This slowdown appears to be uneven and shallow. Of course, much of it is self-imposed. So, for instance the restrictions on credit extension, the property market, and energy & resource intensive heavy industry are all, in theory, easy to reverse and could all even go in the complete opposite direction if necessary – possibly on a moment’s notice, as we saw back at the end of 2008.

Although managing China’s economy is never an easy task, Chinese policymakers should be feeling pretty confident right now. They have just had two consecutive experiences of getting China’s economy to respond extremely well to government-led signals and policies. Just as the old adage “don’t fight the Fed” made its way into the lexicon I suspect that China’s version – “don’t fight the State Council” is probably even more important for many emerging markets equity investors these days.

But China’s past policy “successes” may have sometimes been too successful – with violent reactions in the economy and markets frequently leading to misallocation of capital and other unintended consequences. For instance, the infrastructure spending and bank lending binge that drove last year’s stupendous recovery has led to the morass of local government funding vehicles and their debts. While we are not too worried about systemic risks from local government funding vehicles the fact is that while they have been getting a grip on the problem and making sure it does not balloon into something systemic, things could be bumpy for a while.

Of the many different piecemeal tightening measures put in this year, a large part have already “done their worst” with most of the effects and after effects already visible and “in the price”. The ones whose potency has largely been spent include the three consecutive RRR hikes in 1H, more restrictive quotas for new bank loans and the resumption of the 75% loan-to-deposit ratio requirement for mid- and small-size banks. The effects of these measures are well understood and largely “in the price”.

But a number of other measures will continue to have a meaningful impact over the next 6-18 months. During the first half of the year banks were able sell securitized loans as “wealth management” products through trust companies. This is now extremely difficult and has effectively been shut down as a loophole for getting around bank lending quotas. This has a particular impact on property developers, as the yields were high enough to keep these products attractive and this was an area banks were particularly keen to shift off balance sheet.

The noise about the Local Government Financing Vehicles which were the principal conduits for the infrastructure project surge has also had an impact. The recognition that the current system is far too messy to be allowed to continue in its previous form led to a temporary suspension of new loans to these vehicles while a new system was hammered out. While we do not see any systemic risk here, the new system is likely to be far less free-wheeling.

There are a plethora of other controls and directives, such as limits on leverage for large centrally managed SOEs, restrictions on the use of loans earmarked to pay suppliers of infrastructure construction companies, and a number of measures targeting the property market. These include loan-to-value restrictions on mortgages and tightened checks on first home buyers have been implemented. For property developers they are now required to pay land premiums more quickly, develop existing landbank faster and also face restrictions on the use of loaned funds.

The aggregate impact of all of these measures together is still somewhat unpredictable. Based on how the economy has been coping so far, it looks like it will be easily managed, but whenever measures that directly target multiplier effects in the system are in place, bumps and jolts become a reasonable possibility.

All of these measures will likely continue to dampen liquidity creation over the next 6-18 months and will, at the very least, put a drag on the ability of the system to rapidly utilize liquidity and create leverage. There are positive offsets, of course, such as what is rapidly becoming known as “TARP for China” – otherwise known as the successful listing of the fourth, and worst managed of China’s big state banks, the Agricultural Bank of China. All of the other big state banks have either raised or are going to raise capital as well. This, along with what will likely be continued government support in the form of regulated margins, will mean a continued relatively problem-free banking system for the foreseeable future.

But nonetheless, with most economists now pencilling in continued economic deceleration over the next few quarters, investors are asking “how soon” policy is going to “change” or in other words return to the good old days of massive stimulus and free money for everyone. At the same time, however, most agree that without a substantial fall in property prices, or at the very least a long period of stagnation, property-specific measures are unlikely to be reversed (it is now understood that this is a political movement rather than purely an economic adjustment). In the meantime, the government is serious about the construction of social housing and projects finally seem to be going ahead at a reasonable pace, which will likely accelerate next year, which puts a floor under investment activities, but also increases supply. While this can be viewed as a form of fiscal loosening, it is also a longer-term political priority, and should not be viewed as intending to signal looser policy.

