In a Flash, China Looks Strong

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

Chinas Flash PMI Reaced a month high for May

If you want to know where the world economy is headed, there is one number that I believe investors should focus on: the HSBC China Manufacturing Purchasing Managers’ Index (PMI).

On Thursday, the preliminary flash PMI for May came in at 49.7, beating Bloomberg’s consensus of 48.3.

When evaluating this number from one month to the next, it is common to focus on whether or not it has crossed above or below the 50 mark. A reading above 50 signifies expansion in manufacturing activity, while a reading below 50 signals contraction. This has certainly acted as a warning sign for how the economy will perform moving forward, but at U.S. Global Investors we look at this number a little differently.

Here’s how we see it:
When it comes to China’s PMI, it may surprise you that from November 2005 to December 2013, there have only been six instances when it crossed above 50. The infrequency of this “tell-tale move” is exactly why co-portfolio manager of our China Region Fund (USCOX), Xian Liang, and I monitor the one-month versus three-month trend, in addition to keeping track of its 50-mark movements.

Largest One Month Jump Chinas Manufacturing Activity since August 2013
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Let me explain: When the current flash PMI number (49.7 for May) moves above the three-month moving average (48.6), our research shows that such a move is positive. Historically, since 2005, after the one-month crosses above the three-month average, there is a 61 to 72 percent probability that commodities and stocks will rise in the following one-month and three-month periods.

Looking back to the post-crisis period, after 2008, the probability for such movement has been lower, but still remains above 60 percent for the S&P 500 Index as well as copper.

Purchasing Managers Index PMI Trends
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Life is about managing expectations, and as I wrote about last week, the PMI is an excellent tool to use.  These numbers allow us to anticipate the direction of manufacturing activity and help to shape our investment decisions while simultaneously managing our emotions.

A case in point for China’s numbers.

From November 2005 to December 2013, there were 18 occurrences when China’s PMI saw one-month cross above three-months. Below are a number of these instances.


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China Commodities and Commodity Stocks Historically Rose After PMI Cross-Over

Of course, investors should keep in mind that these are examples of possible ramifications – past performance does not guarantee future results.

China’s flash PMI for May represents not only the highest reading in five months, but also the largest single-month jump since August 2013. This bodes well for industrial production as we move forward, one more encouraging sign for investors to watch, and shows the potential for an exciting second half in 2014 for the energy market and commodity demand.

Government policy is a precursor to change.

Another headline for China this week is the country’s 30-year gas deal with Russia. Vladimir Putin, Russia’s president, signed a multi-billion dollar deal between Gazprom and China National Petroleum Corp. How is this significant for the global economy?

Vladimir Putin and Xi Jinping shake hands 30 year Gas Deal

To start, this deal connects two of the world’s superpowers and allows Russia to expand its gas market to Asia. It’s noteworthy for steel and pipelining as well. Steel demand should grow dramatically along with pipeline production, and this will call for more engineering jobs in China.

Looking forward.

These significant developments out of China, whether in the form of flash PMI or a gas deal with Russia that could boost steel demand, are bullish signs to keep this country on your radar. Look for the opportunity, know what is happening in the global market, and be curious to capitalize on what you find.

Speaking of which, I recently I had the pleasure to catch up with two of U.S. Global Investors’ greatest success stories, Pacific Rubiales and Silver Wheaton, both of which we were seed investors in. This month I attended the Pacific Rubiales Investor Open House 2014 in New York City, and after meeting with top managers, I remain strongly confident that the company will continue to make giant strides in the Latin American oil sector. Also this month, we had the honor of being visited by Randy Smallwood, CEO of Silver Wheaton, whose rise from a startup mining operation only a decade ago to today’s largest precious metals streaming company in the world is certainly a compelling one.

I’m excited to share the stories of these two hugely successful companies and how U.S. Global came to be seed investors in them. Look for the two-part series on these stories soon!

Index Summary

  • Major market indices finished higher this week.  The Dow Jones Industrial Average rose 0.70 percent. The S&P 500 Stock Index gained 1.21 percent, while the Nasdaq Composite surged 2.33 percent. The Russell 2000 small capitalization index galloped ahead by 2.11 percent this week.
  • The Hang Seng Composite rose 1.31 percent; Taiwan gained 1.35 percent while the KOSPI advanced 0.19 percent.
  • The 10-year Treasury bond yield rose by 1 basis point to finish the week at 2.53 percent.

Domestic Equity Market

The S&P 500 Index rallied by more than one percent this week. Cyclical areas of the market bounced back sharply with technology and consumer discretion leading the way, while telecommunications and utilities were down for the week. The driver was likely the better economic news out of China, as Markit’s flash manufacturing PMI rose more than expected and hit a five-month high, boosting investors’ confidence in global growth prospects.

S&P Economic Sectors
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Strengths

  • The technology sector was the best performer as Google rose by more than 6 percent and Facebook wasn’t far behind. Both stocks were strong performers all week as newsflow was positive. Investors appeared to feel comfortable taking more risk this week. The entire sector had a good week with roughly 90 percent of constituents rising for the week.
  • The consumer discretionary sector was also strong this week as internet retailers, broadcasting and homebuilders all posted strong performances, while some of the more traditional retailers were down for the week
  • Netflix Inc. was the best performer in the S&P 500, rising 15 percent this week. The company announced an international expansion into major European countries such as Germany and France that was well received by the market. TripAdvisor also rose by about 15 percent. At a conference this week, TripAdvisor expressed enthusiasm on the strength seen in the second quarter.

Weaknesses

  • The telecommunication services sector was the worst performer this week as AT&T fell nearly 4 percent as the company announced a definitive agreement to acquire DirecTV, which had been talked about for at least two weeks.
  • The utilities sector was a weak performer in a broad based selloff as the market embraced risk again.
  • Petsmart Inc. was the worst performer in the S&P 500, falling 14.88 percent. The company announced quarterly results, which were disappointing along with reducing second quarter and full year expectations.

Opportunities

  • As mentioned last week, expectations in the consumer discretionary sector may have gotten too pessimistic and after a period of underperformance over the past few months, could be potentially setting up a scenario where expectations are sufficiently low that stocks could rally as sentiment swings back to a more neutral position. Costco and Michael Kors report next week and will be key companies to watch.
  • The bounce in cyclicals this week has been very encouraging and we may be finally turning the corner after a period of underperformance that began in mid-March. This bodes well for quality growth stocks with reasonable valuations.
  • The S&P 500 closed at a new high and we have seen other encouraging signs that the modest correction may have run its course for the time being.

Threats

  • The Russell 2000 closed above its 200-day moving average on Friday which is an encouraging sign but we can’t say we are totally out of the woods just yet.
  • As earnings start to wind down, the focus will shift to macro factors and geopolitics. With a Ukrainian election over the weekend and rhetoric still high the conditions remain ripe for turmoil that may spill over into the financial markets.
  • Housing stocks rallied this week but housing data remains disappointing overall. Housing is a key part of the recovery story and key indicators to watch in the upcoming week include pending home sales and the S&P/Case-Shiller Home price data.

The Economy and Bond Market

Treasury bond yields were mixed this week, as the long end of the yield curve rose modestly while short-term yields fell by a few basis points. In the U.S., housing data was in line with expectations of moderate gains. The Conference Board’s index of leading indicators continues its steady ascent and bodes well for the economic recovery over the next six months.

US Leading Indicator Shows Steady Improvement Past Two Years
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Strengths

  • The Conference Board’s index of leading indicators has been very consistent in forecasting better growth; this is especially true over the past year or so. This
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