Q4 2018 Commentary – Mackenzie Resource Team | Mackenzie Investments

Q4 2018 Commentary

Mackenzie Resource Team

Highlights

  • Monetary policy that pushed the US dollar higher and EM currencies lower, compounded by ongoing trade discussions, weighed on global markets during the fourth quarter.
  • Commodity prices moved higher during 2018, but ultimately spent what felt like the blink of an eye above mid-cycle pricing levels, only to end the year at below mid-cycle levels.
  • Our base case scenario thus calls for slower growth in 2019, followed by a stimulus phase which would allow global economies to regroup for a better 2020.

Market Review

  • Monetary policy that pushed the US dollar higher and EM currencies lower, compounded by ongoing trade discussions, weighed on global markets during the fourth quarter. Coincident economic indicators are now pointing to a slowdown in China, with the world’s second largest economy nearing no-growth territory. The market has therefore rightfully turned its focus to any news that could hint at a thawing of the US-China trade impasse. The latest shutdown of the US government has only added to economic growth concerns; however, it also brought, contrary to prior market expectations, a more dovish Federal Reserve and a stalling of the rise in the US Dollar. Thus, when also layering in Brexit and continued challenges amongst Eurozone countries, global economic growth in 2019 will be most likely slower than 2018. Nevertheless, while the probability of slower year-over-year growth seems high, near-term recession risks remain low based on traditional economic indicators.
  • Commodity prices moved higher during 2018, but ultimately spent what felt like the blink of an eye above mid-cycle pricing levels, only to end the year at below mid-cycle levels. This sudden jolt downwards has stunted the capex cycle and is preventing most commodity producers from reinvesting to grow their supply. As a result, current commodity project pipelines appear inadequate to meet any future growth in demand.
  • The threat of stalling growth in China, combined with Eurozone weakness and a US slowdown, will likely bring about fiscal stimulus. China has started already and will likely accelerate its stimulus measures, which should result in pick-up in growth momentum within three to six months. While Washington is unable to agree on much; a bipartisan majority might be able to push through a long-awaited U.S. infrastructure package which would augment raw materials demand.
  • Our base case scenario thus calls for slower growth in 2019, followed by a stimulus phase which would allow global economies to regroup for a better 2020. Most commodities will be starting from a fairly tight supply/demand balance and relatively low inventories, which could set up for better resource opportunities in the 2020-2021 timeframe; provided that the economic cycle does not get prematurely truncated.
  • Energy - During the fourth quarter, energy markets gyrated rapidly from an expected undersupply to oversupply. This oversupply was unforeseen and predominantly caused by a sudden reversal in U.S. sanctions on Iran. OPEC producers, which initially had ramped up production to offset the anticipated Iran sanctions, responded quickly and by early-December announced a roll-back of this incremental supply. These production cuts appear to be materializing, and Saudi Arabia’s commitment to cut enough to meet any oversupply looks credible. Having noted that, although oil demand was strong in 2018, market fears of a demand growth slowdown will likely cap oil prices until the global economy finds its footing.
  • While energy equities have not recovered materially from their pullback in H2/2018, there has been a marked improvement in the Western Canadian Select (WCS) price differentials. Despite depressed global oil prices, reduced Canadian oil prices differentials have resulted in a net positive impact for domestic energy companies. A completion of Line 3 by Enbridge will be the key event to watch for in 2019 as it would ascertain that Canadian oil price differentials will remain low. The market will need time to adjust to the improved conditions, as valuation multiples of Canadian oil producers currently are at some of the lowest levels of the past decades, even when assuming oil crude prices remain at current levels.
  • Gold - With monetary tightening expected to moderate or even reverse in response to weakening global growth, real interest rates (i.e., nominal interest rates minus inflation expectations) have likely peaked for the next year or two. As lower real interest rates lower the opportunity cost of owning gold, such a backdrop has historically proved to be beneficial to gold bullion and gold equities. In addition, tail risks to the global economy have increased with the mounting possibility of policy error by central banks and embattled governments. The combination of lower real interest rates and rising tail risks is anticipated to re-focus investors on gold’s well-proven role of providing portfolio insurance that can provide improved the risk-return characteristics to a traditional portfolio of equity and fixed income investments.

Outlook

  • Now 10 years old, the current economic cycle has not yet followed its traditional complete trajectory towards a mature economic expansion, which normally would be associated with capacity constraints, sharply rising wages and accelerating investments. 2019 will likely give a chance to the economic cycle to regroup, before pushing activity levels to new highs in 2020. For commodities, the juncture will likely be better than in 2015/16, when inventory levels were still elevated. Hence our expectations for a possibly accelerated rally for commodities in 2020; provided that the global economy can regroup and reaccelerate. Combined with undemanding equities valuation for segments of the resources sector, we would expect resources to outperform during a traditional late-cycle economic push.
  • With some lingering tail risks in the short term, the Resource team’s proprietary risk indicators continue to provide a cautious market short-term outlook and we are therefore continuing to carefully manage risk exposures until our indicators turn positive when receiving early indicators of a stabilizing world economy.

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This document includes forward-looking information that is based on forecasts of future events as of December 31, 2018. We will not necessarily update the information to reflect changes after that date. Risks and uncertainties often cause actual results to differ materially from forward-looking information or expectations. Some of these risks are changes to or volatility in the economy, politics, securities markets, interest rates, currency exchange rates, business competition, capital markets, technology, laws, or when catastrophic events occur. Do not place undue reliance on forward-looking information. In addition, any statement about companies is not an endorsement or recommendation to buy or sell any security.

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