In the meantime, we are wondering whether it is worth having another look at inflation. Clearly, July inflation numbers are looking likely to have popped back above the official 3% target. Agricultural product prices have been increasing. Pork supply also seems to face some constraints. Wages are rising somewhat faster than they used to and this is having a particular impact on service sector pricing. Inflationary expectations are contained, still, insofar as most consumers continue to expect prices to
increase at something like a 5% pace. Yes, there are base effects and nothing seems to be out of hand yet, but the number of piecemeal measures (releasing grain reserves, increasing corn imports, directives to local governments to stop hoarding and speculation in agricultural markets, etc.) make us wonder whether to expect some further action to stabilize inflationary expectations.

So the picture in China remains relatively sanguine. The economy is slowing “comfortably” but we expect some unavoidable bumps and jolts on the liquidity front, the beginnings of which can already be seen in a wave of high yield bond issuances and placements by property developers. If we had to guess on the near term market outlook, we would say “range trading”.

For sale: shell company, ‘for carrying on an undertaking of great financial advantage, but no one to know what it is’. Will compete in the open market to buy mining assets against deep pocketed sovereign states (who have no imperative to make profits), prime managerial sponsor has no resource experience, time share on oligarch’s yacht possible for selected investors if failed political spin doctor not using it.

For sale: selection of Australian coal mines, contracted to sell majority of output at fixed, below market prices to local utilities, will require foreign investment approval, offers in excess of DCF valuation.

For sale: in the near future sundry assets unwanted by oligarch. No translation of concepts such as governance or minority rights available from the Russian. Last float down 33% in six months.

If these ads had appeared in the mining press recently, one would be forgiven for thinking that the vendors would not have been knocked over in the rush. Yet African Minerals has received an undertaking from Shandong Steel to invest $1.5bn in Sierra Leone, Vallar has raised $1bn for God knows what and Banpu has taken over Centennial. In addition, Posco has taken a stake in AMCI (Australia), KEPCO has bought 20% of an Indonesian coal miner and Adani of India seems likely to invest $1bn in a very large but currently stranded coal asset in Queensland. Even Oleg Deripaska thinks he can float more of his Siberian ‘assets’. Iron ore prices may have peaked, China may slow a little, but the land grab for resources is still very much on. We are looking for opportunities to get back into some of the mainstream mining companies which are starting to look cheap if one infers valuations from recent deals, and we are very happy to maintain our positions in companies which offer the technology to get more (energy and/ or money) out of existing resources. Some of the acquirers are appearing on our ‘looking to short’ lists. When existing management is happy to sell to a strategic buyer, you probably don’t want to be a minority in the acquirer.

The next time someone tries to tell you markets are efficient, take them gently by the throat and give them a damn good shaking. The bid for Intoll by a large Canadian Pension Fund should have been no surprise to anyone. Where else could they have found an excellent inflation hedge in their own currency with a 90 year duration, a big discount to (everybody’s) valuation and a willing major shareholder? This was one of the most egregious pricing inefficiencies that we could find, but there are plenty of others that offer corporate appeal and a very positive risk/reward trade. With safe yield looking hard to find in fixed interest markets, a lot of equities in predictable, cash generative businesses offer interesting alternatives with corporate appeal thrown in for free. The markets are still being thrown around with a very high degree of correlation in the risk on/ risk off trade by so-called sophisticated investors trying to guess day-to-day newsflow. Fundamental value is the collateral damage of this process, but fear not – cashed -up corporates are prepared to close this arbitrage.

