Gold, Oil and China

Goldman Sachs is forecasting a 27 percent jump in energy and a 17 percent rise in precious metals over the next 12 months. On the oil side, Goldman credits a rebound in industrial production for a 520,000-barrel-per-day increase in China’s implied oil demand in August (year over year). As you can see from the left-side chart, Chinese oil demand has remained a fairly consistent story going back several years.

Globally, world oil demand was up 2.4 million barrels per day on a year-over-year basis in August, according to Goldman Sachs (right chart). Rising demand from emerging nations has created a 600,000-barrel-per-day global supply deficit since May. This month saw a reversal in the U.S., with weeks of growing inventory surpluses swinging to draw-downs after Labor Day.

The long-term prospects for oil haven’t changed. Estimates from Wood Mackenzie and Deutsche Bank show that global oil production will decline 12 percent by 2015 without new investment. Production rates in Britain, Australia, U.S. offshore and Norway have declined 15 percent or more since 2000. Finding future reserves is increasingly difficult and costly, so prices will have to be higher to make developing these reserves worthwhile.

New all-time high prices for gold this week leave many to wonder if we’re nearing a top, but we think gold’s bull run may have further to go. Since mid-August, prices have risen on the back of a significant increase in net long positions on the COMEX and investor interest is near highs for the year. In addition, central bankers have also been stocking up on gold – for the first time since 1988, they will be net buyers of bullion in 2010.

This could also be just the beginning. BCA Research says gold is in a bull market and will “remain that way until macro and/or industry-specific trends change significantly.” BCA cites low real interest rates and high policy uncertainty as the twin engines powering gold higher.

Washington has yet to show how it will reduce the gaping federal deficit, and the Federal Reserve is expected to keep interest rates near zero well into 2011. When you throw in a possible return to quantitative easing, the prospects for higher gold prices look even stronger.

The sturdiest pillar supporting both gold and oil should continue to be China. Even though China was recently crowned the world’s largest energy consumer, the country’s energy demands are still small on a per-capita basis. And for gold, Chinese demand—government, investor and jewelry consumers—remains strong despite high prices. The World Gold Council predicts gold consumption there could double in the coming decade.

Fears of a bubble bursting in the Chinese economy have been deflated as the country prepares itself for a soft landing. Analysts at CLSA says China will remain “the world’s best consumption story” due to income growth, moderate inflation and low household debt. They expect GDP growth to be just under 10 percent this year, and 8 percent to 9 percent in 2011.

There will likely be short-term volatility in commodities, but we believe the enduring strength of the global growth story being led by China and other key emerging markets should be a powerful demand driver in the years ahead.

On a side note, Kudos to our investment team for the mention of the World Precious Minerals Fund (UNWPX) in Investors Business Daily. You guys keep up the good work. We recently published a comprehensive review of our views on gold and precious metals. If you haven’t already had a chance, I invite you to read The Case for Gold at www.usfunds.com.

For more updates on global investing from Frank and the rest of the U.S. Global Investors team, follow us on Twitter at www.twitter.com/USFunds or like us on Facebook at www.facebook.com/USFunds. You can also watch exclusive videos on what our research overseas has turned up on our YouTube channel at www.youtube.com/USFunds.

Index Summary

• The major market indices were higher this week. The Dow Jones Industrial Index gained 1.39 percent. The S&P 500 Stock Index rose 1.45 percent, while the Nasdaq Composite finished 3.26 percent higher.
• Barra Growth outperformed Barra Value as Barra Value finished 0.83 percent higher while Barra Growth advanced 2.07 percent. The Russell 2000 closed the week with a gain of 2.35 percent.
• The Hang Seng Composite finished higher by 3.29 percent; Taiwan gained 3.40 percent and the Kospi rose 1.37 percent.
• The 10-year Treasury bond yield closed at 2.74 percent, down 6 basis points for the week.

Domestic Equity Market

The figure below shows the performance of each sector in the S&P 500 index for the week. Eight sectors gained and two declined. The best-performing sector was technology, up 4 percent. Other better-performing sectors included materials and telecom services. The three worst-performing sectors were utilities, energy and consumer staples.

Within the technology sector, the best-performing stock was Xerox Corp., up 11 percent. Other top-five performers in the sector were Lexmark International Inc., Cisco Systems Inc., Juniper Networks Inc. and Motorola Inc.

Strengths

• The office electronics group was the best-performing group for the week, up 11 percent, led by its single member Xerox Corp. The stock was up following a positive article in Barron’s.
• The retail computer & electronics group was the second-best performer, gaining 8 percent on the strength of gains in Best Buy Co. Inc. The firm reported second fiscal quarter earnings greater than the consensus, and it raised its profit forecast for the full year.
• The systems software group outperformed, rising 6 percent, led by Oracle Corp. and Microsoft Corp. Oracle reported quarterly earnings and revenue greater than the consensus estimate. Microsoft jumped on a press report that it is planning to sell debt to pay for dividends and stock repurchases.

Weaknesses

• The healthcare facilities group was the worst-performing group, down 5 percent, led by its single member, Tenet Healthcare Corp. A major brokerage firm lowered its price target on the hospital firm’s stock, citing lower utilization rates in hospitals.
• The construction materials group was the second-worst performer, down 5 percent, led by its single member, Vulcan Materials Co. A brokerage firm downgraded its rating on the stock to “neutral” from “ buy”
• The homebuilding group underperformed, losing 5 percent. Beazer Homes USA Inc. reduced its full-year outlook for new home orders, saying potential buyers remain cautious amid high unemployment and continued foreclosures.

Opportunities

• There may be an opportunity for gain in M&A (merger & acquisition) transactions in 2010. Corporate liquidity is high, thereby providing the means to pursue acquisitions.

