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China Slowdown Will Weaken Commodity Shares

Morningstar equity analysts expect a structural change in demand growth from China as its economy matures and transitions toward less commodity-intensive industries

Daniel Rohr, CFA 12 October, 2017 | 2:26PM

China iron ore mine

With China’s credit growth slowing, Morningstar equity analysts continue to expect mined commodity prices to fall materially and for share prices to follow. 

With few exceptions, we continue to see mined commodity and miner share prices as overvalued, propped up by Chinese stimulus. 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, such as BHP Billiton (BLT) and Glencore (GLEN) 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.

Iron ore’s shaky fundamentals were laid bare via a sell-off in the wake of the US 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 September 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.

Aluminium to Fall 30%

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 in real terms, 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 - in real terms - which is based on the published figure just above $2,000 in nominal terms. A price decline of this magnitude would have a substantial impact on share prices for Alcoa (AA), Norsk Hydro (NHY), Chalco (ACH), and Alumina (AWC), each of which is trading well above our fair value estimate.

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 is among the few mined commodities that is not 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 are more optimistic, as we expect rising Chinese and Indian jewellery 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.

Deals in the Agricultural Sector

Two of the four big deals in the agriculture industry closed during the third quarter. ChemChina completed its acquisition of Syngenta, then Dow Chemical and DuPont completed their merger. The newly created DowDuPont (DWDP) announced finalised plans to break up into three companies - one agriculture, one specialty products, and one materials science - within the next 18 months. Although the original plan called for a split into these three companies, the specialty products company will now be larger than originally planned, in a nod to activist pressures. 

The other two deals are currently undergoing the regulatory review process. The merger between Potash Corp (POT) and Agrium (AGU) is likely to receive regulatory approval on the condition of minor divestitures. We expect the transaction to close by the end of 2017. Likewise, the European Commission is reviewing the acquisition of Monsanto (MON) by Bayer (BAYRY). The review is expected to be complete by January 2018. We think the deal will receive approval with crop chemical and seeds divestitures from Bayer. We now expect the acquisition to close in mid-2018.

Residential construction in the United States has remained a disappointment heading into the final quarter of 2017. This is partly a consequence of short-term labour constraints and stagnating rents, which have cooled previously hot multi-family construction. The remainder of 2017 will likely prove to be a mixed bag for North American wood product companies. We expect that volumes could come under pressure amid a bruising hurricane season that has kept labourers off job sites. In contrast, pricing has remained above $400 per thousand board-feet, in response to additional mill downtime in the Southeast United States. 

Over the medium to long term, we remain far more optimistic. As a wave of millennials age deeper into their 20s and 30s, demand for housing is set to rise substantially. As families form, young adults become more likely to live independently. A combination of restrictive trade policies implemented by the Trump administration and already stretched North American lumber, and panel capacity will lead product pricing far higher in the coming decade, as supply struggles to keep up with rising demand.

While US non-residential construction activity has remained strong, US-focused aggregates and concrete share prices have declined, as optimism for a Trump infrastructure plan has waned. However, we think this decline is unwarranted, as strong underlying demand continues to drive gains in volumes, price increases, and margin expansion. We see value in Vulcan Materials (VMC) and Martin Marietta (MLM), as current share prices underestimate the significant profit growth to come. Hurricane damage in key states like Texas and Florida might weigh on near-term shipment activity but can also boost the backlog of repair work, strengthening long-term demand.   

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
Agrium Inc107.65 USD-0.11
Alcoa Corp47.93 USD2.99
Alumina Ltd2.34 AUD0.86
Anglo American PLC1,435.50 GBX0.24
Bayer AG ADR34.80 USD-1.16
BHP Billiton PLC1,379.50 GBX-0.29
DowDuPont Inc71.18 USD0.41
Eldorado Gold Corp2.17 USD-0.46
Glencore PLC378.70 GBX0.13
Martin Marietta Materials Inc216.16 USD3.18
Norsk Hydro ASA60.85 NOK0.91
Potash Corp of Saskatchewan Inc19.27 USD0.10
Rio Tinto PLC3,589.50 GBX-0.29
Vulcan Materials Co121.61 USD1.31
About Author

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