Over the last ten years (according to the IEA), China’s energy usage has doubled and overtaken that of America. Aside from being a truly depressing statistic when one considers how far apart the per-capita usage still is, it puts into sharp focus the pressing need to increase energy efficiency. Conventional silicon-based solar and wind projects may continue to be the mainstream focus of unimaginative politicians, but the sad fact of the matter is that the economics of this type of generation do not work without subsidy and in the West the money is no longer there. In the absence of a breakthrough in fusion technology, which seems increasingly unlikely as research funding will be first on the chopping block, the planet is running out of conventional options. Yet the stock market seems unwilling to recognise this glaring anomaly, and refuses to give many promising new technologies the benefit of the doubt. Five years ago, coal bed methane was viewed as an unworkable pipedream by mainstream commentators. Now four of the biggest global energy groups are head-to-head in developing $20bn plus of projects in Queensland. There will be a major thrust in energy-starved Asia to develop this type of resource as they have (a) a lot of coal, (b) a lot of mine explosions due to the failure to remove methane and (c) a pressing need to access cheap gas to reduce emissions. In the same vein (no pun intended), UCG will also be a major focus in order to exploit otherwise uneconomic coal deposits, and when combined with fuel cell or gas to liquids technology, a way to reduce carbon and other pollutant emissions. Technologies to improve coal quality, enhance uranium enrichment efficiency, access geothermal resources and massively improve on conventional photo-voltaic efficiency are all well represented in listed form in the markets, yet few if any trade on valuations that seem to give any real credence to ultimate commercialisation, even in cases where it is already a reality, albeit at an early stage of revenue generation.. We would term this ‘irrational pessimism’, and having lived through many valuation bubbles (Japan land, TMT, biotech etc, etc) where the underlying story was far flakier but where the market adopted a bullish view from the outset, this seems to us a compelling opportunity.

Although an unexciting month in football terms (unless you happen to be Spanish), July has been a good month for markets and a decent one for us with our portfolio registering its highest score of the year. We have taken the opportunity to take a few profits and modestly reduce our exposure, but feel disinclined to go heavily liquid just yet as we can find a lot of interesting stocks – but would be rather less optimistic at the overall market level. The sigh of relief that has followed the ‘stress’ tests of the European banking system – modelling more a minor headache than a hospital admission in our opinion – has been reinforced by a significant deferment of the more stringent Basel 3 requirements for solvency and liquidity. Blue skies ahead then? Unfortunately not. Financial markets care greatly about where numbers are placed in a financial statement – the difference between the banking book and the trading book may fascinate a few analysts who need to get out more, but to any rational person it is irrelevant. A security is worth what someone will pay for it, and for a business that depends on confidence – as every banking institution does – it increasingly behoves banks to demonstrate transparency. We do not believe that the western banking system is sufficiently capitalised to cope with an extended period of low growth and on-going sovereign fiscal strain. For that matter we don’t believe the Chinese Banks are solvent either, but don’t care as we don’t invest in them and are confident that the Government is able to plug the holes in the Balance Sheets as they continue to treat the banking system as an extension of the social security net. This is not the case in the West where the taxpayer’s money has run out and the banks’ managements are less pliable. Still a sector to avoid and one that will continue to weigh down on global recovery prospects.

The conundrum that lies ahead is this: valuations on large companies have fallen so sharply that they no longer look expensive compared to more durable, less cyclical companies. The issues going forward are clearly the extent of any further yen appreciation but more importantly whether the recent weak economic data, especially in the US, is a forewarning of slower top line sales in the coming months. Will the developing economies compensate for the anaemic growth in the developed economies?

Our sense is that there are minimal prospects for any sudden reacceleration in US growth rates. We remain concerned that recent Japanese corporate results exaggerate the underlying margin levels as inventory restocking has clearly produced an unusual and probably unsustainable positive impact on selling prices which will correct as the very tight demand/supply conditions ease from here. We do expect that any near term investor interest may centre upon the more cyclical larger cap companies but given our outlook we are not prepared to sacrifice our more durable earnings growth situations. Furthermore with a political impasse following the Upper House Election, expectations for any developments in government and/or monetary policy look remote and this has further depressed more domestic sectors, especially financials and real estate. Whilst we do not own banks, we concede valuations, both within the market and globally, do not appear expensive. If and when macro investing finally subsides, Japan should prove a lucrative market given the abundance of very inexpensive stocks although the index may struggle given that the only marginal buyer, the foreigner, is reluctant to participate against the clearly slowing global economic indicators.

The portfolio’s most profitable position was in Linc Energy, which is utilising underground coal gasification (UCG) technology to produce hydrogen and methane gases from coal seams deemed uneconomic to mine. The cost of UCG is significantly more competitive than production of coal-bed methane and LNG. However, the catalyst for unlocking value is the negotiation to sell several of its non-core assets, including Australian coal deposits Emerald and Galilee in Queensland, which alone could be worth more than $1.5 billion, a multiple of the current market capitalisation of the entire company. We expect a transaction to close shortly on the sale of the Galilee coal assets to an Indian buyer for a price above what has been expected by the market, while negotiations for the sale of the coking coal asset is on-going. Given the tight supply for coking coal on a global basis, it is quite possible that the asset is sold at a price above what we projected. The portfolio holds a 4.9% weight to the stock and is the largest holding in the portfolio.

