Written by Michael Waring
Saturday, 30 September 2006

There has been a steady stream of bad news for equity markets during the last three months including plummeting automotive sales, a downward spiralling U.S. housing market, and a U.S. led global slowdown if not an outright recession.
Bears outweigh the bulls in investor sentiment surveys and many market strategists have turned defensive. Yet despite all this negative news, the Dow Jones Industrial Average has managed to reach an (albeit narrow) all time high. The classic ?Wall of Worry? perhaps?

In recent years, investors seem to swing from overt pessimism to extreme optimism overnight. In our view, it has reached manic proportions, perhaps made worse by the rise of hedge funds that are interested only in market volatility. Short term, investor sentiment has turned decidedly bearish and more defensive.

However, we see a number of factors now falling into place that suggest a more positive view in a few months time.

1. Lower energy and commodity prices off of peak levels are contributing to a reduction in inflationary pressures.
2. A slowing in the growth rate of U.S. Gross Domestic Product (GDP) when combined with the point above suggests an end to interest rate hikes by the US Federal Reserve Bank for this cycle.
3. A significantly lower price for gasoline (from peak prices) at the pump should provide both a psychological and financial lift for consumers.
4. The decline in U.S. housing markets thus far has been no worse than previous corrections. The decline in housing has been discussed ad nauseam for well over a year, which suggests to us that much of the downturn has been discounted by the market.
5. China?s economy remains strong. After a recent ten day visit to Beijing and Hong Kong for an investors? conference, we came away more upbeat on the outlook for economic growth than we have been for the past year and half. Inflation remains benign and run-away investment in certain industries (ex. aluminium, commercial real estate) appears to be slowing due to the efforts of the authorities in Beijing. We expect China?s GDP growth to slow to 8.5% in 2007 down from the current level of 9.5-10%. A slowing yes, but only marginally so. As we have suggested in previous letters, China?s economy is becoming more of a domestic consumption story (driven by a rising standard of living and government policy) thereby reducing the importance of exports to the U.S. As an aside, we also came to the conclusion that China is rapidly reaching the tipping point with respect to environmental pollution. The authorities in Beijing seem to finally realize the toll that air and water pollution is taking on the economy. (The air quality in Hong Kong is impeding the economy.) We anticipate a large number of initiatives to reduce pollution levels will be announced over the next few years and we are on the lookout for investment opportunities.
6. A return to positive growth in Japan after fifteen years of deflation and negative growth rates. While the Japanese economy is currently experiencing a softening in GDP growth from levels early this year, the numbers remain positive and are a welcome addition to global growth after a very protracted absence.

For all these reasons, we expect that investor sentiment will turn positive in the next few months from the current bearish outlook. To date, we believe that we are experiencing nothing more than a mid-cycle slowdown in the global economy.

In our view, commodity prices may have peaked in the short term and are poised to retreat from their lofty levels. However, we remain of the view that, we are in an extended up-cycle that will see prices remain higher than in the recent past based on the following;

1. Political risk around the globe is increasing. Many governments are seizing assets or re-writing contracts (ex. Venezuela, Russia, Bolivia, Mongolia), due to the recent strength in commodity prices. Investors have long known that higher risk requires higher return if projects are to proceed.
2. An acute shortage of skilled labour at all levels, but especially experienced engineers and geologists, most of whom are close to retirement.
3. Shortages from engineering to fabrication and even rubber tires for mining trucks are leading to project delays.
4. Strict environmental regulations that were absent ten to fifteen years ago ensure a lengthy permitting process today. As a proxy, the nickel discovery at Voisey?s Bay required twelve years before initial production! We suspect that environmental delays will only become more pronounced in the future.
5. Cost escalation and timing overruns are seriously impeding project economics. Simply look to the cost pressures in the Canadian oil sands or Russian mega energy projects (ex. Sakhalin 1 & 2 where costs have escalated by 60%).

As we have said many times before, all the easy, low cost resources have been accessed. Going forward, projects will require a greater engineering component, higher capital costs, and longer lead times resulting in higher investment risk.

If any new commodity supplies are to be brought to market, prices will have to stay higher, for longer, to justify the risk. Otherwise, new supplies will simply not be forthcoming. A glance at current inventories for copper, nickel and zinc show extraordinary tightness (See Charts One thru Three). Inventories are back to levels last seen in the late 1980?s when global GDP was much smaller than today.

Chart One: Copper

Chart Two: Nickel

Chatt Three: Zinc

Using nickel as an example, there is little new supply coming on-stream in the next few years. Chart Four indicates an average of 80 KMT of incremental nickel production annually for the next three years. This compares to annual global nickel demand of approximately 1,436 KMT growing at 4% annually. Thus, if every project were to proceed, the amount of new production does nothing to alter the shortage of metal in inventory. A similar situation holds true for copper, zinc and uranium.

With respect to zinc, Brook Hunt, an internationally respected metals forecasting firm, offers one of the more bullish outlooks for inventory levels. They assume that Chinese demand growth for zinc will slow to 10% year over year in 2007 versus 14% demand growth in 2006. If this occurs, they project a 9,000 tonne inventory surplus in the metal by the second half of 2007. But note this number is insignificant when compared to annual consumption of 11.5 million tonnes.

Chart Four: World Nickel Mines ? maximum incremental metal production annually

Barring a significant slowdown in global GDP growth, we do not see how inventories of base metals will be re-built anytime soon in a meaningful way unless prices remain higher than markets are currently discounting. Yes, copper prices can decline from their current lofty levels but a return to sub $1.50 per pound and markets are in trouble from a supply standpoint. No doubt copper exploration and new production would be seriously impeded.

We expect commodity producers to enjoy high levels of free cash flow for years to come. The challenge for energy and global mining companies is to identify new supply opportunities to replace depleting production. In a world of heightening global tensions, with heightening global risks, the list of opportunities is rapidly shrinking. This is the challenge going forward and acquisitions in geo-politically friendly countries are highly likely.

We remain upbeat with respect to global GDP growth unless there is a negative surprise awaiting us. As we said earlier, at this point, the slowdown appears to be nothing more than a mid-cycle correction.

All is unfolding as it should. Investors need to be patient.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

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