June saw significant volatility during the month with slower growth anticipated for China acting as the main catalyst to drive resource equities much lower mid-month. The CBOE SPX Volatility Index or VIX ranged from 24% mid-month to 35% at the start of June and also by month end. Correlations between asset classes remain high by historic standards and implied volatilities continue to trade at a premium to actual.

One measure of economic activity, the Baltic Freight Index, is down 40% over the past month. Despite a huge injection of both fiscal and monetary stimulus, Europe looks moribund and US growth appears to be slowing. First quarter US GDP growth was revised down from 3.2% to 2.7%. In addition, two-year Treasury yields stand at a record low yield of 0.6%, which was not even seen during the depression and the 10-year yield has fallen below 3%. These low Treasury yields are clearly incompatible with most economists’ estimates of 3% annualised growth for the next few years. In Europe, the financial system remains under duress across Europe and according to the Bank of England’s June Financial Stability Report, banks in Europe and the US need to re-finance/roll-over $5 trillion in debt by 2012.

We believe that the rate of recovery will be slow and low. Governments have limited ‘ammunition’ available to provide additional stimulus. Given that we believe forecasts in the market are overly over optimistic and will have to be revised lower we expect the volatility to continue in the short term. Despite this however, transactions continue to be announced in the renewable energy space, mainly in Europe and Asia. In the natural resources asset class, commodity prices remain well supported due to constrained supply and demand that remains fairly robust.

We recently attended ‘The Future of Energy’ conference hosted by Credit Suisse in Washington, DC. The main takeaways were the short term challenges facing the sector from a lack of energy policy. Longer term however, prospects remain extremely bullish given the structural issues in conventional energy. In wind, large independent developers were still encountering difficulty in obtaining project financing due to lower projected power prices and infrastructure issues. The solar companies presenting indicated strong backlogs and order books for the balance of 2010, but offered no visibility for 2011 and beyond. One of our holdings, Yingli, is seeing strong growth in the US – 100MW out of a total of 950-1000MW shipments in CY10. The stock is trading at 10x 2010E P/E.

Batteries and energy efficiency (smart grid) were areas of huge potential, but short on near term cash flows. Using current smart grid technology, energy consumption can be reduced and pressure on the grid at peak times of the day relieved. Key to smart grid technology is having smart meters to provide the real time information to both end users and energy suppliers so that both can modify their behaviour. So far just 10 million meters have been installed in the US but it is estimated a further 150 million are required. In addition, there are big opportunities within both Europe and emerging markets, which lag the US in adopting this technology.

One of the most interesting discussions we attended centred on bio-fuel with advances in enzyme technology that are improving the ability to turn non-food crops into ethanol, diesel and chemicals. Only 33% of current Brazilian sugarcane is converted into usable sugars, creating a significant opportunity for turning sugar rich biogas waste into ethanol or other higher value hydrocarbons. Although the speakers believe there is a real market in biofuels with significant technological innovations to drive longer term growth, current valuations appear stretched, so we will wait for a better entry point.

In the alternative energy sub-sector two issues caught our attention during the month. The first is that the major Korean semi-conductor manufacturers are aggressively increasing their investment into solar power. For example, LG Electronics will invest U$828m by 2015 into developing this business with an objective of generating U$2.5billion of revenue and production capacity of almost 1GW within three years from 240Mw at the end of 2010. LG is not alone. Samsung Electronics has also entered the photo-voltaic business with equally ambitious targets. Both companies have huge brand name recognition with global distribution channels. The solar industry should not under estimate the potential competition that the Koreans will bring to the sector.

Elsewhere with the fiscal crisis in Europe and attention being turned to Spain, the headlines were alive with risks to Spanish renewable energy projects having their feed-in-tariffs cut. We have believed for sometime that the FiTs in the EU are unsustainable longer term and will need to be restructured. Germany has started the process. Spain has already adjusted the subsidies to Solar and the latest focus is on Wind projects. This is a healthy development though obviously painful in the short term. Consequently while
enthusiasm for renewable energy remains high the current economic environment will be provide a headwind to growth in the sub-sector.

China remains the biggest factor impacting the commodities market, accounting for nearly 40% of bulk commodity and base metal demand, but only 7% of global GDP. China is likely to slow in growth in the second half of 2010 before growth re-accelerates in 2011. China, India, Japan and Korea are all concerned about being resource constrained and are undertaking acquisitions to secure supply. It should come as no surprise that China is reportedly interested in acquiring BP’s 60% interest in Argentinean based Pan American, valued around $9 billion.

We believe that resource related companies have been oversold after the recent global growth scare, with many trading at a large discount to intrinsic value. Copper remains our favourite base metal with supply constraints in 2011. In addition, LME stocks have decreased 20% since mid-February. Several holdings remain excellent value and should see significant upside over the next several months including Rio, Lundin, Xstrata and Mercator. As an example, at the current share price, Mercator is priced at more than a 50% discount to NAV based upon the copper futures curve and is priced for sub $2 copper, even though it has hedged more than 50% of its production for the next 24 months at over $3.

Gold bullion just keeps rising. It hit a new record high above $1,260 an ounce during the month. Ongoing jitters over Europe helped underpin prices. In addition, news that
Saudi Arabia’s central bank had upwardly revised its estimate of its gold reserves was a reminder that central banks are becoming keen on the metal after two decades of selling. However, it may be vulnerable to some short term profit taking. The summer season is traditionally weak for gold. Also, gold mining stocks have been trailing the metal, which often precipitates a setback. Still, the long-term outlook remains compelling with tight supply and plenty of potential worries to fuel demand for a safe haven, including fears that central banks could debase their currencies even further by printing yet more money as a double dip becomes more likely.

We believe that the markets will be volatile before heading lower over the next 6-12 weeks due to revised growth estimates. We are maintaining low net exposures until we get increased clarity on market direction and/or near term catalysts. Valuations remain very attractive. Nevertheless, in the current climate, with volatility as it is, we believe a portfolio that is positioned around neutral on a beta adjusted basis is appropriate in the short term.

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