Despite considerable recent press coverage on rare earth mineral availability, the United States and Europe have been remarkably insouciant about supplies of rare earth minerals so crucial to frontier technologies, from hybrid engines to mobile phones, superconductors, LED light bulbs, wind turbines and smart bombs. China’s commerce ministry has cut export quotas for these metals by 72% for the second half of this year. The sudden shortage in supply now threatens to choke off the profits of a legion of green and consumer tech groups that depend on them. Lynas is perfectly positioned to benefit from the developing shortage in rare earth minerals and is sitting on a very valuable resource. The firm should start production in the third quarter of next year – offering the first significant source of new supply outside of China. Meanwhile prices for the rare earth composition of its Mount Weld deposit have more than doubled in the last year to pre-recession levels under pinning the unique value of the asset.

The sceptics of global warming suffered a double blow with the “Climategate” scientists cleared of charges by an independent inquiry, and a hot summer, as June was the warmest June on record globally. For those of you who have any remaining doubts, Jeremy Grantham’s (a highly regarded fund manager/market commentator) most recent newsletter “Summer Essays – Everything You Need to Know About Global Warming in 5 Minutes” which should clear any remaining climate change misconceptions.

The problem is political, especially in the US which lacks a clear energy policy. In spite of the political ineptitude, investment in the US is taking place, but at a level considerable below potential. For example, during the second quarter of 2010, investment into venture capital projects reached U$6.5 billion, a 53% increase on the same period last year.

In Europe, renewable generating capacity accounted for 60% of newly installed capacity and more than 50% installed in the US according to UNEP (United Nations Environmental Programe). While in Asia, the region is investing heavily in alternative energy. It is not just China, but Korea, India, Taiwan and Japan. Asia is taking the initiative and in turn its alternative energy companies are beginning to see their investment bearing fruit. It is estimated that solar PV module shipments increased for the fifth consecutive month in 2Q’10 to 3.7 GW generating U$ 7.1 billion in revenues according to IMS Research and are forecast to increase again in 3Q’10 to reach 4.3 GW. Further evidence of strong activity comes from the poli-silicone suppliers. Poli-silicon prices have stabilised at around U$45/kg while activity in the solar sector has remained more buoyant in-spite of the feed-in-tariff cuts in Germany, Spain and Italy (which are the largest single markets). Recently solar cell and module prices have actually increased at the margin during the last two months while poli-silicon suppliers are now pushing solar wafer customers to sigh 3-year supply contracts.

Even Russia, which has spurned clean-energy has recently signed a deal with Siemens to install wind turbines with a total capacity of 1.25 GW by 2015.

According to the IEA, China surpassed the US as the world’s #1 total energy consumer doubling its consumption over a ten year period. China’s ravenous energy demand explains why it passed the US in 2007 as the world’s largest emitter of carbon dioxide and other greenhouse gasses. While most of the world was in a nasty recession, China’s GDP grew 9.1% and oil demand grew 7.8% in 2009. Since then, auto sales have skyrocketed past the US, ensuring Chinese oil demand will remain strong. China will soon announce a new Energy Development Plan that will likely aggressively expand cleaner conventional energy sources such as natural gas and accelerate construction of alternative energy generation projects amounting to an estimated U$738 billion. Part of this plan is to increase its wind and nuclear capacity targets to 124GWs and 82GWs respectively by 2020.

The steady drumbeat of decelerating macro data has continued over the past month with GDP, housing and consumer confidence slumping in the US and economic expansion in the rest of the world is slowing considerably. Although seen somewhat as of a farce by the market, banks in Europe passed the stress tests and new financial legislation was passed in America. Although banks reported decent earnings, loan growth has turned negative in Europe for the 1st time in 50 years. Furthermore, despite Bernanke’s ‘uncertain’ outlook for the US recovery during his congressional testimony, sovereign debt worries temporarily abated and markets trended higher while yields on 2-yr US Treasuries reached a record low.

