Global equity markets recorded one of their worst months of performance since the 1970s. Alternative energy and natural resources were not immune. The MSCI Global Materials and Energy Index fell 12.1% while the S&P Global Clean Energy Index fell 18.4% while Tiburon Terra posted negative performance for May, down some 9.4%.

Although the portfolio had a low net long exposure in alternative energy coming into the month the weak economic outlook in the EU and concerns over sovereign debt in Greece, Spain, Portugal and Italy contributed to that sub-sector falling heavily. Elsewhere the portfolio’s holdings in Australian resource companies were hurt by the Australian Government’s decision to implement a Resource Super Tax on mining companies. The mining sector also suffered as a result of the Chinese government moving to slow the luxury residential property market in tier one cities. With transaction volumes taking a nose dive, we believe that Beijing has now achieved its objective of slowing the market in this sector and will probably relax its policies in the coming months. The portfolio had in place short exposure to international steel companies in Europe, US and Asia, which did provide some downside protection. Our exposure to gold was also a positive contributor.

Many of the macro economic factors that impacted markets in April remained in place throughout May and continued to depress the alternative energy and natural resource markets during the month. In China, government economic policies to deflate the property bubble in the main cities were beginning to show up in economic statistics with imports of base metals slowing and steel prices weakening. In Australia, the Labor government announced its proposal to introduce a super profits tax on the mining industry. The handling of this by the government without consultation with the industry, at best can be described as clumsy. The industry has responded with threats of postponement of new mine development. The impact on mining stocks was savage.

And then of course geo-political risk and sovereign credit risk in Europe increased dramatically during the month. The debt crisis in Greece reached a climax where riots in Greece resulted in several deaths as the government sought to introduce fiscal tightening. While the markets have probably digested the economic risks to Greece and the probability of default in the future, they then turned their attention to Spain and Portugal which saw short term interest rate spreads over German Bunds increase sharply, raising concerns that these countries may also require assistance from the ECB and IMF. The governments of Spain and Portugal reacted by announcing fiscal tightening in response to the market’s demands that decisive action be taken to reduce the level of national debt. These were passed by the slimmest of margins, suggesting that the governments of these countries continue to live in denial of the realities that confront their economies.

The uncertainties that have enveloped the European debt markets have caused investors to look with a jaundiced eye to UK, Japan and US. All these countries run high levels of debt. Without putting too-fine-a-point on it, the question investors are raising is how will the astronomical levels of debt be refinanced going forward without interest rates having to rise and governments continuing to print money?

The up-shot of this has been that the Euro has weakened substantially against the USD, in turn, the gold price has rallied to close at a short term high of U$1238/oz. Media reports from Germany, Austria and Switzerland suggest that the demand for gold coins has skyrocketed and in Austria, supply has run out! Gold, being a metal that thrives on fear and uncertainty, has been portrayed by some commentators as a ‘currency’ in these unstable times. Meanwhile in the United States, sales by the US Mint of more than 190,000 ‘Golden Eagle’ coins during May represented the highest for eleven years, while the South African Rand refinery has increased Kruger Rand production by 50%. People are worried, especially in the highly indebted countries. While this activity reflects sentiment of the moment, there is also a reflection that Central Banks may look to inflate their way out of the debt crisis by printing money.

However, it is worth emphasising that in spite of the torrid time investors have had to suffer during April and May, commodity prices generally have remained very well supported and well above the levels seen in 2008. This is important. Structurally, the demand for commodities is growing at rates which are unprecedented. In spite of the current poor investment climate, resource companies are generating significant levels of cashflow. As such, these companies are trading on valuations that are compelling and up to 40% discounts to their net-asset-values. For this reason the portfolio has maintained long positions in core stocks, including Rio Tinto, Xstrata, Lundin, BPZ and Suncore. In the alternative energy sub-sector the portfolio has continued to hold a core position in Linc Energy, Yingli Green Energy and Lynas. The portfolio has to some extent mitigated the downside by continuing to retain a short position in Suzlon and steel companies in Europe, US and Japan, while also holding short positions in stock baskets and equity indices.

