Another interesting development from China which is having a huge impact on global stock markets is how China is deploying the massive foreign reserves that are being generated from their continued trade surpluses.  Thus far most of that has been going into US Treasury bonds.  But, with the U.S. debt problems, the continued weakness in the U.S. dollar and the fact that China already holds over US$800 billion of this paper, they are starting to diversify their investments.  They have been investors in many of the European ‘rescue’ bonds that have been issued to backstop the sovereign debt of Greece, Spain, Italy and Portugal.  They have also been substantial buyers of basic commodities such as gold, oil, uranium and copper.  But now China is mounting a foreign takeover offensive, fueled by a stronger currency and worries about one of its prime holdings, US Treasury’s, as the debt debate drags on in Washington.  Mergers and acquisitions between Chinese companies and foreign entities have jumped 29 percent so far this year, to a record 217 deals worth $24.3 billion, according to Dealogic. Canada has been one of the preferred destinations for these deals, particularly in the oil sands projects.  This should support the already high level of corporate activity taking place in the resource sector as companies are finding it more attractive to grow through acquisitions rather than organically due to the low levels of stock prices in the resource sector.

The commodity stocks have been extremely volatile in 2011 and mostly to the downside as worries about global growth supersede what is actually happening in the markets. Copper has been a classic example of this as prices have moved higher while the copper stocks have been under pressure.  While demand continues to be robust, many investors lose sight of what is constantly happening on the supply side of most basic materials, which is that growth has been slowing down as production is missing estimates.  This supply tightness is one of the key reasons why the commodity prices have stayed firm.  The world’s two largest copper mines, Escondida and Grasberg, have seen production fall 8% and 16%, respectively so far this year. Most of this has come from technical mining issues, strikes and lower grades of ore but they all point to the same conclusions, that supply growth will be less than expected and at higher costs.  This has lead to a fall in copper inventories in London and Shanghai and has been a key reason why copper prices have moved back near record highs at US$4.40 per pound, despite slower economic growth, fears about China and the impact of the Japanese earthquake.  This same scenario is playing out in other resources as well.  The floods in Australia pushed metallurgical coal above US$300 per tonne while reduced uranium supplies have kept the price above US$50 per pound despite the Fukushima shutdown and its impact on nuclear energy output.

The stock market has had a much closer correlation with the moves in commodity prices over the past few years as the basic resource sector has become a much larger part of the global index and, more importantly, the outlook and performance of stocks has been driven by the outlook for the strength of the global economy.  The chart below shows how close the moves between the Industrial Metals index (blue) and the S&P500 stock index (black) has been since the market peak back in 2007.  Clearly the most important factor in driving stock prices higher has been the performance and/or outlook for global economic growth.  This is logical and rational and another one of the reasons we are bullish on stocks, since we also have a positive outlook for global economic growth and use it as our prime indicator in our asset allocation model.

Stocks and Commodities Moving 'In Sync'

In terms of our Stock Market Strategy we are back to the highest level of stock exposure we have had since the stock market lows seen last summer at around this same time. The announcement of the second phase of Quantitative Easing (QE2) at that time was one of the key reasons why stocks then rallied for the balance of the year.   While we don’t expect a ‘QE3’ is going to occur, we do believe that economic growth will accelerate in the second half of 2011 as inventories are re-built following the Japanese earthquake, auto demand continues to gain, Chinese growth will not slow further and global corporations will continue to spend their record levels of cash accumulated over the past three years.  In terms of sectors, we continue to favour the natural resource sectors including Energy, Basic Materials and Gold.  We also like large cap US stocks, particularly in the Industrials and Technology sectors.  Financials in the U.S. are also looking tempting for a trade given that earnings are starting to recover, loan losses are falling and valuations are at ‘rock bottom’ levels.  We remain underweight in bonds.  Although we don’t expect interest rates to rise dramatically anytime soon, we don’t expect rates to fall from current levels and expect that mid and short-term rates will start to move slightly higher over the next year.

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