OTHER ASSET CLASSES

Gold plays best defence against share slump in four years

Investors have bolted back to gold (+15% in euro since the beginning of the year) after three years of losses as a souringglobal economy, including in China, pummels stock prices. The turbulence has eroded expectations that the FederalReserve will raise interest rates this year, hurting the dollar and adding to bullion’s allure. Central bankers fromTokyo to Stockholm have embraced the notion of negative rates and even Fed Chair Janet Yellen said the U.S. central bank istaking another look at the tool, if the economy falters. While, in theory, the approach could bolster growth by charging lendersfees for parking money at central banks, investors have worried it may rattle money markets.

Gold, even at a yield of 0%, may prove to be a higher yield relative to other assets during a time wheninterest rates are eroding capital globally. Investors turn to gold when faith in their currencies and financial systemsis shaken. Countries seeking to weaken their currencies turn their population into gold buyers, as has been the case inChina, Russia and other Emerging Markets. Gold is used as a currency, one that cannot be directly changed by centralbank whims.Gold trades at $1,240 an ounce and beats all other raw materials in the Bloomberg Commodity index.While bullion may be overbought in the near term, we turned overweight on gold because the precious metal is set tobenefit from sinking expectations for higher U.S. interest rates and the potential for further market turmoil.Volatility in financial markets due to the Chinese/global slowdown and low oil prices and doubts regarding theeffectiveness of monetary easing could continue. This could keep risk appetite in check and U.S. dollar rates low,supporting gold.Investors have poured funds into bullion-backed exchange-traded products this year as prices climbed. The assetshave surged by 300 metric tons so far in 2016, eclipsing the drop of 138.4 tons in all of last year.

While precious metals are back to their highest level since May 2015, a gauge of returns on main raw materials is still near itslowest since at least 1991, extending the agony that producers of energy, industrial metals and agriculturalcommodities faced in 2015. The Commodities index of S&P and Goldman Sachs fell as much as 12% (in euro) in 2016, itsworst start to a year ever. The rout is hurting producers including Freeport-McMoRan, Glencore and Anglo American, whoinvested in boosting output following a decade-long super cycle.

The expansion of the global economy has faltered, supplies of everything from oil to copper to grains are ample and astronger dollar has eroded the appeal of raw materials as alternative investments. Recent market turmoil in Chinafurther added to concerns that consumption in the biggest commodities buyer will slow.

FEBRUARY 2016

The analysis of Thierry MassetRout has probably room to runFear and loathing of negative yieldingdebt: bond investor’s dilemmaGold plays best defence against shareslump in four yearsCash is king in developing nationsFinland is the new sick man of EuropeInvestment spending in the Euro-Areahas failed to recover

The prolonged price slump is a reversal from the previous decade, when booming growth across Asia fuelled asynchronized surge in prices, dubbed the commodity super cycle. Farmers, miners and oil drillers expanded supplies,encouraged by prices that were at record highs in 2008. Now, that output is coming to the market just as global growth isslowing. The World Bank lowered its growth forecast for the global economy, warning that the slowdown in China will meanmore weakness for raw materials.

There is no short-term reason why this trend of falling commodity prices will end. While the Bloomberg commoditiesindex tumbled 25% last year in a fifth straight annual loss (that was the longest streak since the measure’s inception in 1991),hedge funds are positioning for more losses, holding the biggest net-short bet across raw materials since at least 2006.A combined measure of net-short positions across 18 commodities reached 85,000 future and options contracts as ofFebruary 12, the latest government data show. That’s one of the most bearish since the data begins in June 2006. The gaugeturned negative for the first time ever in November.

A long winter in commodities can be what we have to be prepared for. From places like Russia to Australia thecurrencies have fallen a lot and so the marginal cost of production for some of these commodities in those countries hasn’tfallen that much and that have shielded some of their companies from lower oil prices, deterring them from cutting output.

A 200-year history of commodity prices shows they typically move between a decade of bull market and twodecades of a bear market. It takes many years to clear the additional capacity that a bull market generates. This timearound, the slowdown in economic growth in China, the world’s biggest buyer of raw materials, will continue to erodecommodity prices that surged in the mid-2000s. As no other Emerging Market nation has the demand to fill the gap left by thatslowdown, China continues to be the central player as far as demand is concerned. Even if the Chinese economy stabilizes,the industrial part of the economy is likely to be much weaker.

Here’s one more way to measure just how bad the commodity meltdown has gotten: compare the asset class tostocks. The commodities Index of 24 raw materials is now trading near its cheapest since 2000 compared with the S&P 500index of U.S. shares. But if you trust history for providing guidance, that’s still not low enough. During the last big shift fromcommodity bull markets to bear markets, the ratio dropped even lower. After peaking in October 1980 amid supply shortages,producers responded to higher prices by boosting output. As gluts emerged, the ratio tumbled 96% to a record low of 0.1 inFebruary 1999.