Clearly the markets have put the risk trade back into portfolios given the rally in July. Yet the macro economic fundamentals in the Western economies remain delicate. However, in China, there has been a growing consensus that the government has achieved the economic slow-down from over 12% GDP growth to around 9% and will begin to relax its austerity policies. This has lead to a sharp increase in base metal prices and also a bottoming in steel prices internationally. For example, the copper price increased during July to U$3.31/lb an increase if 12%.

We are entering what has historically been the period when China restocks its base metal inventories. This has provided a sharp rebound in resource company stock prices during July. The portfolio has remained weighted to copper stocks through Mercator, Lundin and Oz Minerals while also weighted to the large diversified mining companies.

What is worth putting into context is China’s place in the global commodity market place. With an ever-growing and voracious appetite for natural resources, China already consumes 1/3rd of the world’s copper and 40% of its base metals, and produces half of the world’s steel. To satisfy that appetite, companies based in China or Hong Kong participated in $13Bn of mining acquisitions in 2009, 100 times the level of 2005. In 2009, China accounted for 1/3rd of all cross border mining deals, up from less than 8% in 2007 and 1% in 2004. Though demand for commodities has eased a bit as the pace of China’s growth has slowed this year, it is nevertheless expected to stay strong in the long term.

The portfolio has increased the net position during July increasing exposure to the alternative energy sub-sector, adding several new stocks, including Centrotherm Photo-voltaics, Dart Energy and Solutia. In the mining sub-sector, the portfolio has added Invanhoe Australia which has potentially the world’s largest resource of rhenium which is used in the aero-space and gas turbine industry allowing for the highly efficient combustion of fossil fuel and in turn significantly reducing the emission of noxious gases and particulates by burning fuel at much higher temperatures. Rhenium is already being used in jet engines for aircraft such as the A380. However, going forward its use will increase as new aircraft replace older planes as they are taken out of service. We are also looking at the attributes of Alkane a developing zirconia and rare earths in Australia which will compliment the investment in Lynas.

Last month we wrote that the volatility would remain in place. It has. Markets have rallied on the back of the European Banks passing the ‘stress-test’, in-spite of the scepticism that surrounds it. We don’t see volatility going away. While the markets rallied, the portfolio took advantage of taking profit and reducing exposure to stocks that had performed strongly during the rally and in turn reducing stock specific risk.
Looking forward, markets may trend higher in the short term, but we are conscious of a potential consolidation and therefore the net position remains at a moderate level. However, as we have written above, several areas of interest are presenting positive developments and the portfolio has gradually positioned itself toward these.

Our primary concern for several months has surrounded earnings forecasts, especially for next year when clearly the benefits of inventory restocking will be removed resulting in a lower base effect and therefore requiring strong sales to post a positive sales number. Analysts have remained very optimistic and have retained target prices that now look attractive given the recent market decline but this still appears overly ambitious as economic growth rates globally are clearly decelerating and the yen remains firm. This matters because investors, based on historical patterns, tend to lose patience rapidly once earnings momentum has peaked.

Given this background and the additional market risk from a resumption of significant equity issues, we are pursuing an investment approach targeting companies with less cyclical earnings streams. Somewhat bizarrely many of these companies trade on valuations well below those of the more depressed cyclicals. This anomaly should be corrected in the coming months but could appear pedestrian near term if risk appetite temporarily recovers. Equally the potential benefits from individual corporate restructurings should be considerable in terms of earnings over the next two years. Given that these opportunities reside in the more domestic sectors, they remain overlooked today. We are further encouraged by a recent meeting with one of our companies. Senior management admitted that not only is their anti takeover poison pill ineffective against a foreign trade buyer but that their leading domestic institutional investors have told them that they cannot be relied upon to thwart any such takeover given the woeful performance of the company in recent years. We believe this is symptomatic. Hence there are enough acorns in the forest to construct a portfolio that is less dependant on more global trends.

Lastly, the political situation remains important in as much as the yen doomsday merchants may have reason to reconsider if the Kan administration does start to overhaul the tax structure. Investors should appreciate that the consequences will be far reaching and will result in a faster pace of consolidation in domestic areas such as retailing as many small operators wither away. Historically it has never been sensible to invest around politics and we are certainly not doing so but we are monitoring events closely.

