GLOBAL MARKET COMMENTARY

June 9, 2016

GLOBAL MARKET COMMENTARY EXECUTIVE SUMMARY

2. Oil continues its run -- watch closely. Global oil supply/demand balance is tightening on the heels of geopolitical supply disruptions in Nigeria and Libya, and a huge cut in Venezuelan production, which may worsen still further. Positive growth and psychology inflections could also continue to support crude oil’s rally. 3. Time to revisit the Guild Basic Needs Index. In 2012 we created the Guild Basic Needs Index™ (GBNI) to track the costs within four categories of primary and essential living needs. Our intention was to provide another view of inflation, since the official CPI data compiled by the Bureau of Labor Statistics are subject to complex and constant

manipulations. The prices we track are down considerably in the past several years as commodities have fallen in U.S.-dollar terms. In spite of this, the overall U.S. consumer price basket has continued to slowly grind higher. What is interesting to us at this juncture is that the U.S. dollar looks like it may have peaked last year. If so, much of the corresponding decline in commodity prices is likely to be lapped in the coming months’ year-over-year numbers. Now, with the prices of many commodities on the rebound, one can expect an acceleration in overall prices. Accelerating prices have a profound effect on inflation expectations… and inflation expectations have a profound effect on investment markets. Let’s not forget that central bankers in the developed world have been actively trying to stimulate prices in their countries. We are starting to see evidence of their success. The latest data from the U.S. government suggest we are entering a period of price acceleration. How high will it go? Nobody knows, but we will be monitoring the data closely going forward. 4. Market Summary. Here’s where we see investment opportunities today. First, India, where good monsoons will help the economy and give the central bank room to cut rates. Second, Brazil, where the turnaround in the country’s political and economic management is ongoing, leading to rallies in Brazilian currency, stocks, and bonds. Third, Russia, where the bold investor can find beaten-down stocks and a currency strongly linked to the price of oil. Fourth, Europe, where we see several markets that are cheap on a historical comparison to the U.S. And fifth, the U.S. itself, where we are bullish especially on technology, specialty retail, materials, oil, and gold stocks.

© Guild Investment Management Inc.

1. Europe -- ripe for a reversion-to-the-mean trade. Most European markets have historically traded at a discount to U.S. markets. Our analysis of forward estimates of corporate profits over the past 10 years, however, shows that this discount has become significantly larger. Aside from Spain and Denmark, all the major markets of the continent are trading at significant discounts to their usual relationship to U.S. market multiples. Notably, Germany, which over the past ten years has traded at an average 17.8% discount to the S&P 500, now trades at a 31.2% discount. There are macro reasons for these discounts, as our regular readers know we are well aware. However, we think that when the potential departure of Britain from the European Union is settled on June 23, Europe’s troubles will be medium- and long-term -- and in the meantime, if the U.S. market breaks out to new highs, and European growth continues its current recovery, the resultant optimism will create an investment opportunity in Europe.

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EDITORS

MONTY GUILD Chief Investment Officer

ANTHONY DANAHER President

Time For Bargain-Hunting In Europe? On Sunday and Monday we heard about two new polls in the U.K. -- both showing the “leave” vote pulling ahead of the “stay” vote in the contest to determine whether Britain will remain in the European Union. The momentum was visible also among the U.K.’s book-makers, with London online gambling outfit Betfair showing a 28% chance of Brexit as of this writing, versus 19% last week. The pound reacted poorly on Sunday, but British markets were more sanguine when trading opened on Monday, and the currency reversed its previous losses. In spite of the new polls, we continue to think that British departure from the E.U. is unlikely, for several reasons. We’ve gotten helpful perspectives from some friends and colleagues in the U.K. They note that Prime Minister David Cameron has a reputation even from political opponents as a canny political

tactician; it is unlikely that he would have called the vote at this juncture if he didn’t think he would win it. He knows that demographics are working strongly in his favor. The city of London and its commuter belt have 14 million residents, 22 percent of the U.K.’s population, and will swing heavily to a “remain” vote. Scotland and Wales, with about 8.5 million residents between them, have palpably benefitted from various E.U. programs, and will also provide strong support for Cameron. (The Scots always love an opportunity to confound the right wing of the Conservative Party.) In the rest of the country, votes will fall along economic lines, with working-class ethnic Britons who have suffered most from immigration and globalization forming the backbone of the “leave” vote -- but we doubt that this group is strong enough to carry the day. We think that “remain” will win on June 23.

