Investment Manager Commentary
Prudential Investment Management

Conviction on a mining sector recovery waivered with signs of shifting stimulus in China, indications from the US Federal Reserve of a cautiously more hawkish stance on interest rates, and reversal of the emergent weaker US dollar trend. While shifts in market sentiment make a poor investment case, what does appear to have played out year-to-date is that commodity markets are no longer getting worse, from the perspective of rate of decline in demand expectations and rate of growth of supply. However the recovery in certain commodity prices does pose the risk of undermining the necessary supply discipline that was starting to occur on the prior price rout.

Looking at the behaviour of four major commodities during May indicates market forces pulling in different directions, but also an emergent differentiating factor. Firstly gold; the bell weather for risk aversion, fell $80/oz suggesting improving risk appetite (although likely simply reflecting US specific news emanating from the more hawkish than expected Fed). Conversely, iron ore, the bell weather for Chinese old-economy growth, fell $15/t, indicting deteriorating appetite there, arising from waning stimulus and unwinding of speculative froth. Oil and copper are respected indicators for global economic health. Oil has held its recent highs despite the US dollar strength, while ‘Doctor’ copper has maintained levels near multi-year lows; a key differentiator on the fundamentals on these two commodities is supply, with oil experiencing supply falls from US shale as well as elevated levels of supply disruption, while copper is seeing some new-mine supply but also relatively unusual stability in existing production.

For a trend improvement in the resources sector we would prefer a demand driven tightening in market balances, but perhaps for now we need to be satisfied with relative outperformance from supply constrained commodities, and hope to not undo the good work of dis-incentive pricing in forcing supply restraint where needed. In the meantime balance sheet repair may not be the focus of the market, but remains core to the companies, and resultant restructuring (together with supply constraint) may change the corporate landscape for when the recovery eventuates and further differentiate the next generation winners and losers.

During May we added small new positions in Gold Fields, Harmony Gold Mining, ArcelorMittal and African Oxygen, and closed the Sibanye Gold position. We also added to Northam, South32 and Sasol and trimmed Anglo American Platinum, Glencore and AngloGold Ashanti.

The Nedgroup Investments Mining and Resource Fund lost 3.4% over the month of May 2016 (gross of fees). The biggest detractors from the fund’s performance were the positions in Anglo American plc, Impala Platinum Holdings and Exxaro Resources as these stocks suffered some of the biggest losses over the months. The exposure to Mondi, Sappi and Sasol contributed positively.

Many examples across the spectrum of geopolitical, macroeconomic and financial risks that are supportive of the safe haven case for gold (and SA gold equities) played out during January (and December 2015). These include North Korean hydrogen bomb claims, Iran/Saudi diplomatic tension, Chinese currency and stock market policy uncertainties. While these events had relatively limited effect on the US$ gold price in absolute terms they supported gold relative to other commodities (specifically oil), and even more so, had an exaggerated impact on the rand. Thus the gold miners with South African assets were clear outperformers in the period. While the risk to the stocks is clearly a retracement in the rand denominated gold price, we view the current price as providing a material tailwind to earnings momentum and revisions and we have added positions to DRDGold Ltd, Pan African Resources plc, Sibanye Gold Ltd and Harmony Gold Mining Co. Thus, while current gold price supports further upside to gold equities, current industrial and platinum group metal prices continue to provide downside risk to their associated equities.

A striking factor of these risk factors is the opposite effect on oil - often a beneficiary of geopolitical tension especially when it emanates from the Middle East. Weakness in oil over the past 18 months has reflected the supply surge, particularly arising from the US shale oil revolution, and the generally massive splurge in capex across commodities. However more recent weakness appears to reflect demand slowdown, in particular relating to emerging markets and China, which has been the dominant driver of demand growth over the past decade. The commodity and emerging markets cycle tend to be highly correlated, and this observed and implied weakness provides ongoing reason for caution in operationally and financially geared resource counters. Besides adding to the gold equities, the Fund also added to Exxaro Resources Ltd and Sasol and trimmed the diversified miners (Anglo American plc, Glencore plc, BHP Billiton plc and South32 Ltd), as well as Mondi.

The Nedgroup Investments Mining & Resource Fund lost 1.1% over the month of January 2016 (gross of fees). The biggest detractors from performance were the fund's large exposure to general mining stocks BHP Billiton plc, as well as Mondi Ltd and Mondi plc that lost in excess of 15% over the month. The gold and platinum stocks enjoyed strong gains over the month.