oil Explorers & Producers Index. The Canadian oil producers rallied on the back of crude oil posting its second consecutive weekly gain.
• The best performing stock for the week in the broader natural resource space was Gamesa, a leading wind turbine manufacturer. Shares of the renewable energy company surged following a report that Siemens is studying a bid for the company.

Weaknesses

• OPEC delegates rebuff speculation that they have a meeting planned with Russia to discuss coordinated oil output cuts. Despite oil prices posting strong gains after media reports suggested Russian delegates would meet with OPEC counterparts, Gulf members said no meeting or proposal to trim production by 5 percent is being considered.
• The worst performing sector for the week was the S&P Container & Packaging Index. The sector went under pressure after trade journals reported that containerboard prices fell for the first time since 2009 on slowing Chinese demand.
• The worst performing stock for the week in the S&P Global Natural Resources Index was Packaging Corp. Following reports on price weakness, both Citi and Macquarie downgraded the stock arguing that it does not warrant a premium over its peers in a weak pricing environment.

Opportunities

• U.S. PMIs may surprise to the upside next week following strong reports from Milwaukee and Chicago purchasing managers this week. The data released in anticipation of the official PMI reading showed manufacturing conditions have recovered despite the resilience of the strong dollar. PMIs have historically been the best leading indicator to help forecast commodity demand trends.
• The commodity rout comes with significant cost savings for miners. Caterpillar, as an example, reported that in the fourth quarter alone, it saved $2.3 billion in costs, led by tumbling input prices such as steel. For miners, lower diesel prices coupled with shorter lead times, as well as partial cost-saving pass-through from Caterpillar and others, can result in multi-billion dollar cost savings at a critical time.
• Cheap oil is no longer an impediment for renewable energy growth, as government policies increase carbon regulation and big money investors continue to commit funds to companies not exposed to increasing climate regulation. Amundi, one of Europe’s largest money managers, announced it has “decarbonized” about $5 billion worth of assets over the past 12 months at the request of its clients.

Threats

• A study published by Capital Economics suggests the rebound in oil prices is insufficient to alter the dynamics in the energy markets. The chart below presents the long-run versus the short-run crude oil breakeven levels, showing how U.S. shale producers cannot grow production at current prices. The lack of oil capex in North America will continue to strengthen the Gulf States advantage over the long run.

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• Laurence Fink, chairman of BlackRock, the world’s largest money manager, said as many as 400 energy companies may not survive because oil prices are not high enough for them to meet their debt obligations. Although Fink did not make a forecast for oil prices, he did suggest that prices will remain depressed for longer.

• Potash Corp, the world’s largest fertilizer producer, missed fourth-quarter earnings expectations and cut its dividend for the first time since its initial public offering in 1989. Fertilizer producers are under pressure as oversupply conditions resulted in realized prices for nitrogen fertilizer sliding 29 percent, while potash prices declined 16 percent.

China Region

Strengths

• The Bank of Japan announced on Friday that it had adopted a negative interest rate policy, sparking a global equities rally in response to the stimulus measure.
• Fourth quarter GDP in the Philippines came in at 6.3 percent, well ahead of analysts’ expectations for 5.9 percent.
• Once again, the Malaysian ringgit strengthened this week, finishing up more than 3.5 percent as oil continued its recent gains.  Malaysia is the region’s only net energy exporting country. 

Weaknesses

• The Shanghai Composite Index made a new 52-week closing low week.
• In the currency world, the Japanese yen finished as the worst performer in the region, down almost 2 percent as the Bank of Japan took rates negative.
• Freeport-McMoRan lost its right to export copper concentrate this week after ongoing talks with the government of Indonesia reached deadlock.  The Indonesian government seeks a $530 million deposit from the miner, which would weigh further upon the company’s debt load.

Opportunities

• Publicly-traded Chinese firms have been splurging on foreign purchases this year, with M&A in 2016 already over $8 billion and marking more than one-third of last year’s record tally.
• Several regional markets remain oversold in the near-term.
• The PBOC injected record amounts of liquidity into the Chinese economy this week by means of reverse repos, attempting to stabilize outflows while also smoothly anticipating higher-than-average demand for cash ahead of upcoming Chinese Lunar New Year holidays.