RUDI VON ABELE Senior Research Anaylist

CONTACT INFO 1-310-826-8600 [email protected]

Mon-Fri 6:30-4:30

Source: Bloomberg


Pound Takes Brexit Risk in Stride

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Europe, cont’d... Our regular readers also know that we see many medium- and long-term problems for Europe. To sum up: • European business dynamism and productivity growth will continue to be impaired by individual E.U. countries’ large welfare states and onerous regulatory regimes. • In one way, Europe is insufficiently integrated -- it has a common currency and monetary policy, but each member state largely has its own fiscal policy. Although the Union is struggling towards a coherent framework of bank regulation, it has not yet achieved that goal. The tensions that result from this half-union are chronic and could lead to a financial crisis at some point in the not-too-distant future. • However, in another way, Europe is far too integrated -- not by critical regulatory frame works, but by the growth of a bureaucracy which can be oppressive, opaque, arrogant, and unaccountable to ordinary citizens and voters. • Europe is dealing with an inflow of refugees and economic migrants which is straining to the limit their capacity to integrate these new arrivals. Indeed, that capacity was questionable even before the new influx -- poorly integrated migrant communities across the continent continue to pose risks to cultural cohesion, social trust, and basic security, as evidenced by recent terror attacks and threats as well as ongoing simmering tensions, particularly in France, Belgium, Sweden, and Germany. • Public resentment against slow growth and the migrant flood have contributed to the rise of populist right-wing parties across the continent. Their showing has been strongest in Eastern Europe, where such parties have taken power in

Poland and Hungary. They are making electoral strides in France, Austria, and Germany. These parties are fiercely skeptical of the current direction of ongoing European integration, and their rise creates uncertainty and volatility. • Finally, let’s not forget Russia. A resurgent Russia threatens what seems like an old and tired NATO alliance which has come to rely almost exclusively on the United States, and to a degree, the U.K., for its fighting spirit. Most European nations have been negligent about their defense budget obligations to NATO, and the alliance is unprepared to deal with Russian aggression against member states, according to many analysts. Sea soned and realistic observers see the Baltic states especially in Russian cross-hairs. (The U.K. is fortunate not to suffer from these problems as much as their continental brethren -which is one reason why we hope they chart their own course and send a clear message across the channel.) So those are all the negatives. Nevertheless, continental Europe, with all those woes, may be cheap enough to warrant an investment. The European Positives Simply looking at the charts, while the S&P 500 is near its old highs of a year ago, the major European indices are all weaker. Only Denmark and Ireland are near or above the levels of 12 months ago. In U.S. dollar terms, the broad EuroStoxx index is down about 12%; Germany and France are down about 8% each; Sweden and Switzerland are down about 13% each; Spain is down about 18%; and Italy brings up the rear, down more than 21%.


European Opportunities

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Europe, cont’d...

Despite the negatives mentioned above, there are also positive fundamentals emerging. European economic growth is picking up; the most recent data from Eurostat show the Eurozone

Source: Bloomberg

economies growing at an annualized real rate of 1.7%. This is the most robust rate of growth since 2010 -- before the Eurozone debt crisis of 2011. Should these data continue strong, they would also help shift investor psychology back to looking at European markets. Currency Is Stable-to-Rising In the lead-up to the initiation of a quantitative easing program by the European Central Bank (ECB), the value of the common currency declined dramatically. It bottomed last April, as measured by the basket of trading partners’ currencies tracked by the ECB. It is now in the upper half of its channel:

Source: Bloomberg


Aside from Brexit, there are no pressing and immediate catalytic events in store for Europe. If the U.S. market finally succeeds in breaking out above its old highs -- pushed for example by higher earnings anticipations caused by a stable-to-falling dollar, the ongoing recovery of the energy sector, nascent inflation, and the fading of fears about a Chinese-driven global recession -- Europe, cheap by comparison, could also be lifted out of its doldrums. European markets could attract funds simply because they have been relative laggards.

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Europe, cont’d Given the different dynamics at work for the euro and the dollar, we feel that the currency exposure of a position in European stocks would be neutral or a net positive in the near term. Is It Cheap? Historically, most European markets have been cheaper than the U.S. The table below shows the long-term average forward price-to-earnings estimate for European markets. (We have averaged ten years’ worth of estimated earnings looking out to the next full calendar year. For example, right now, this would compare present prices to anticipated 2017 earnings.) Data Source: Bloomberg

However, although European markets have historically been cheaper than U.S. markets, that spread has widened -- they are now relatively much cheaper than they have been over the past 10 years.

Data Source: Bloomberg

Right now, by this metric, U.S. markets are rather expensive compared to their history, with the S&P trading at 15.79 times 2017 earnings estimates, a 16% premium to its 10-year average. European markets have also appreciated since the financial crisis, are generally not so expensive compared to their history.

