July-August 2010

COMMODITY EQUITIES: the vanguard of recovery

opencast_miningDemand for natural resources will support resource-related equities for much longer yet, says Daniel Wills of ETF Securities.

Resource-related equities rallied strongly in 2009 on the back of recovering developed market economic growth and strong demand from China for a broad range of commodities. For 2010 a key question facing investors is whether the strong performance of commodities and basic resource equities can continue.

While the shorter-term cyclical outlook is less clear as extraordinary government fiscal stimulus is pared back and China tightens monetary policy, long-term structural factors remain strongly favorable for the resource sector. Rising per capita incomes in large-population emerging markets continue to drive structural demand, with supply constraints supporting product prices.

Basic resource equities have been at the vanguard of the global economic recovery that began in early 2009, with basic resource companies tending to be highly geared to the global business cycle. Although basic resource equity performance has traditionally been driven by the cycles of the largest developed economies, emerging economies such as the Brics (Brazil, Russia, India and China) have become increasingly important since 2003, reflecting their rising share of global GDP growth.

The rebound in equity markets, tightening of credit spreads and outperformance of cyclically sensitive assets in 2009 coincided with a rebound in global lead indicators of economic activity. Global manufacturing surveys started to rebound at the end of 2008; by late 2009 global manufacturing had returned to expansion after a sharp contraction in the immediate aftermath of the credit crisis.

The recovery in economic activity was supported by a rebuild of manufacturing inventories in emerging markets, particularly China. Chinese purchases of manufacturing inputs such as coal and iron ore helped to underpin rapid annual imports growth in these products of up to several hundred percent over 2009. This import growth has retained momentum into 2010,

albeit below previous peaks in some cases. Since the end of 2008, China’s demand for commodities has picked up strongly. Buying by the State Reserve Bureau to build up strategic reserves is one factor behind the rise. Another is demand related to China’s substantial fiscal pump-priming program – particularly in the infrastructure sector. Despite more disparate import growth trends recently amongst basic resource commodities, iron ore and coal imports have continued to trend up. More recently, manufacturers in developed economies have been increasing stocks, responding to stronger orders.

Market attention in early 2010 focused on the extent to which Chinese authorities may tighten monetary conditions. A rapid rebound in Chinese growth momentum has helped fuel rising inflation pressures in the economy and raised concerns about potential excessive speculative activity, particularly in real estate markets. China’s chief tightening tool has so far come in the form of raising bank reserve ratio requirements to slow credit growth, with authorities raising reserve requirements three times since the start of 2010. To date these measures have met with success in curbing a further acceleration in money supply growth.

To date some China activity indicators have moderated, though investment growth has maintained much of its momentum. Auto sales growth remains well above average, likely reflecting the impact of lower sales tax and trade-in incentives to purchase energy-efficient vehicles. Chinese authorities reiterated in December 2009 that such measures will remain in place in 2010, albeit in a scaled-back version.

China’s economic ascendency continued through the credit crisis and its aftermath, with the country maintaining close to double-digit growth with investment spending and consumption/export incentives. These initiatives saw manufacturing rebound quickly compared to developed economies, with the uptrend in China’s contribution to global economic growth continuing. 2009 saw two key milestones in China’s economic development. First, it eclipsed Germany as the world’s largest exporter in 2009; and second it overtook the US as the world’s largest vehicle market. Based on some analyst projections, China could overtake Japan as the world’s second largest economy in 2010.

China to dominate resource markets
These developments have seen a sea change in basic resource consumption globally, with China overtaking large developed economies as the largest source of demand. China now accounts for between 20-50% of global demand for industrial metals, and looks set to dominate demand in other basic resources such as coal. China has only recently gained the critical mass necessary to impact global demand. Given the typical rise in resource consumption relative to incomes, it appears that we are only in the early stages of this trend – particularly given its large population. Other large population countries such as India are likely to follow. As an example of these trends and their impact on the composition of basic resource demand growth, China now accounts for almost half of global steel deliveries vs 15% at the start of the decade: Asia more broadly now accounts for almost two-thirds of global steel demand, with demand from the region up 134% between 2000 and 2009.

Investing in basic resources equities
Large global mining companies with extensive, diversified geographical reach, together with large domestic players in China, look well placed to take advantage of the trends in global basic resources markets. Shares in these companies provide access to commodity prices, such as iron ore and coal, that are difficult to access directly. Baskets of the largest, liquid equities across the globe provide diversification across operational risk. Furthermore, companies operating across a wide variety of geographic locations also offer investors the opportunity to diversify across political and legislative risk – highlighted most recently with the introduction of a 40% tax on mining profits in Australia. Baskets of leading global steel and shipping firms provide alternative plays on the basic resources theme: such sectors are upstream and downstream providers under the influence of similar macroeconomic trends.

Some of the largest global steel manufacturers also benefit from vertical integration. Vertically integrated steel companies with mining interests such as ArcelorMittal and United States Steel Corporation should be well placed to deal with commodity price hikes. Indeed, steel makers in general appear adept at passing on at least a portion of higher raw materials costs. Continued consolidation within the industry, declining reserves, and the growing scarcity of a number of commodities will likely support long-term pricing power of resources companies. Exchange-traded funds following baskets of the largest global miners provide a convenient and cheap way to get such exposure to a diversified basket of basic resource companies.

Basic resources equities historically have tended to follow the business cycle, though strong long-term demand for basic resources is likely tempered by the slowdown during this cycle, and possibly assisted in the strong rebound as the business cycle appeared to have passed its trough. While long-term supply-demand fundamentals should drive prices higher on a medium- to long-term basis, the near-term outlook would appear to depend on a continuation of the recovery in cyclical indicators.

Strong demand from emerging markets – particularly China – for a range of commodities has driven high revenue and earnings growth for many basic resources companies recently. Basic resources equities were at the forefront of the global economic recovery that began in early 2009, reflecting their high gearing to the global economic cycle. Recovery and restocking in emerging markets, followed more recently by developed economies, has seen global manufacturers shift back into expansion mode and has boosted demand for raw materials worldwide. China has strengthened its position as the key driver of basic resource demand, reflecting robust growth as export and domestic sector stimulus has seen it maintain much of its growth momentum through the credit crisis. Recent monetary tightening has tempered economic activity in China at the margin, with the balance between growth and inflation a difficult one for Chinese authorities. The possibility of over-tightening remains a possibility, but history indicates that this is a low probability outcome.

Structural demand growth for a range of basic materials ranging from steel, coal, iron ore, industrial metals and precious metals is expected to remain strong over the long term as these economies build new infrastructure and per capita incomes rise, with China and other emerging markets still in the nascent stages of their economic development. Resources equity baskets provide an efficient method of accessing basic resource themes, providing exposure to underlying raw commodity prices through the most liquid stocks of the largest, integrated resource providers and primary product manufacturers around the world.

• Daniel Wills is a senior analyst at ETF Securities

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