Caution Urged Amid Resources Rally

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-Iron ore price unlikely to stay the course
-Over-capacity an underlying problem across sector
-Potential outperformance for zinc, nickel
-Gold miners reap benefit of more bullish outlook
 

By Eva Brocklehurst

The Year of the Monkey so far has been punctuated by a broad rally in resources but the critical question is whether this is sustainable. Most brokers believe, from a fundamental perspective, the answer is no. At the very least, from the mildest standpoint, it depends on what other drivers can be amassed.

Deutsche Bank is not that surprised by the rally in iron ore prices, given the first quarter is seasonally weakest in terms of supply because of common weather related disruptions in Brazil and Australia. Prices do tend to rally at this time.

Low inventories, a flush of liquidity in January and a supply shock from Samarco are in the mix this time as well. The issue for the broker is whether a US$60/t price is sustainable. The answer appears to be in the negative. Fundamentals have not changed dramatically.

Deutsche Bank believes, once the re-stocking rally is over and liquidity ebbs, Chinese steel demand will contract by a further 3.0% this year. Moreover, the ramp-up of new projects continues unabated from major producers such as Vale, BHP Billiton ((BHP)) and Rio Tinto ((RIO)) as well as Roy Hill.

This will apply pressure to the mid tier of miners and some will need to shut for a balanced market to prevail, the broker contends. This is expected to occur at prices in the low US$40/t range. So, while the recent rally will have given some hope to marginal producers, making them hang on longer, Deutsche Bank suspects it is a forlorn hope.

Ord Minnett admits to being surprised by the strength of the rally in resources, with iron ore in particular up 30% year to date. The rally has benefitted stocks such as South32 ((S32)) and Fortescue Metals ((FMG)) significantly. While there are encouraging signs, the broker suspects the rally will be shortlived and retains an underweight call on the sector.

Moreover, the rise in iron ore prices has underpinned a rally in the Australian dollar, which has gained 10% since mid January. The broker's strategists consider the currency overvalued but also that the gap to fair value is small, at around US1-2c.

A focal point for Ord Minnett is the adverse effect the Aussie's rally will have on certain stocks earning in US dollars. Such stocks include Brambles ((BXB)), James Hardie ((JHX)) and the healthcare sector.

Macquarie is more upbeat, at least in terms of considering the fundamentals have stabilised somewhat, albeit from an extremely low base. Yet the trend is not that healthy and the broker does urge care in terms of expected upside, as demand is just not strong enough.

What can be deduced is that fundamentals are not getting worse, but overcapacity remains an underlying problem and there are significant balance sheet concerns among producers. Still, for the first time in a while, the broker does have more upgrades than downgrades in its current round of reviews to commodity price forecasts.

Precious metals are expected to continue as relative outperformers over the rest of 2016. Palladium should benefit from strong global vehicle output. Zinc and nickel are also expected to outperform in the second half.

Nickel is considered he most obvious commodity where there is potential for event-driven upside from supply cuts. Zinc is likely to be the best performer among base metals, in Macquarie's view, and the only metal where there is valid evidence of raw material constraint.

Most notable of changes are upgrades for lead and coking coal and a downgrade to uranium forecasts. The broker believes uranium has fallen to a level where it is attractive to utility buyers.

Long-run copper and zinc forecasts are reduced as cost compression is built into Macquarie's incentive price analyses. The broker reiterates a view that thermal coal and aluminium are set for long-term underperformance.

Macquarie makes several downgrades to recommendations as some stocks are running ahead of reality on the back of the lift in sentiment, and spot prices for iron ore, manganese and aluminium now sit well above forecasts for 2016. Macquarie downgrades BHP Billiton, South32 and OZ Minerals ((OZL)) to Underperform from Neutral and Independence Group ((IGO)) to Neutral from Oupterform.

One segment that shines is gold. Macquarie continues to have a bullish medium-term outlook for the precious metal although remains cautious for the short term, given the expectation the US Federal Reserve will probably raise rates this year.

The broker has re-evaluated its approach to Australian gold miners and methodology now favours those with strong and sustainable cash flow. A number of gold stocks are still trading above Macquarie's target prices. Hence, Northern Star Resources ((NST)), Doray Minerals ((DRM)) and Saracen Minerals ((SAR)) are downgraded to Underperform.

Those which have the strongest cash flow are Evolution Mining ((EVN)) and St Barbara ((SBM)), upgraded to Outperform, and Beadell Resources ((BDR)) upgraded to Neutral. Macquarie also likes the developers, Gold Road Resources ((GOR)) and Dacian Gold ((DCN)) for their stand alone value and potential as takeover targets.
 

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