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Mining Stocks Overvalued as China Demand Slows

Gold is among the few mined commodities that isn't directly tied to the fortunes of Chinese fixed asset investment

Daniel Rohr, CFA 28 September, 2017 | 10:39AM

Gold is one of the few commodities not affected by China demand

Mined commodity and miner share prices are overvalued, propped up by Chinese stimulus, say Morningstar equity analysts. Iron ore's relative buoyancy since early 2016 is emblematic of most industrial commodities. The steelmaking ingredient's Indian summer continued into July and August.

The iron ore price rose from $63 per metric ton at the start of July to peak just shy of $80 per metric ton in August, despite record and rising iron ore port stockpiles. Recent conditions have been highly favourable for miners, particularly the bulk miners, as exemplified by our forecast 2017 adjusted earnings for Rio Tinto (RIO), which are in line with 2012 levels. 

We do not expect this to last. With China's credit growth slowing, we continue to expect mined commodity prices in general, and particularly iron ore, to fall materially and for share prices to follow. Miners we cover are generally substantially overvalued, and few trade in line with our fair value estimates.

This reflects our expectation for a structural change in demand growth from China as its economy matures and transitions toward less commodity-intensive and more consumption-driven economic growth. High-cost miners and those with outsized exposure to iron ore and coking coal tend to be most overvalued.

Commodities React to Fed Rate Hint

Iron ore's shaky fundamentals were laid bare via a sell-off in the wake of the U.S. Federal Reserve's September 20 announcement that it would begin to trim its balance sheet in October and would likely hike rates in December. Prices dropped 7% to $63 in response, continuing a sell-off that had begun a week prior. 

Aluminium has fared better than iron ore in the closing days of September, with spot prices on Sept. 20 reaching their highest level since 2012. Prices have moved higher because of better-than-expected aluminium demand as well as the perceived benefits of capacity reductions in China.

We believe investors have become overly enthusiastic on both counts. We forecast a significant deceleration in aluminium demand growth and anticipate that the impact of capacity cuts will prove far overstated. Accordingly, we forecast a long-term aluminium price of only $1,475 per metric ton, nearly 30% below current levels.

Our long-term midcycle price forecast, to be achieved by 2021, sits 18% below the Metal Bulletin consensus outlook of $1,790 per metric ton, which is based on the published figure just above $2,000. A price decline of this magnitude would have a substantial impact on share prices.

On the demand side, the key factors underpinning our bearish outlook are our below-consensus forecast for Chinese fixed-asset investment and fading benefits from China's recent stimulus package.

Additionally, we contend that India is still a number of years away from picking up the slack as the next major driver of global aluminium consumption. On the supply side, we expect Chinese structural overcapacity to remain in place, as large swaths of new, low-cost capacity more than offset the country's progress in closing high-cost facilities.

Gold Demand Not Linked to China

Gold is among the few mined commodities that isn't directly tied to the fortunes of Chinese fixed asset investment. Investor demand continued to drive gold prices higher in the third quarter, reaching more than $1,300 per ounce as of September 20. Geopolitical uncertainty has pushed ETF gold holdings to levels last seen before the December 2016 rate hike. 

But as the Federal Reserve continues to pursue rate increases, prices look primed to fall. Although stubbornly low inflation has worried central bankers, market inflation expectations have strengthened in recent weeks, nearing the long-term target of 2%. Additional rate hikes have the potential to unleash accumulated ETF holdings back into the market, raising the opportunity cost of gold ownership and pressuring prices. 

Longer term, we're more optimistic, as we expect rising Chinese and Indian jewelry demand to fill the gap of shrinking investor demand for the yellow metal. We see limited opportunities in gold miners, but consider Eldorado Gold EGO undervalued given ongoing challenges in its critical Greek expansion projects.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Rio Tinto PLC3,522.50 GBX-0.44
About Author

Daniel Rohr, CFA  is a senior equity analyst at Morningstar.