Ireland, which over the past 10 years has traded at an average of an 18.1% premium to the U.S. market, is now trading at a 6.2% discount. Even Germany, Europe’s bill-payer and economic stalwart, has historically traded at a 17.8% discount to the U.S. -- and now trades at a 31.2% discount.


In short, among European markets, all except Spain and Denmark are trading significantly cheaper than their historical discount to the U.S. market.

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Europe, cont’d

Green figures represent a discount; red figures a premium Data Source: Bloomberg

One of our themes for the year is reversion to the mean. In Europe’s case, such a reversion would indicate a move back towards recent historical patterns of performance relative to the U.S. Yes, Europe continues to have the significant macro overhangs we mentioned. We note especially that the European indices are heavy with financial companies, and Europe’s negative rates do not spell profits for banks, to put it mildly. So in the medium to long term, we continue to have reservations about Europe, and would certainly not be long-term buyers at this point. However, in the near term, Europe could be cheap enough to enjoy a reversion-to-the-mean rally -- particularly if the U.S. market finally succeeds in breaking out to new highs and improving global risk sentiment, and if Eurozone GDP growth continues on the positive path it has taken thus far this year. We would certainly wait for the Brexit vote to pass before looking for an entry point, however. Investment implications: Most European markets have historically traded at a discount to U.S. markets. Our analysis of forward estimates over the past 10 years, however, shows that this discount has become significantly larger. Aside from Spain and Denmark, all the major markets of the continent are trading at significant discounts to their usual relationship to U.S. market

multiples. Notably, Germany, which over the past ten years has traded at an average 17.8% discount to the S&P 500, now trades at a 31.2% discount. There are macro reasons for these discounts, as our regular readers know we are well aware. However, we think that when the potential departure of Britain from the European Union is settled, Europe’s troubles will be medium- and long-term -- and in the meantime, if the U.S. market breaks out to new highs, and European growth continues its current recovery, the resultant optimism might create the opportunity for a “reversion to the mean” trade in Europe. For such a trade, we would look particularly at Germany and Ireland. (While Denmark is attractive, it has not gotten as cheap as other European markets.) U.S. investors could approach this theme through a number of ETFs and shares, but we should say that we are not interested in investing in European banks. Investors who wish to invest in Europe should realize that the major European country equity indices’ largest weightings are usually banks and financials. We prefer to stick to select energy, mining, and industrial shares. However, while we are exploring opportunities in Europe, we don’t plan to initiate positions until we have more clarity on the outcome or consequences of the Brexit vote on June 23.


June 9, 2016

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Oil Supply Disruptions and Tightening Supply/Demand Balance Suggest Crude’s Rally May Continue

Source: IEA

The report noted (we quote): • Crude prices firmed on the back of unscheduled supply outages in Nigeria, Ghana and Canada that exceeded 1.5 m/d by early May. This more than offset bearish sentiment in the wake of the mid-April Doha output talks… • Global oil supplies rose 250 kb/d in April to 96.2 mb/d as higher OPEC output more than offset deepening non-OPEC declines. Y-o-y world output grew by just 50 kb/d in April versus gains of more than 3.5 mb/d a year ago. 2016 non-OPEC supply is forecast to drop by 0.8 mb/d to 56.8 mb/d. • Global oil demand growth for 1Q16 was revised upwards to 1.4 mb/d, led higher by strong gains in India, China and, more surprisingly, Russia. For the year as a whole, growth will be around 1.2 mb/d, with demand reaching 95.9 mb/d…

• Stock builds are beginning to slow in the OECD; in 1Q16 they grew at their slowest rate since 4Q14 and in February they drew for the first time in a year. In March OECD commercial inventories fell by a slim 1.1 mb, with April preliminary data suggesting that stocks re bounded while oil held in floating storage rose. “Unscheduled supply outages” may become more significant due to fragile geopolitics in Venezuela, Nigeria, and Libya. (Venezuela is on the brink of social chaos, and the ongoing drought is threatening to shut down the Guli Dam, which supplies about half the country’s electricity. Nigeria is facing a new terrorist insurgency, the Niger Delta Avengers, who are targeting oil production in reprisal for the Nigerian president’s anti-corruption campaign, which is disrupting long-standing networks of theft, cronyism and patronage.) Recent data have also shown unexpectedly robust crude oil import growth in India and China. Any growth inflection, and especially a shift in negative sentiment about China, could shift market perceptions and continue to support the recovery of crude prices, which have nearly doubled from February’s lows.


A brief note on global oil supply/demand balance. May’s Oil Market Report from the International Energy Agency (IEA) shows demand stable to rising, and supply moving down.

