Our Outlook for Basic Materials Stocks

China continues to lend support to the basic materials sector, and deal activity is heating up

Elizabeth Collins, CFA 30 September, 2010 | 11:47AM

Despite early-summer concerns about China's economy and the government's efforts to cool property markets, subsequent economic releases have shown strong fixed asset and industrial production growth year-to-date. Meanwhile, the government's steps to increase energy efficiency and trim emissions by enforcing production cuts in steel and aluminium are bolstering the fortunes of global producers. Overall, the basic materials complex remains highly leveraged to China given OECD's relative weakness, so any reversal of these trends would likely pressure commodity prices, earnings, and share prices.

Meanwhile, diversified global miner BHP Billiton has made a hostile takeover attempt for fertiliser producer Potash Corp, and robust gold prices are enhancing the yellow metal miners' ability and willingness to pursue acquisitions at seemingly premium valuations. Will this deal mania spill over into other parts of the basic materials sector? Few companies have the balance-sheet strength to pull off a deal the size of BHP's attempt at Potash Corp, so medium-sized transactions will likely be the name of the game.

Finally, we note that with the change in the pricing mechanism for seaborne iron ore earlier this year, the steel industry is likely to see increased volatility in the future. Now, quarterly contacts are based primarily on the average spot price of iron ore for the three months prior, with a one-month lag. One result of this new mechanism is that it creates the incentive to overproduce steel during periods of rising spot iron ore prices, setting up cycles of greater volatility in prices for steel and raw materials.

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About Author

Elizabeth Collins, CFA  is an associate director of equity research with Morningstar.

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