There has been increasing speculation that the feed-in-tariffs and subsidies provided by individual countries are at risk of being withdrawn or retrospectively adjusted down which impacted European companies in particular. Although this is likely to act as a drag on sentiment in the near term, solar PV manufacturers are still reporting strong demand from consumers in Europe and we continue to see transactions being consummated with new projects being announced not just in Europe, but also US and Asia.

While the portfolio currently has reduced its long exposure to wind and solar stocks, there are a number of investments that are being researched for potential investment. These include Centrotherm, a German company that produces machinery that manufactures solar cells and modules. Its largest market is in China. The solar market is becoming increasingly polarised. Small companies in Europe and the US remain under significant selling pressure due to margin compression. On the other hand, larger companies such as Suntech Power, Yingli and First Solar continue to dominate and grow market share. When the economic climate stabilises we shall be looking to increase our exposure to this sub-sector. In China the outlook for wind turbine manufacturers is more optimistic and Dongfang Electric and China High Speed Transmissions are major market participants and we shall be looking to buy back into these names when the government’s tightening policies stabilises.

One area that is gathering momentum is electric vehicles. As well as the growing number of city runabouts the major sports car marques are now preparing the market for their versions of hybrid cars. The application of rare-earth metals and lithium holds huge potential in the improvement in energy efficiency with very few producers of globally.

In the Energy sub-sector the market’s focus has been on BP’s catastrophic accident in the Gulf of Mexico. The situation is now becoming very politicised and the market is rife with conjecture of the ultimate cost to BP and whether the company will be forced to relinquish assets in the US or even be forced into bankruptcy! Clearly the company has a problem but it is also producing over 1 million barrels of oil per day and generates over U$26 billion per annum in cashflow from operations. The market capitalisation of the company has fallen over 40% since the accident and on current numbers yields over 7.5%. Potential contingent liabilities of BP make it too early to buy at this stage, but this is a huge global company with blue-chip assets. BP will survive and there will be a time to buy. The portfolio has focused its investments in the oil and gas sector with companies owning assets on-shore US and Canada and Latin America where big discounts are on offer. The point to emphasis here is given the sell off in equities over the last two months, the baby has been thrown out with the bath water and there is compelling value being offered.

A similar situation exists among some of the miners. The major diversified mining companies, Rio Tinto and Xstrata, trade on discounts to net-asset-value of around 15% yet are generating cashflows that are likely to see dividends increase over the next two years. While investors have sold down positions in these companies on the back of the Chinese government’s recent policies to deflate the bubble in the property market, Chinese policy action has probably now achieved the desired adjustment and the policy foot is likely to be lifted off the growth brake. Furthermore, the second quarter is also when Chinese imports of materials typically slow following inventory re-build following Chinese New Year. Therefore as we move into the third quarter of 2010, commentators’ forecasts for demand are increasing. This, we believe will provide support to the commodity market, notwithstanding markets will continue to experience periods of volatility.

Market stability rests on the policy actions of Central Banks in Europe and United States. Investor confidence is critical to markets and economic recovery and therefore policies must gain the confidence of investors. Meanwhile investors remain hyper sensitive to indications of economic recovery in the US. Evidence that these factors are stabilising will in turn see markets gather confidence and begin to recover. Valuations across the alternative energy and natural resources asset class have become significantly more attractive given that commodity prices have not collapsed and underlying demand remains on a firm footing. The BP disaster is bad for BP but positive for the oil price given that the US government has placed a moratorium on exploration in the Gulf of Mexico. Alternative energy stocks are positively correlated to a rising oil price. The catalyst to buy these stocks will be stability at the macro economic level and when the oil price begins to recover on the back of forecast increase in global demand. The portfolio is positioned for a rebound in the sector but given the febrile atmosphere continues to hold a fair amount of cash, leaving the opportunity to increase exposure to over-sold and attractively valued stocks across the asset class when sentiment improves.

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