Threats

• Should investors’ expectations for an improving economy not come to fruition on a reasonable time frame, it could be a threat to stock prices.
• As governments around the world begin to wind down the monetary and fiscal stimulus programs put in place during the economic crisis, it will likely present a headwind for stocks.

The Economy and Bond Market

Treasury bond yields moved lower this week. The chart below shows the yield on the 10-year Treasury, which was 6 basis points lower for the week, ending at 2.74 percent. The yield is up about 27 basis points for the month of September to date.

Strengths

• U.S. retail sales for August rose 0.4 percent, slightly better that the 0.3 percent consensus and the second consecutive monthly gain. Sales excluding automobiles advanced 0.6 percent, twice the 0.3 percent consensus forecast.
• Initial jobless claims for the week ended September 11 dropped by 3,000 from the revised number for the prior week to 450,000, better that the 459,000 consensus.
• The U.S. government’s August budget deficit was $90.5 billion, less than the $95 billion median forecast by economists and down 13 percent from the $103.6 billion deficit in August 2009.

Weaknesses

• The New York Fed’s Empire State manufacturing index for September fell to 4.1 from 7.1 in August. While index readings above zero signal expansion, the report was below the consensus estimate of 8.0.
• The Philadelphia Federal Index for September rose to minus 0.7 from minus 7.7 in August, but it was below the consensus of a positive 0.5, and it was still in negative territory. Some economists consider the index as a gauge of sentiment among manufacturers in the region.
• Although confidence among U.S. small businesses rose in August for the first time in three months, the NFIB’s optimism index, which increased slightly to 88.8 from July’s 88.1 reading, is still in “recession territory” according to the report. The measure averaged 100.6 in the five years before the economic slump began in December 2007.
• The University of Michigan preliminary index of consumer sentiment for September fell to a 12-month low of 66.6 from 68.9 in August, and it was below the consensus estimate of 70.0.

Opportunities

• Inflation is unlikely to be a problem for some time and this gives central bankers and other policymakers around the world room for expansive policies.

Threats

• European financial concerns have intensified recently as the long-term solutions still appear elusive for many economies.

Gold Market

For the week, spot gold closed at $1,274.30 per ounce, up $28.05, or 2.25 percent, for the week. Gold equities, as measured by the Philadelphia Gold & Silver Index, rose 3.64 percent. The U.S. Trade-Weighted Dollar Index fell 1.55 percent for the week.

Strengths

• Gold rose to a new record high of $1,279.60 this week as investors increased their safe haven demand and as the result of the release of weaker-than-expected industrial production data out of the euro zone. In addition, gold rose on the forecasts that central banks will be net buyers of gold this year for the first time in two decades.
• The market rally has come with inflation expectation expansion, with the 5-year forward TIP increasing nearly 20 percent in September. Ted Scott, director of strategy at F&C Asset Management, said “because gold had always performed well in periods of high inflation, this was often the sole reason investors held it in their portfolios. But in spite of bond yields plummeting recently, reigniting fears of deflation and a double-dip recession, gold had continued to strengthen, showing it was more than just an inflationary hedge.”
• Marc Faber, publisher of the Gloom, Boom & Doom Report, said “Gold is the one financial asset for which investors do not have to worry about a default or bankruptcy, making it attractive in times of financial uncertainty and the rising geopolitical tensions that may be coming. I believe geopolitical problems will rise in the next 10 years and could have a devastating impact on financial assets.”

Weaknesses

• Record high prices dried up demand for gold in India. One dealer in the world’s largest gold market was quoted as saying, “Demand is absolutely nil. People are not even making inquiries.” India’s gold collection under ETFs for August almost doubled to 12.1 metric tons as investors sought to hedge to protect wealth from global economic uncertainty.
• The Dow-gold ratio (the Dow Jones Industrial average divided by the gold price in ounces) is currently at 8.4 and is approaching its 20-year low.
• Billionaire financier George Soros believes gold is still the ultimate bubble and said, “While (gold) may go higher, it is certainly not safe and it is not going to last forever.”

Opportunities

• A PriceWaterhouseCoopers study noted more large pension funds will invest in mining and suggested, “As the potential for commodity scarcity escalates, M&A activity in the global mining sector will likely intensify, mimicking a ‘global arms race.’”
• One of the trends in gold in 2009 that generated positive investor interest in gold was the news of central banks adding to their gold reserves. Thus far in 2010, activity from that sector has been light, but we are now seeing signs of renewed central bank interest, which may act as a catalyst for further investor interest.
• Doug Casey, chairman of Casey Research, forecast “the Greater Depression” is ahead and that gold will be one of the most important assets to own. He predicted that the gold “could enter a stage where the price rallies by up to $50 a day over the next few years.”
• Richard Russell, writer for Dow Theory Letters, wrote “ This great gold bull market is something that one sees maybe once or twice in a lifetime…I’ve said before that we’ve already gone through the first psychological phase of the gold bull market, and that we are now deep in the second phase of a bull market. If my instincts are correct, the third speculative phase in gold lies somewhere ahead. Often during the third phase, the item makes more for investors than all their profits through the first and second phase.”

Threats

• Nevada lawmakers warned miners that the state’s budget situation is bleak and that things will only get tougher in 2011. The state Legislature told miners that mining is one aspect on which the state has been overly reliant.
• Fannie Mae recently released a survey showing that 63 percent of Americans believe that housing is a “safe” investment, down from 83 percent as the boom was turning to a bubble.
• According to Moody’s, allowing President Bush’s tax cuts for high-income earners will have no effect on aggregate consumer spending because they would otherwise save this money.