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.

Remarkably, a Greek default and significant further weakness amounting to an effective “double dip” are now already factored into many managers’ “base case” scenarios. For instance, in recent surveys no less than 80% of fund managers expect a Greek default or restructuring some time in the next couple years, as well as bank recapitalizations in Spain, and serious problems in most of the rest of Europe. Investors have firmly embraced the notion that if we are having a recovery, it sure isn’t a normal one.

Asian markets have sold off (partially as “growth proxies”) and China continues to face a barrage of negative sentiment whether its accelerating, slowing or sitting still. And some of the street economists whose forecasts for Chinese growth were higher than the mean have finally recognized that Chinese growth has decelerated in the wake of stricter lending controls and a pretty serious property market crackdown and downgraded their forecasts for GDP growth this year. But if you’re looking for clear signs of a huge problem in Asia or China, the evidence is weak, to say the least. The deceleration in economic indicators is natural, given that a large part of the previous acceleration was off of a very low base and in many cases, such as bank lending and money supply, we expect a re-acceleration in the second half of the year. In the property sector, fears of future bad news are firmly embedded in investors’ expectations. However, the potential for anything disorderly looks remote, given that neither property developers nor consumers’ balance sheets are stretched. While forward looking indicators such as PMIs have decelerated, they remain firmly expansionary while Eurozone concerns have kept policy on hold. In short, we are hard pressed to find anything clearly indicating the onset of a double dip. We see a slower, but self-sustaining recovery. And as long as investors can start to believe in growth again, they can set aside, at least temporarily, fears about debt.

In the meantime, policy has firmly moved away from tightening towards “neutral”. This can be seen from the fact that the Chinese media seems to be going out of its way to telegraph the fact that there are no further tightening measures scheduled. While some of the motivation for this may have come from a property-led slowdown in China, we suspect that the more powerful incentive has been the increasingly obvious problems in Europe, which Chinese policymakers have been cautious on for some time already.

However, armed with June data showing a slowdown in exports, further slowdown in loan growth and monetary aggregates, the possibility of something more than merely “no more new tightening” begins to increase. And while it would seem slightly odd to have a complete reversal in property tightening measures when in most places in China (apart from Beijing) property prices have hardly fallen, stranger things have happened. It is now beginning to be possible to make a case that the “property prices only ever go up in China” mentality has faded away and this should help Chinese policymakers to stop worrying that hot money inflows are causing a property market bubble. As long as these pressures remain subdued, a sharp reduction in “braking activity” could set this sector alight again.

Regular readers will know that we have held an unambiguously positive outlook out China generally, and we have been willing to position the portfolio accordingly. Over the past two months, we have had the misfortune to have some of our exposure in two areas where the numbers have continued to come in better than expected, where investors are overly bearish, and where the stocks have nonetheless been indiscriminately sold down.

One part was Macau gaming where revenues from Chinese tourists continue to increase in the range of 50-70% year on year. Add to this the fact that most investors have been bearish on the sector, valuations are low, and we correctly anticipated that numbers would surprise on the upside, in most cases quite substantially, and we felt comfortable putting money to work here. Another area was the solar sector, where, despite concerns about European subsidies, the Chinese solar companies continued to increase market share and profits well ahead of investor expectations. But as bearish sentiment on the world in general, and China’s guilt by association continued to play out, we “risk managed” out of the positions at a loss. Our concentrations here hurt us and this is a mistake we are unlikely to repeat.

We still believe investors are over-discounting the possibility of a double-dip, or even a serious slowdown in growth, and that the risk/reward of holding long positions is good. However, we acknowledge that tail risks remain, and we can still manage to find a few shorts where expectations are stretched. The volatility profile of the fund is now much lower, and, in this context, we will do our best to capture some portion of the snapback in investor expectations that we expect, while guarding against the risks of the false sense of confidence any such snapback might engender.