From shortages to gluts - sound familiar? Now, with a similar supply shift, the ratio between the commodity and equityindices reached a low near 0.15, down about 90% from its 2008 peak.Assuming the S&P 500 index continues to trade at its actual level, the commodity measure would have to fall a further 33% inorder for the ratio to reach the 1999 low of 0.1.

3.1 Gold: neutral => overweight

Gold’s safe-haven rationale is back in vogue, for the time being as renewed losses in equities spurred demand for lessrisky assets. The tumultuous start to the year has led investors to seekbullion, boosting prices around 15% (in USD and in euro) to $1,240 an ounce.

Investors are so keen to get their hands on more gold as prices rally that they have boosted holdings in exchange-tradedproducts in the opening weeks of 2016 (holdings in gold-backed exchange-traded products surged 300 metric tons to1,666 tons, the highest level since November 2015) by more than they shrank in all of last year (139 tons).

They flee a bear market in global stocks, a weakening dollar and the fallout from the spread of negative interest rates. Themetal’s inverse relationship to global stocks the strongest in more than four years. Its correlation to the MSCI AllWorld Country index over 30 days registered -0.487, the largest negative reading since 2011. A measure of -1 indicates thetwo values move in opposition to each other all the time.

Investors have bolted back to gold after three years of losses as a souring global economy, including in China, pummelsstock prices. The turbulence has eroded expectations that the Federal Reserve will raise interest rates this year,hurting the dollar and adding to bullion’s allure. Central bankers from Tokyo to Stockholm have embraced the notion ofnegative rates and even Fed Chair Janet Yellen said the U.S. central bank is taking another look at the tool, if the economyfalters.

3.2 Crude oil (Brent): neutral

Brent oil held losses near $35 (a 12-year low) as investors waited for signs of whether Iraq and Iran will back a plan bySaudi Arabia and Russia to freeze production at near-record levels (the kingdom produced 10.2 million barrels in Januaryand Russia pumped 10.9 million, a post-Soviet Record) amid a global glut. For memory, oil has dropped about 25% since theOrganization of Petroleum Exporting Countries (OPEC) effectively abandoned output targets at a meeting in early December.

The preliminary deal to fix output at January levels is the “beginning of a process” that may require “other steps tostabilize and improve the market,” Saudi Oil Minister Ali Al-Naimi said.As Iraq and Iran are the two countries that are going to contribute to growth from the OPEC nations this year,getting an agreement from these is going to be very difficult, particularly in the case of Iran. Iran, the second-biggest member of OPEC before sanctions were intensified in 2012, is seeking to boost production by 1 million barrelsa day and regain market share after penalties were lifted. Iran pumped 2.86 million barrels a day in January, making itthe fifth-biggest producer in OPEC, and will be able to increase oil production by 400,000 in six months, according tothe median estimate of 12 analysts and economists surveyed by Bloomberg.

The problem with using a production freeze as the bedrock for deeper cooperation is that none of the parties involved have tomake any effort to comply. The four producers involved are already producing close to their peak. The freeze is the oil-market equivalent of calling for a cease-fire when they’re running out of ammo.

In this context, it would be therefore difficult to rebalance a massively oversupplied oil market.

While the slump in oil prices is affecting producers across the globe, this situation will keep oil low and volatile in theshort term. The CBOE Crude Oil Volatility Index, which measures expectations of price swings, is at the highest level since2009.

A rapid appreciation of the U.S. dollar may send Brent oil to as low as $20 a barrel. Oil is particularly leveraged to thedollar and may fall between 10 to 25% if the U.S. currency gains. A 3.2% increase in the U.S. dollar — as implied by apossible 15% yuan devaluation — may drive crude in the high $20s, according to Morgan Stanley. If other currencies move aswell, the shift by both the dollar and oil could be even greater.

Oil, particularly from higher-cost suppliers, faces a tough road in 2016 and beyond. OPEC's move to capture market shareand the U.S. shale boom will drive continued strong supply. Meanwhile, the specter of potential emissions limitslooms over demand as China, the major driver of marginal demand growth, continues its shift to a service-basedeconomy. The ratio of China's growth in oil consumption to GDP expansion dropped to only 0.5 times last year, comparedwith an average of 0.67 times in the past 30 years.

