The main development of the quarter has been the substantial weakening of the rand, which depreciated by 7.6% against the dollar -most of which happened in the last month of the quarter. Although this does provide an added boost to revenues for domestically domiciled Resource counters, we have previously seen that most of these gains achieved through rand depreciation are lost through future inflation and wage increases. Historically, there is little evidence or re-rating of commodity shares from rand weakness. This explains why, despite the fairly robust rand/gold price, the Gold Index has fallen by 14% in the quarter.
Also in the quarter, there seems to be growing evidence that the peak in commodity cycles for most metals has passed. Although tightness in supply will remain and Chinese demand will not evaporate, it is probably correct to have a view that commodity prices will fall and soften for the next three years. Like most previous commodity downturns, the difficulty is determining the speed and magnitude of the decline. The current view is for the decline in commodity prices to be orderly and the magnitude of the decline to be shallow.

This quarter - while delivering decent returns of 19.1% for the Resource stocks - will be noted for two trend changes. One is the end of the speculation in commodities, and the other is the end of rand strength. The end of the speculation in commodities will mean that stock prices will no longer be driven by movements in commodity prices, but will eventually gravitate back to earnings and valuation. We have been positioning the portfolio for a long time to avoid stocks that were exposed to commodity speculation and high valuation. The sector that fits best into this is the Diversified Mining sector, where the sector is priced on moderate commodity price assumptions and bottom of the range valuation multiples. With regards to the rand, some stocks, because of their lower margin, are more geared to the rand.

Thus, Anglos benefits more than BHP in a rand-weakening environment. Similarly, Amplats benefits more than Impala in a weak rand environment. With our portfolio traditionally being structured to take account of a stronger rand, this is a new development that we need to incorporate. One stock, which will benefit from both these trend changes is Kumba - where there is no speculation in the iron ore price and it is a big beneficiary of rand weakness.

Fund managers Graham Mason and Gary Quinn of Prudential argue that the prices of commodities (with palladium, rhodium and cobalt being the best examples) are being set by speculators rather than intrinsic demand. The fund has sought safety in the diversified miners Billiton and Anglo as well as non mining shares Group Five and Astral. The managers are happy holding platinum and oil where there is substantial real demand.

Financial Mail - 14July2006

This quarter has brought a continual upward revision to analysts 'earning forecasts for commodity stocks, as the consensus view in quarter four 2005 for global weakening proved to be wrong. Most commodities are trading at multi-year highs and some of the traditional relationships between commodity prices and macro data have broken down. The most noted one is the dollar-euro gold relationship where the gold price used to mimic movement in the dollar-euro.

This quarter has brought the first signs of tightening in global liquidity as evidenced in the Japanese and US long bonds. Short-term interest rates continue to be nudged upwards and this, together with rising volatility in both equity and bond markets, all suggest that risk appetites could start falling. Other signs of increasing risks are the New Zealand dollar falling to18-month lows and, given the recent correlation between ZAR and NZD, further strengthening of the rand is probably at an end. Given the above, it is no coincidence that commodity metals are struggling. Coupled with large speculative interest in the unwinding of long positions, the riskiness of being invested in commodities is quite high in the short-term.

Although there have been some upgrades to next year's earnings on some commodity companies, most notably Platinum and Gold companies, the real issue facing investors is where long-term prices will settle.
In the case of copper, current spot prices are some 50% above people's long-term estimation of $2,800 per ton. The low forward price/earnings of the diversified mining companies suggest that investors still believe in commodity prices falling quite substantially, plus companies like Billiton have very little downside as most of this falling commodity prices is priced in. Sasol too has priced in oil prices lower than the current $55 per barrel.
None of the major mining companies are using current metal prices to make their investment decisions on future projects and this is a strategy that we will also follow.

Graham Mason & Gary Quinn
Prudential Portfolio Managers