MARKET REVIEW
1st Quarter 2013

espite a broad equity market rally, commodity futures and related equities declined in the first quarter. Investors have been more aggressive in buying what are often called “later stage cyclical” stocks and largely ignoring commodities. Financial stocks have had inflows since the major banks passed the latest stress test. Those banks are allowed to return capital to shareholders and are benefiting from loose global monetary policy. Companies with US focused businesses have also been attractive to global investors as the US economy has performed well, while Europe has slipped back into recession. In contrast, many aspects of the natural resource markets, particularly mining and mining equipment, are seen as too global and without an obvious catalyst for higher returns.

Energy has been the major bright spot in commodities. Natural gas prices rose 18% in the quarter and have doubled during the last twelve months. Gas production companies and gas focused drillers responded positively. Companies that use gas as an input, like chemical and agrichemical businesses, also gained. Gas prices are still low enough to benefit these companies, and have not increased to a point where coal has become relatively attractive to users that can switch back and forth. Both coal and coal companies had price declines.

Approximately 45% of the Portfolio is allocated to energy, nearly equally split between production and servicing/drilling companies. The focus in servicing/drilling is in companies with unique expertise or technologies, typically in fracking or deepwater drilling.

Mining stocks declined during the quarter. The Philadelphia Stock Exchange Gold and Silver Index fell 17.6% and the HSBC Global Mining Index was down 12.7%. The weakness in this sector has multiple causes. The strong US dollar negatively impacts gold (down 4.9%) most directly, but also impacts copper and aluminum (down 5% and 9.6%, respectively).

We modestly reduced exposure to mining, primarily due to company specific reasons rather than macroeconomic changes. Our view on metals is specific to each commodity and largely determined by inventories and supply/demand considerations. Global supply for copper is relatively tight, as new sources of the metal have been delayed to the market. A number of companies have announced production cuts of iron ore and metallurgical coal. This helps sustain prices in the long run. However, there can be an immediate adverse reaction in the companies themselves, as curtailing production can reduce cash flow and earnings.

Commodities have underperformed both stocks and bonds, given the underlying economic fundamentals of low inflation and a strong US dollar. Yet they remain an important investment hedge given global monetary policy and currency instability. If anything, the value of that hedge has increased over the past two years, even as the asset class has underperformed broad equity benchmarks.