Mackenzie Resource Team
- The performance during the quarter is consistent with the Portfolio Managers’ view that the global economic expansion appears to be gaining breadth. This backdrop is supportive of energy prices however precious metals holdings suffered a decline.
- Oil demand remained strong in the fourth quarter. Vehicle miles driven in the U.S., an important data point that tracks closely with employment, reached new highs. On the supply side, OPEC finally came to an agreement and promised to output by 1.2 million barrels per day, which should accelerate a decline in global oil inventories. Assuming full compliance, inventories could reach “normal” levels very rapidly pushing prices higher to mid-cycle levels. The more likely scenario, partial compliance, would take inventories down to normal level towards year end.
- Gold suffered a setback during the fourth quarter as sovereign bond yields (as expressed by the U.S. 10-year Treasury) rose in anticipation of higher growth rates, whereas inflation expectations (as expressed by the 5-year forwards) initially only rose modestly. The resulting rise in ‘real’ interest rates (i.e., nominal yields minus inflation) temporarily weighted on gold. Subsequent to the much-anticipated rate hike by the U.S. Federal Reserve, bond yields have recently declined whereas inflation expectations have continued their steady rise. As a result, real yields have once again declined, providing a somewhat benign backdrop and allowing gold prices to stabilize for now.
Outlook & Strategy
- U.S. and European labor markets continued to tighten, supporting accelerating wage growth. Monetary policies in both regions remain highly accommodative as central banks, hesitant to derail progress, remain willing to accommodate some inflation. In addition, political developments in the U.S. and Europe confirmed the population’s desire to augment monetary stimulus with fiscal stimulus policies, such as tax reform, deregulation and infrastructure investments. While capital expenditure currently remains at multi-decade lows, these stimulative measures should provide upside to the economy.
- Improved demand for major raw materials, such as lumber, copper and steel is supported by improving global industrial production. China’s supply-side reform is starting to address global manufacturing overcapacity and as a result the global steel industry is enjoying better balanced supply and demand. Notably, the copper market appears to be tightening, consistent with the managers’ view that a deficit should emerge over 2017 or 2018. After several years of growth, supply in now expected to stall, at a time when the grid is about enter a secular period of growth in order to meet electric vehicle needs.
- Demand for natural gas in North America continues to track well above GDP growth rates, when adjusting for seasonal and weather effects. This trend should continue, supported by increased liquid natural gas exports and increased demand for cleaner-burning fuels in 2017 and 2018.
- China also enacted forceful fiscal stimulus which supported a re-acceleration of their economic growth. 2016 confirmed the portfolio managers’ view that China finally exited a multiyear slowdown, thus avoiding a “hard landing” scenario that the market had been concerned about. We would expect China’s policies to continue pushing for further rebalancing of their economy towards consumption.
- In aggregate, Emerging Markets (EM) have also ceased their downward trajectory and are now showing signs of stabilizing. Interest rate differentials to the U.S. and higher oil prices, should lead to a stabilization of EM currencies, which should allow for renewed capital flows into EM. After seeing the U.S., then Europe join the global economic bandwagon, we would now expect the baton to be passed on to EM economies in 2017.
- The portfolio managers continue to actively monitor inflation, the precursor to the economic cycles’ completion, and resources outperformance. While central bankers seem to be willing to let wages run hot in order to repair the damages done to the labour market, we suspect that populist policies such as trade tariffs, restrictions on the movement of labour, and infrastructure development programs, increase the risk of an inflation overshoot. The likelihood of increased volatility in currency, bond and equity markets may see return of investor interest towards gold as ‘risk insurance’. The portfolio managers therefore continue to recommend a 5 to 10% allocation to gold or gold equities throughout the cycle in an effort to reduce portfolio volatility and enhance returns.
- In summary, the portfolio managers believe that the acceleration of economic growth is consistent with the maturing stage of the economic cycle. Demand is steadily increasing, while supply growth is moderate to low for most commodities, all the while commodity prices are at, or below mid-cycle levels. This backdrop has historically been a good precursor for natural resources outperformance. The portfolio remains well-diversified across the energy and materials sectors. As always, the portfolio remains constructed of companies generating strong sustainable free cash flow – leaving residual cash flows to grow shareholder value through per-share production growth, or return of capital.