So are European Governments tightening too early as the US has been saying? The answer is a resounding no. There is never a ‘good’ time to go cold turkey – in this case on debt – but the longer you leave it, the worse it is. The politician’s favourite fable of a vigorous recovery that leaves economies in a position in a year or two to take a major fiscal tightening on the chin and not go down is wishful thinking of the worst kind. It merely adds more debt in the interim and if there has been any kind of recovery in that period, dilutes the political will to make the difficult choices that have to be made. While the Germans are donning a hair shirt with possibly too much relish, the Americans seem behind the curve, lulled into a false sense of security by their ability to print reserve currency and a sense that any kind of tax increase is tantamount to wholesale adoption of European communism – sorry, socialism, but hey, what’s the difference? We note with interest that the Californian City of Maywood has just disbanded its police force and fired all its employees in order to contract out services and preserve cash. It is unclear to whom they plan to contract out. The resignation of Peter Orszag as US budget supreme is also an indication of political procrastination. Obama needs to renege on his ‘no tax increase for sub $250k households’, but is lacking the political capital to do so. Something major will have to give and at that point US treasuries will cease to look like such a safe haven. We don’t know when, but it will happen. The premium accorded to safer Asian credits will rise.

In Australia, the demise of the Socceroos in the World Cup has been eclipsed by a crunch match in Canberra: Mining Cos 1: Labor Party 0 with K. Rudd shown the red card. It was always going to be hard for Labor to push through controversial legislation after the spate of recent gaffes, and the companies did a good job of highlighting the potential employment issues of a penal tax rate on a low rate of return in a highly capital intensive industry. Julia Gillard is aware that she needs an early resolution to have any hope of success at the ballot box in a few months time, so compromise is coming and will involve some commodity exemptions, a higher permitted return and legacy projects in at ‘market’ value. This last point may be contentious as to how an unlisted asset is valued, but there will be time to worry about that later. In the near term the market seems more worried over a mid-year slowdown in Chinese growth and its effect on commodity prices. We would not be surprised to see some more cooling of the Chinese economic statistics over the coming months as the reduction in real estate activity feeds through to the broader economy, but would stress again that some reduction in growth is desirable anyway in order to pre-empt more draconian tightening measures. We remain relaxed about the ‘commodity currencies’ due to their superior fiscal positions and do view the mining sector as undervalued (along with the rest of the Aussie market). However, in the light of the likelihood of near-term poor newsflow, we continue to be absent from (but not short) the general mining sector. We remain long of gold, platinum and rare earth – where prices continue to rise.

The long awaited change of Chinese currency policy finally came and to describe it as a damp squib would be unfair to squibs, whatever they are. Yet it does herald a longer term appreciation and combined with the much publicised increases in manufacturing wages (catalysed by the spate of suicides at Foxconn) is supportive of our strategy which focuses on Asian domestic demand stories rather than the export sector. It certainly heralds the end of the era of manufacturing cost decline and in concert with our downbeat and now more consensual view of western demand gives us some comfort on our positioning in low beta utilities and non-life insurance, a sprinkling of secular (mainly healthcare) growth stocks, minimal exposure to mainstream technology and capital goods. We remain zero weighted in banking.

Sentiment has flipped from glass half full to glass lying smashed on the bar room floor in short order. As the stark reality of the West’s parlous economic position has become uppermost in trader’s minds capital has fled risk assets and value has now appeared in many equity markets. We believe that in the near term markets are sufficiently oversold to make the risk/ reward of being liquid unattractive and as a result we have increased our net exposure materially over the last few weeks. This may turn out to be a relatively short term trade, but as mentioned above we have no problem in buying a lot of Asian equities at current prices for the long term anyway. However, we will not be too greedy either and when the technical position has normalised we are likely to revert to a more cautious attitude again.

At the same time, in China, the leadership appears to be mainly preoccupied with domestic issues, such as cracking down on perceived property market speculation. The measures have been forceful and frequent and there is no reason to think they will stop before the perceived aim of a “meaningful” correction in prices is achieved.

In the meantime, the media has focussed heavily on a factory strike at one of Honda’s component suppliers and a handful of suicides at an electronics assembly plant (Foxconn). Many companies subsequently increased wages by 30% or more. China’s manufacturing model appears to be under siege with recent very substantial increases in minimum wages. The newspapers have had a field day with this and everyone seems to think it’s “the end of an era”.

