Equities lag commodities despite strong cash flow and fundamentals
Global macro events have continued to impact mining equities (down 8% in 2Q). However commodity prices have remained robust (+6%). We expect the sector to re-rate in 2H driven by: 1. Strong fundamentals (robust Chinese demand combined with supply constraints) should support commodity prices, 2. Cheap valuations (sector P/NPV of just 0.93x) and 3. Strong balance sheets (-15% ND/E) and cash flows (+40% EBITDA margins). Our top picks are; BHP, RIO, NCM, AWC, AQP, AQG, WSA, SFR (all BUYs), and we upgrade PDN to BUY on valuation.
Top commodity picks - no major sign of roll over
The 2H11-2013 story remains one of supply constraints and improving global demand. We remain bullish gold (constructive interest rate and exchange rate environment, further central bank buying), PGMs (auto production normalization and support from gold), copper (Chinese restocking and supply issues), and aluminium (Chinese energy and cost issues). Robust Chinese steel production has kept iron ore and met coal tight and this could continue into 2013. Uranium remains our least preferred commodity. In this review we have made modest cuts to base metals in 2011&12 (down 2-6%), gold and PGMs (down 5-7%), PCI coal and uranium. There are no upgrades, however we still forecast +10% price increases for base metals and +20% for precious metals in 2012.
Equities lagging commodities - expect a 2H re-rate
We have shown the performance of the Australian iron ore, gold and copper sectors vs. the iron ore, gold and copper price in Figure 1 below. It clearly shows that stocks continue to underperform commodities. We expect a 2H re-rate on continued commodity price strength combined with compelling valuations.
David Fuller's view I maintain that commodities have been experiencing no more than a lull in a supercycle that we initially commented on in the first half of the last decade. It is caused by historically low prices at the beginning of the 21st century and the rapid economic development occurring in Asian-led emerging markets, which are better described as growth economies.
However there is a difference today which will remain with us for the foreseeable future, at least until the business cycle produces its next genuine recession, in contrast to the comparatively mild economic slowing that we are currently experiencing.
Commodity prices were rallying from a low base at the beginning of the last decade and did not exert any significant inflationary pressures until prices accelerated higher in 2H 2007 and 1H 2008. Moreover, that commodity inflation was largely offset by deflationary pressures in manufacturing emanating from China.
The recession of 2H 2008 and 1H 2009, caused by the spike in crude oil to $147 plus the Wall Street-led banking crisis and credit crunch, temporarily lower inflationary pressures and fanned deflationary concerns.
The massive and unprecedented monetary stimulus in response to the west's credit crisis and deflationary fears predictably ensured the inflationary pressures which the world is experiencing today. The rise in commodity prices remains at the centre of this global problem.
Going forward, commodity prices are unlikely to fall sufficiently to lower significantly inflationary pressures without another global recession. Also, a considerably richer China is no longer exporting deflation in manufacturing goods following its strong growth in wages.
Consequently, the global economy is now much more susceptible to commodity price inflation, which puts upward pressure on prices of most goods and also services. This problem is compounded by tight oil supplies due to the loss of Libya's production, plus the global push to rely on considerably more expensive renewable energy.
The economic consequences of these events are stagflation in the west and Japan, plus often uncomfortably high levels of inflation in growth economies.
There will be fewer so-called 'sweet spots', let alone 'Goldilocks' (not-too-hot-and-not-too-cold) periods in this environment. However, there are positives. Real interest rates will remain historically low and therefore a tailwind for equities more often than not. Successful companies should continue to prosper in this environment, particularly those with a global reach.
Today's equity valuations are reasonable, not least for Fullermoney themes. Equities can perform following corrections in commodity prices, especially when governments perceive that growth is more of a priority than reining in inflation. Conversely, rising commodity prices will fan inflationary pressures, inviting a monetary headwind for equities.
This may result in a mild form of stop-go cycles over the next several years, with some additional monetary stimulus following slowdowns and moderate tightening when inflation is increasing. A resumption of normal oil production from Libya would help but this appears to be at least a year or two away. Even when that returns increases in energy consumption by the growth economies will ensure that the supply/demand equation for energy is often uncomfortably tight.
Fullermoney projects that this will change in approximately 10 to 12 years, when the global production of known shale gas and shale oil, currently in its infancy outside the USA, has been fully developed, possibly to a point where it exceeds conventional supplies. A parallel development of modern and considerably safer nuclear power plants would help to bring about the next change from energy shortages to energy surpluses.
We believe these events will be transformative, ensuring a faster rate of global economic development without igniting a corresponding increase for inflation. Even the debt-burdened west should prosper in this GDP growth supercycle environment. It would be very good for stock markets.