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Oil, cont’d Investment implications: Global oil supply/ demand balance is tightening on the heels of geopolitical supply disruptions in Nigeria and Libya, and potential disruption in Venezuela. Positive growth and psychology inflections could also continue to support crude oil’s rally. We favor U.S. producers;

for the bold, we suggest a careful selection of well-run but financially challenged producers whose viability will become clear as crude advances. Oil services are also worth attention, as U.S. producers look to bring drilled-but-uncompleted wells online.

After a Few Years of Cooling, the Cost of Living is Rising Again The official inflation rate has been running at extremely low levels for the past few years, in large part because of the collapse in energy prices from late 2014 to early 2016. The strong U.S. dollar, and corresponding decline in commodity prices, has helped keep a lid on how high consumer and wholesale prices have been able to rise. In the past few months, these trends have changed, and prices around the world are showing signs of accelerating.

contents, makes adjustments to the weighting of the components, and smooths seasonal patterns. Such tinkering with data, as we have mentioned over the years, usually results in an understatement of the inflation rate and creates an unreliable, misleading cost of living index.

Inflation has to be a key consideration for investors, businesses, consumers, and, of course, governments (who are responsible for calculating and publishing official inflation rates). As our long-term readers know, we believe the current methods of calculating the U.S. inflation rate leaves a lot of room for improvement. For instance, the most widely quoted “official” inflation index -- the Consumer Price Index (CPI) -- does not actually reflect the cost of living. It represents data on a changing basket of goods and services that comes from thousands of consumer spending surveys. In addition to basic, essential needs like food, clothing, shelter, and energy, the CPI includes many other expenditures. It includes insurance, taxes, and plenty of discretionary spending items such as personal care services, entertainment purchases, and consumer electronics, like flat-screen televisions.

In 2012 we created the Guild Basic Needs Index™ (GBNI) to track the costs within four categories of primary and essential living needs. Each category is assigned a specific percentage of the overall index: Food Clothing Shelter Energy

30% 10% 30% 30%

While food, clothing, and shelter are self-explanatory, the energy component represents what is used by consumers in the U.S. every day for heating, electricity, cooking, and transportation. While the prices of the underlying components can be volatile, we choose not to smooth or seasonally adjust the calculations. The categories and their values within the Guild Basic Needs Index™ are fixed, and components are not going to be replaced.


Further, the calculator of the CPI, the U.S. Bureau of Labor Statistics, periodically alters the index’s

Time to Revisit the GBNI

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As you can see in the above table, the prices of basic, essential needs that we track are down considerably in the past several years as commodities have fallen in U.S.-dollar terms. In spite of this, the overall U.S. consumer price basket has continued to slowly grind higher. What is interesting to us at this juncture is that the U.S. dollar looks like it may have peaked last year. If so, much of the corresponding decline in commodity prices is likely to be lapped in the coming months’ year-over-year numbers. Now, with the prices of many commodities on the rebound, one can expect an acceleration in overall prices. Accelerating prices have a pro-

found effect on inflation expectations… and inflation expectations have a profound effect on investment markets. Let’s not forget that central bankers in the developed world have been actively trying to stimulate prices in their countries. We are starting to see evidence of their success. The latest data from the U.S. government suggest we are entering a period of price acceleration. How high will it go? Nobody knows, but we will be monitoring the data closely going forward. Stay tuned to these letters and to www.gbni.info for more.


Cost of Living, cont’d

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Market Summary Emerging Markets India. The monsoon has started strongly, and is forecast to be normal or better than normal after two below-par yards. A normal monsoon will improve consumption in rural areas and will allow the central bank to cut rates on August 9. Lower rates will improve the GDP growth rate and encourage reinvestment in capital projects. Brazil. Brazil continues to make progress. New management is turning around the economic system and creating confidence among foreign investors. Brazilian stocks, currency and bonds are all rallying. We remain bullish on Brazil. Russia. If you are bullish on oil stocks and you are bold, consider Russia. The market is not without risks, but the economy is highly connected to the price of oil. If Asian demand for oil continues, and if supply continues at current levels, oil will move higher, and so will Russian stocks and the ruble.

Europe We see Europe as a potential area of opportunity; see our section above. The U.S. We remain bullish on the U.S., especially on technology, specialty retail, materials, oil, and gold stocks. We note the worldwide demand for oil is strong with U.S., China and India all increasing usage. Increased demand of this amount has not been included in most research on oil supply and demand and will act as a catalyst for oil to move higher in coming weeks. We will not be surprised to see oil at $60 per barrel in 2016. Thanks for listening; we welcome your calls and questions.


Let’s outline areas of the globe where we see investment opportunity.

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GLOBAL MARKET COMMENTARY

GLOBAL MARKET COMMENTARY

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