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Commodity Stocks: Proceed with Caution

Optimism continues to reign in the basic materials sector year to date, but investors are overestimating the sustainability of recent commodity price rallies, say analysts

Daniel Rohr, CFA 30 June, 2016 | 3:25PM
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Optimism continues to reign in the basic materials sector year to date, but investors are overestimating the sustainability of recent commodity price rallies. The US basic materials sector remains severely overvalued, with a market-cap weighted price/fair value estimate of 1.26 as of May 31. Mergers and acquisitions have significantly picked up in seed and crop chemicals. But, consolidation is unlikely to either generate significant benefit for the combined companies or destroy shareholder value.

We continue to consider gold and gold miners overvalued, its attractiveness only improves if inflation rises too

Steelmakers have rallied sharply year to date, but we maintain a negative outlook on the steel industry. Every U.S. steelmaker under our coverage is trading well above our estimate of fair value, and we urge investors to approach the space with caution.

We argue that U.S. steel prices are at or near a cyclical peak and will likely decline materially by the end of 2016. In our view, the benefits of steel trade cases that are currently under investigation will prove less impactful than many investors expect. Additionally, market fundamentals remain highly unattractive amid weak demand and massive overcapacity in China.

Looking forward, improved second-quarter earnings results that will be filed in late-July might inspire hope that a recovery is in store. However, we anticipate that market conditions will deteriorate in the second half of the year and see more pain ahead. While the iron ore rally has lost some steam, we think the decline in prices isn’t done.

After rallying more than 80% from their December trough to a peak of $69 per metric ton in April, iron ore prices have since given back some ground to trade around $50 per metric ton. Still, we see more downside as the long term outlook for demand remains weak. The recent acceleration in Chinese fixed asset investment, driven by debt-burdened state owned enterprises, looks fragile. Meanwhile, private FAI continues to decelerate.

Steel Demand Due to Drop

We continue to expect Chinese steel demand to decline by roughly 60 million metric tons by 2020, with iron ore demand faring worse as scrap availability improves. Despite tempering near term production expectations, the major miners; BHP, Rio, Vale, and FMG, continue to grow production and reiterated their long-term volume targets.

The recent rally in iron ore prices has also increased the likelihood of smaller, higher cost iron ore miners to remain in or return to the market, exacerbating the supply glut. We continue to believe iron ore prices should fall to $35 per metric ton in 2017 and to $30 per metric ton by 2025. The massive 2016 gold price rally has continued to hold.

Furthermore, the June jobs report spooked the Federal Reserve, with chances of rate hikes falling amid much weaker-than-expected job creation in May. Worse still, the passing of the June referendum for the United Kingdom to leave the European Union severely hurt the chances for interest rate hikes this year.

Weaker Outlook for Gold

Although the outlook for rate hikes in 2016 is now more muted, we think rate hikes will at least continue in 2017, which leads to a weaker outlook for gold. When it comes to gold investment, it’s not just interest rates that matter, but inflation, too. While unemployment and Brexit have caused a change in the rate outlook, inflation weakness continues to linger, as well.

While flat rates mean it remains relatively “cheap” to hold gold for now, its attractiveness only improves if inflation rises, too. We continue to consider gold and gold miners overvalued given what we see as over-exuberant market views on future interest rates.

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.

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About Author

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