Of course China’s exports were going to be facing headwinds anyway from fiscal contraction in Europe and a jobless recovery in America. And while domestic consumption in China remains a bright spot, it is not perceived to be improving so rapidly that it can carry everything else. So, at the same time as Europe collapses into a heap of dust, China could soon see an economic hard landing.

The bearish view is widely perceived to be inevitable – as if the future had only one path. In many cases, markets have begun to price in a doomsday scenario. The cost of downside protection in the options market has skyrocketed – just look at 3 month skew for a variety of major market ETFs, including the US listed China ETF, FXI, etc… In some of these, skew now exceeds the very highest levels seen in 2008 or 2009.

The key question right now is, when will the high levels of fear seen in the market right now dissipate? Or, conversely, how easily could investors get more fearful from here? Markets have clearly already moved to discount these worries, so the big question is whether they have moved enough that forthcoming data can provide positive surprises. There are indications that we are nearly there or thereabouts.

While gauges of fear such as skew can always go higher, given their record levels, odds are that they have gone too far. It has also become increasingly clear that policymakers are now more concerned about “risks”. This was implicit at the recent G20 meeting held in Korea and can also be seen in Bernanke’s recent comments that he would not rule out a double-dip recession. Chinese officials continue to be deeply concerned about risks to the global economy. None of this leads us to believe that politicians will pull rabbits out of hats soon, but it does at least give us some comfort that a trigger point for more meaningful action is not far away.

While it is perhaps clearest in China that the concerns are overstated, this also appears to be the case for Europe and the global economy.

First, on China. So far, there are not too many indications that property measures have been impacting construction activity and fixed asset investment – but there is a significant lag, and this should be expected. Yes, the government wants to continue to increase supply, but as long as the incentive to speculate in property and invest in property is being stamped on, the incentive to build a lot of stuff won’t be there.

While credit default swaps on Chinese property companies imply a reasonably high chance of default sometime in the next 5 years, judging by Taiwan’s experience, this is highly unlikely to happen to more than one or two of the listed ones. The companies may very well end up as shadows of their former selves, but actual default by substantial listed Chinese property companies with net gearing of, say, 70%, is a possibility, but not the 50%+ probability that CDS markets seem to imply.

It is already clear that the property crackdown (among other things) has had an impact on equity markets – and to a lesser extent property markets. Property transactions are down sharply, and prices have also edged off. Transactions should lead prices, and as long as the property measures are not entirely reversed (and it would take fairly extreme circumstances to get policymakers to reverse them), we should see prices fall further. However, given how severely Chinese property stocks have underperformed the market, this should, to a large degree, be already priced in. We are almost at the point where rapid drops in property prices would be welcome news as a harbinger of looser policy.

Inflation is also near its peak. Base effects are likely to peak over the next few months. In the meantime food prices, a big inflation driver in China, have begun to tail off. So, while it is probably too early to say that inflation is not a worry in China, we expect a brighter future in the second half.

We think the market is heavily over-discounting the likelihood of contagion from Europe, property measures and labour cost rates and a sharp decline in the currency that are receiving too little focus. Amid the latest round of worries, policy rate expectations and longer-dated yields have largely fallen outside the most vulnerable economies too (US mortgage yields are at fresh lows). And the transmission from banking system problems to a broad funding crisis or the real economy – both inside Europe and beyond – is not as transparent as many assume.

When markets are skittish volatility increases and short term movements can clearly be very choppy. But incoming data has already begun to surprise on the upside – and this is the best reason for thinking that fears are likely to recede in the near future.

A brief read of the more recently released data looks good. Exports from China and Taiwan have already surprised on the upside – up 48% yoy in China in May versus 32% yoy in April, while in Taiwan they were even stronger – up 58% yoy in May versus 48% in April. Recent inflation numbers are benign, and in line with expectations (3.1% in China, 0.7% in Taiwan). Loan growth also slowed to a more sustainable, but still quite reasonable pace of RMB600bn. In China, property price growth has slowed, but there are no signs of an imminent nationwide collapse. From a Chinese policy perspective, it looks like everything is going in the right direction, and policy is currently on hold.

We expect most of the further data to support an outcome of “less bad than expected” which in the current context of very high risk aversion, will be enough to drive markets higher. Considerably higher than they are now by the end of the summer, we believe.

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.