City Natural Resources High Yield Trust has announced its interim results for the six months ended 31 December 2016. During the period, the Trust provided an NAV total return of 19.4%, thereby outperforming its benchmark index, which the company says returned 18.8%. The Trust’s share price total return was 30.8% was better than the NAV total return, reflecting a narrowing in the discount at which the Trust’s shares trade from 22.7% to 15.8% during the period. The Trust says that the average discount over the year to 31 December 2016 was 17.9% per cent, and over three years it was 17.4 per cent. The board says that its aim is to mitigate the discount at which the Company’s shares trade by long term good performance.
The managers say that, over the six months the Fund’s NAV progression proved resilient and occurred without the volatility that may have been expected against a backdrop of unlikely geopolitical outcomes. Notably, they say that markets are digesting the implications of Brexit and radical policy proposals put forward by the newly elected US president. In their assessment prospective changes to international tax rates, exchange rates and arguably heightened geopolitical risks have created a more fluid investment environment. However, while assessing headlines and possible knock-on effects of potential policy changes, such as the scope and timing of US tax changes, presents investment challenges it also offers significant opportunity. Importantly they believe enduring underlying investment themes together with a quality bias to investment leave the Fund well to capitalise in such an environment.
Base metals led commodity market gains in the half-year to end December 2016. Ebbing fears of European contagion and Donald Trump’s later election success increased expectations for greater US infrastructure spending and raised investor risk appetite. The managers say that, for base metals, this improved sentiment outweighed the strengthening dollar as the prospect of greater government bond issuance and backdrop of robust labour market data, lifted US interest rate expectations. Zinc, lead and copper made strong gains over the interim period; the managers say that each of these commodities remains an important focus within the Fund. While Trump’s victory was a catalyst for the move, particularly of copper, the managers believe that China remains a more important driver to fundamentals and they are encouraged by the continuation of strong regional house price trends.
The managers say that they believe that China’s ongoing commitment to environmental reform is a theme with longevity. In their view, an environmental focus remains central to Chinese government policy, removing domestic supply for many commodities while driving greater usage of higher grade imports as authorities seek to address regional pollution. They say that this is favouring internationally sourced supplies. Zinc is a notable beneficiary as moves to reduce contamination from lead, which is generally mined in association to zinc, has reduced domestic output while demand to galvanize steel has remained robust. Prior year mine closures have also contributed to supply reduction and a continued drawdown of warehouse inventories. Prices increased 22% over the six months to end December and continue to trend upwards. Tightening smelter treatment charges, which have declined to multi-year lows, corroborate tight market conditions. Zinc is a large and active exposure represented by two of the Fund’s top positions, Trevali and Ascendant. Despite the commodity’s strong price performance, the managers say that they believe both equities have further room to re-rate.
In comparison copper, nickel and lead prices ended the period up 14%, 12% and 6% respectively, though have again continued to rise into 2017. The managers say that Nickel mine closures in the Philippines announced after the election of the Duterte government, whose campaign promised to address poor mining practices in the country, drove initial metal price gains. However, subsequent relaxation of export terms from Indonesia, which had previously banned the export of unprocessed ore, latterly weighed on prices. Longer-term the managers believe that nickel demand will benefit as higher quality stainless product gains a greater share of the steel market.
The managers comment that the Fund has recently acquired some restructured miners of iron ore and coking coal which they believe will benefit most from ongoing Chinese actions and potential implementation of more resource friendly US policy. They say that, in the short-term, Trump’s election has boosted prospects for a pick-up in incremental demand from the region while indicators of global manufacturing activity, such as PMI data, signal continued improvement. Against this backdrop the managers say that there is no sign of material increases in growth capex from mining majors, whose strategies remain focused on balance sheet repair and dividend reinstatement. In their view, this is encouraging as such discipline should act to tighten markets further. They say that this may lead to later cycle consolidation as majors are pressured to replace depleting resource.
The managers say that, although they had expected gold to have a more positive reaction from inflationary policy, more so under a Trump’s administration, sentiment shifted away from the precious metal sector as investor’s risk appetite increased. While precious metal exposure was a drag to Fund performance in the later stages of 2016, the managers say that its insurance value has arguably increased given the more fluid geopolitical environment. In their view, precious metal remains an important diversifier and the Fund’s less volatile performance bears testament to its relevance in the portfolio.
The managers remain of the view that the responsiveness of US production undermines OPEC’s position as swing producer. They say that the recovery in rig count and flat forward prices, around US$55/bbl for WTI, are evidence of US producer hedging in advance of their increased output later this year which the managers expect to bring the global market back in to surplus. They say that this will maintain pressure on OPEC to extend its production restrictions beyond the initial six months which ends in June. Elsewhere they say that Libya and Nigeria, which were excluded from the cuts, also remain a risk to OPEC’s plan. Overall, the managers say that they continue to find better value investment opportunities in other resource sectors. As a result oil and gas exposure remains low and remains focussed on oil producers and service providers operating in regions such as the Permian Basin.
The managers say that bonds remain the backbone of income, representing approximately 26% of assets under management, and the bond element of the portfolio generates around 65% of income. The main features of the period were the continued recovery of the resource focussed bonds such as Tizir 9% 2017 up more than 10% in the period, and the addition of more Trafigura 7 5/8% perpetual and Louis Dreyfus 8 ¼% perpetual to the portfolio along with First Quantum 7 ¼% 2019 and Hudbay 9.5% at just above par. The latter was called 3 months later and 4 1/4pts higher, which the managers say reflects the improved financial position of the parent.
City Natural Resources beats benchmark and experiences strong narrowing in its discount : CYN