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Threats

• Investors remained focused upon recent questions about the pace of capital outflows and FX reserves in China.  Next weekend on February 7, China will release its FX reserve levels for the end of January, with the issue sure to remain topical before the release.
• Recent or continued volatility in the region may continue to weigh upon sentiment.
• Devaluation races may continue to spark volatility.

Emerging Europe

Strengths

• Turkey was the best performing market this week, gaining 4.6 percent. The country rebounded with improving emerging market sentiment. The Central Bank of Turkey left its main interest unchanged at 7.5 percent, as expected.
• The Russian ruble was the best performing currency this week, gaining 3.2 percent against the U.S. dollar. Brent crude oil gained 4.3 percent in the past five days. The Central Bank of Russia left its main interest rate unchanged at 11 percent and warned that it may tighten monetary policy if inflation stays elevated.
• The consumer staples sector was the best performing sector among Eastern European markets this week.

Weaknesses

• Romania was the worst performing market this week, losing 1.7 percent.  Wood & Company stated that recent weakness has created a buying opportunity. The group forecasts GDP growth at 5.1 percent this year and 5.8 percent in 2017.
• The Ukrainian hryvina was the worst relative performing currency this week, losing 4.29 percent against the U.S. dollar. The International Monetary Fund (IMF) withheld a third $1.7 billion loan after President Petro Poroshenko’s government delayed the implementation of a pledge to overhaul its tax system and adopt a budget.
• The health care sector was the worst performing sector among Eastern European markets this week.

Opportunities

• The Czech Republic’s GDP accelerated to an annual 4.7 percent in the third quarter, the third fastest pace in the European Union. This data, combined with a narrowing budget deficit, is attracting more capital.  Foreign holdings of Czech domestic bonds jumped 36 percent in the year to November 30. The yield on Czech 10-year sovereign bonds dropped to 0.63 percent on Thursday, trading 0.22 percentage points above German bonds. The cost of borrowing in neighboring Poland and Hungary runs at 3.13 percent and 3.54 respectively.

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• Russia’s energy minister said he is ready to meet OPEC members to discuss oil production cuts. At the previous meeting between OPEC and Non-OPEC countries, a 5 percent output cut had been discussed. A cut of 5 percent by Russia and OPEC would remove more than 2 million barrels a day of production, helping to rebalance oversupply in the market. The Russian economy should improve when oil recovers, as most of the country’s revenue comes from the oil trade.
• Inflation in the eurozone has risen 0.4 percent in January from 0.2 percent a year earlier, but still remains well below the European Central Bank’s target of 2 percent.  ECB President Mario Draghi has already indicated another stimulus package could be presented as soon as March.

Threats

• Transparency International recently published its 2015 Global Corruption Rankings. Turkey was among the nations that declined the most, falling two spots to 66th place and continuing its descent from 53rd place in 2013.  President Erdogan’s ambition to expand his presidential power was boosted by an election victory in November; the government’s influence has crept into universities, law enforcement, the media and the judiciary.
• On January 15, Standard & Poor cut the credit rating for Poland to BBB+ from A-. This was the first ratings change for Poland since 2007 and the first actual downgrade in Polish history. This week Moody’s made some negative comments about Poland’s fiscal policy, suggesting that it may follow the S&P in downgrading the country. Moody’s rates Poland at the highest at A2, followed by Fitch at A-. 
• National Bank, in its Geopolitical Briefing publication from January 27, pointed out the growing trouble in Germany. The popularity of Chancellor Merkel, the EU’s longest serving and most liked leader, is declining due to a growing migration crisis. Sixty-three percent of Germans feel there are too many migrants, compared with 45 percent in September. And, even more worrisome, is the rise of support for a far-right political party called the Alternative for Germany, which advocate for shutting the border to migrants and exiting the eurozone. Alternative for Germany is the country’s third most popular party at this time, with a 12.5 percent approval rating up from around 3 percent in September 2015.

Leaders and Laggards

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All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

Holdings may change daily. Holdings are reported as of the most recent quarter-end. The following securities mentioned above were held by one or more accounts managed by U.S. Global Investors as of 12/31/2015:
Boeing Co/The
Eldorado Gold Corp.
Exxon Mobil Corp.
Freeport-McMoRan Inc.
Gamesa Corp. Tecnologica SA
Orex Minerals
Potash Corp. of Saskatchewan In

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