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scott barlow

Domestic mining stocks are having a terrific 2016 with the S&P/TSX diversified metals and mining index higher by 122 per cent. This incredible performance is entirely justified by global metals prices – the S&P GSCI industrial metals index is also climbing (less dramatically) – but the difficult part is figuring out the fundamental basis for the commodity price strength.

China is the largest source of demand for commodities and it's clear from the first chart, below, that the country's credit binge pulled metals prices out of the financial crisis doldrums. Growth in China's money supply, because the funds were used primarily for infrastructure-related construction, was the best leading indicator for global commodity prices for most of the past five years. Starting in early 2016, however, China's money-supply growth rate declined, while metals headed higher.

One possible explanation for the recent strength in the mining sector is an apparent stabilization in the global economy. The middle chart shows that economist growth forecasts for 2017 have moved higher to 3.2 per cent after an extended slide. The JPMorgan global PMI manufacturing index – which combines surveys of manufacturers across the globe – has shown the same pattern, ticking higher after sustained weakness (a reading above 50 indicates expansion).

Historically, mining sector performance has been inversely correlated with the U.S. dollar, as the bottom chart highlights. This is not solely because commodities are priced in greenbacks – rising as the dollar falls – but also because the U.S. currency reflects the relative growth expectations for emerging versus developed economies.

In the post-crisis period, a weaker dollar indicated flows of investment assets from developed to faster-growing emerging economies. Because economic growth in the developing world is more resource intensive – using more copper, iron ore and coal for each unit of gross domestic product growth – the falling dollar represented a profitable environment for investors in commodity sectors.

The dollar, however, has been stronger of late in anticipation of a Federal Reserve interest rate hike. This casts a bit of a shadow on the recent rally in metals.

I'm not entirely sure where this leaves us in terms of the future course of mining stocks. It's speculation, but to me it looks like the recovery is a relief rally – a snap-back in stock prices on the realization that the economic growth outlook in China and elsewhere will not deteriorate forever.

Based on the charts, however, the rally looks fragile, at least for now. Further strength in global manufacturing activity and growth expectations for next year would be a definite help in sustaining the sector strength. More strength in the U.S. dollar, on the other hand, would be unhelpful.

Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.