While OPEC's practice of raising and lowering output quotas has proven effective against temporary supply anddemand shocks to the oil market, the cartel has no recipe against permanent shocks, which shale oil is likely tobecome. That means OPEC members' only option is to maximize market share by nudging higher-costproducers out of the market.OPEC production will remain elevated in 2016 as Iran reintroduces supply and Saudi Arabia continues to sellcrude oil below break-even in an effort to recapture Asia market share. The Sunni-majority country also may beattempting to pressure alternative fuel and higher-cost OPEC producers, as well as resurgent Shia majorities in Iraqand Iran. Battling unconventional shale producers in the U.S. is not its central focus.Nonetheless, shale will take a hit, and U.S. output is likely to decline modestly. Subdued prices will lead to M&A asfinancially distressed operators seek options. The highly standardized and repetitive character of drilling shale-oil wellsmeans shale can adjust quickly to a changing environment. Producers can fine-tune operations and generateconsiderable efficiency gains. This should give shale an advantage versus conventional production with long leadtimes.

Should emissions regulation create persistent oil oversupply, shale may be better able to adapt to low oil pricesand raise its share of global oil supply at the expense of higher-cost sources. Limiting emissions on environmentalgrounds would cap oil prices, locking in some oil discoveries and driving a shift to lower-emission gas. Carbon capture andstorage technology would only offset the trend if widely applied, which is unlikely given the high cost.

The combination of these trends means global producers engaged in large, mostly offshore conventional oilprojects with little exposure to shale may suffer. These include Russia's state-controlled Rosneft, PetroChina, ExxonMobil, Petrobras, Lukoil, BP, Chevron and Shell. The North Sea is one of the most expensive areas to produce oil and gasworldwide, and may suffer more than most. Enquest, Lundin, Faroe, Premier, Taqa, Cairn, Ithaca and Det Norske are amongthe E&P companies operating in the North Sea. Large-cap North American oil producers include ConocoPhillips, Occidental,Hess, Noble, Marathon and Murphy. They are active in shale plays in North America and conventional projects globally. Bigshale specialists include EOG, Chesapeake, Anadarko, Pioneer and Devon.

Barring a major geopolitically driven shock (there are huge tensions in the Middle East and European countries raiseterror threat level and increase counter-terrorism operations), this set of dynamics will mean that oil prices will stay lowand volatile in the short term.

Over time, this price configuration will drive out the higher-cost energy producers and encourage higher demand, whichwould restore OPEC's influence. Hopes are that the current oil supply glut gradually dissipates thanks to demandemboldened by lower oil prices. The debate is now focused on how quickly the oil market will rebalance, which dependson both the impact of lower upstream investment and the trajectory for demand.

Speculators’ short positions on crude are near the most since at least 2006 while longs are at an eight-month high, withtotal wagers close to unprecedented levels, data from the U.S. Commodity Futures Trading Commission show. Thissuggests that most of the negative impacts from declining oil prices are likely behind us at this point.

3.3 Industrial metals: underweight

Zinc jumped to the highest level since October 2015 to move into bull-market territory as production cuts tighten globalsupplies. Most other metals and mining shares also climbed. The metal used to galvanize steel raised almost 10% since thebeginning of the year (the best performance on the London Metal Exchange) and closed at $1,770 a metric ton, an increase ofmore than 20% from the low at the end of trading on January 12.

Zinc suppliers including Glencore Plc, Nyrstar and the biggest smelters in China have announced production cuts to cope

with prices near the lowest level in more than six years. The market will have a deficit of 440,000 tons in 2016, the most inmore than a decade, according to Mitsui Mining & Smelting, Japan’s biggest maker.

Tin is next with an increase of 8.4% and the LME gauge of six industrial metals has climbed about 8% since dropping tothe lowest level in almost seven years last month.

In this context, whether a turnaround is imminent or more gloom lies ahead will dominate conversation. According to us, themining industry is probably still in the midst of an extended period of above trend production growth, while demandfor industrial metals in China, the world’s biggest user of many resources, faces the weakest growth in a quarter of a century.

Producer prices fell 5.3% in January (on a yearly base), extending their streak of negative readings to 46 months. Thecontinuing slump in producer prices shows how weak manufacturing is. China’s manufacturing conditions slipped inJanuary to the weakest level in more than three years as sluggishness in the nation’s old growth drivers add to risksfacing the government’s growth target. The official purchasing managers index fell to 49.4 (numbers below 50 indicatedeterioration), the lowest level since August 2012.In other words, Chinese demand for raw materials won’t be enough to eliminate a supply glut.

With inventories ample and slowing economies eroding demand, cheaper oil lowers the price floor for miningcompanies to remain profitable. Oil’s 70% decline since last year’s peak is reducing energy costs for mining companiesand bolstering speculation they will boost output further.

