The intense use of basic commodities in emerging economies is outlined in the chart below, which shows the intensity of use of steel per unit of growth in global output.  When the US, Europe and Japan were leading a global expansion that started after the end of the 2nd World War, the intensity of steel use increased for about two decades (see chart).  Once those economies became more mature, then consumer goods and services became a bigger part of the growth and the intensity of steel use declined for the next two decades.  Over the last ten years the emerging economies have grown more strongly and more consistently than the developed economies and they now make up over 35% of the global economy.  Their industrialization process once again means that more basic commodities are needed to support this growth than in the more developed economies of the world.  This can be seen in the chart where the intensity of steel use has started increasing again.

Resource Demand continues to Grow with Emerging Ecomomies

The key to the emerging markets growth story over the next few decades remains intact.  Capitalism, by default, allocates capital to the lower cost countries, indicating a greater movement in global capital to these markets.  The emerging markets growth profile is one of industrialization, urbanization and infrastructure building.  Most of the emerging market economies are not self-sufficient in energy and natural resources (except for Russia and Brazil).  They will therefore remain major importers of copper, oil, iron ore, coal and other basic materials necessary to supply these needs.  Those key resources also have longer-term supply constraints, they are capital intensive to produce and have long lead times to production.  Combining finite supplies with superior demand growth and it’s easy to see why the outlook for most commodity prices remains robust for the next number of years, barring some new, disruptive low-cost production like we have seen in the natural gas market.

So where does this leave us for the stock market outlook in 2012?  Definitely bullish.  While we have been both surprised and frustrated by the negative focus by investors in 2011, we think that those fears will abate next year as global growth resumes its upward trend.  We also expect that corporations, flush with the largest cash balances they have ever had, will continue to engage in takeover activity to supplement their growth.  Acquisitions are cheaper for companies right now than organic growth since financing costs are low and the prices of their targets are extremely low, particularly in the resource area.  We have seen the early indications of this activity with a large number of medium-sized deals in differing industries taking place in this past quarter.  These deals have been done at average prices more than 50% higher than the existing market prices at the times of the deals.  The purchases have been in a diverse number of industries including energy (Daylight Energy at 100% premium), base metals (Quadra), coal (Grand Cache), and golds (Eldorado this week announced buy of European Goldfields).  With oil prices hovering near the US$100 per barrel level, stocks are not reflecting this commodity strength and we believe that the oil patch could see a disproportionate share of this activity.  We also expect the major Chinese resource entities to continue buying long-lived assets in Canada in the metals space.  They are using US$3.50-3.75 as the long-term assumption for the copper price as opposed to the US$2.50 level used by most North American analysts.  This explains why they have been willing to pay substantial premiums over market prices to get these assets.  We assume that their view applies to other commodity sectors as well.

We have overweight positions in the resource sectors in Canada going into 2012, with Energy and Basic Materials making up over 60% of our equity weight.  We are overweight those same sectors in the US as well, but also add the Industrial and Technology sectors in the US to that list as we find great value in the multinationals such as FreePort Copper, Peabody Coal, Walter Energy, Ford, GM and the major tech firms such as Google, Apple, Intel, Microsoft and Qualcomm.  We remain underweight in the defensive sectors of the market due to their high valuations relative to their growth rates and we also remain underweight in financials due to increased capital requirements and expected slower industry growth which will impact the profit margins, earnings growth and valuation multiples.

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