Industrial metals are extracted with diesel-engine diggers and trucks, while smelters that process metal run onelectricity from coal-fired power plants. Energy accounts for as much as a third of the industry’s costs at a timewhen everything from aluminum to zinc is mired in a prolonged slump and more mines are losing money. It’s about16% of what the industry spends on average to produce every metric ton of copper, and about 35% for aluminum,according to Macquarie.With oil tumbling about 70% in the past two years to less than $30 a barrel, cheaper fuel is allowing metalscompanies to delay production cuts needed to halt their own slide in prices. The drop in oil and the dollar’s rallyagainst Emerging Market currencies will cut copper-mining costs by about 11% in 2016, London- based researcherCRU Group estimates. That means that more energy declines won’t fix the long-term problem for the metals industry.While lower costs can help, they won’t help ease the surpluses. The leg lower that we’ve seen in oil prices couldhave created another wave of deflationary effect.

As the U.S. has started to lift rates, the greenback could reinforce its positive momentum, which is also, de facto,negative for industrial metals prices.

3.4 USD (positive) & Euro (negative)

With a U.K. referendum on whether to quit the European Union now set for June 23, expectations of the pound's depreciationagainst the euro are at their highest since immediately before Scotland's failed secession vote. But Britain’s referendum onits membership in the European Union isn’t just a threat to the pound. It’s raising currency-market risks across thecontinent.

While the pound led declines among major currencies with its biggest slide since 2010 (-5% against a basketof 10 major currencies since the end of January), the euro had the second-largest decline (-1%), weighed

down by signs of slowing growth. The cost of options protecting against losses on Europe’s 19-nation currency alsojumped. The U.K.’s potential exit may damage trade and encourage other members to renegotiate their relationshipwith the EU, signalling scope for further losses in the euro in the run-up to Britain’s June referendum.

Though European Central Bank (ECB) President Mario Draghi may welcome a weaker euro to help revive theregion’s economy, depreciation stemming from systemic risk would be more troubling. With the euro region stillstruggling to recover from its sovereign-debt crisis, the bloc can ill afford additional growth-threatening turmoil. Draghihas already pledged more than a trillion euros in asset purchases and cut policy interest rates below zero in an attemptto boost inflation, and the prospect of more stimulus is further weakening the euro.Seven of the U.K.’s nine biggest trading partners are in the EU, according to data compiled by Bloomberg,meaning an exit may be a blow to both sides if business conditions worsen. Smaller European countries includingIreland, Luxembourg and Malta would fare the worst if the U.K. loses some its access to the single market, economistsat Germany’s Bertelsmann Foundation said. Even the continent’s heavyweights such as France, Germany and Italydon’t come away unharmed.The euro will thus weaken and remain weak.

The highest currency-market volatility in more than four years is depriving investors of a cheap way to protect against risks infinancial markets -- including Britain’s referendum on its membership of the European Union. A JPMorgan Chase & Co. indexof swings in exchange rates averages more last month (11,5%) than at any time since 2011. Because volatility helpsdetermine the price of currency options, they are losing appeal as a way to speculate in foreign exchange markets, leadingmoney managers to seek less-expensive alternatives. Global markets have been subject to above-average swings since thestart of the year on concern that a slowdown in China’s economic growth will bite into the health of the global economy. TheOrganization for Economic Cooperation and Development warned of “substantial” financial stability risks and exchange-ratevolatility as advanced economies struggle to compensate for reduced demand from emerging markets. It’s a scenario that’salready playing out in foreign- exchange trading, and one that makes protecting against future shocks costlier for moneymanagers.

Of all the major currencies tracked by Bloomberg, Britain’s pound has the highest implied volatility relative to itsrange during the past three months.

The yen has witnessed the biggest increase in six-month implied volatility since the start of the year after theBank of Japan announced a negative interest rate strategy on January 29. Japan’s currency has rallied 5.6% this yearagainst the euro this year as a flight to haven assets burnished its allure.While Asia imports the bulk of the oil it uses, cheaper crude does little to boost the region’s currencies. Oilprices partly reflect the outlook for global growth, which also impacts prospects for Asia’s exports and demand foremerging-market assets. The Bloomberg-JPMorgan Asia Dollar index, which tracks the region’s 10 most-usedcurrencies excluding the yen, fell 5.7% in the past year as crude slumped 70%.Investors looking to make the most of negative interest rates in Europe and Japan could earn the bestreturns if they park cash in Peru, India and Turkey. The countries offer the highest expected carry trade, whichinvolves borrowing where interest rates are low and investing in assets that promise better yields, according to datacompiled by Bloomberg. The sol, rupee and lira topped the list of 31 major currencies worldwide after adjusting forexchange-rate volatility, which threatens to wipe out any gains from the trade.