Material Matters: Value In Commodity Stocks, Steel Included

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By Chris Shaw

Recent economic data have been marginally less supportive for the mining sector in the view of Deutsche Bank, as the wholesale stockbroker notes leading indicators in some key regions such as China, India, the US and Europe have weakened of late.

The other issue for Deutsche is the sovereign debt crisis in Europe, as this has lifted the level of investor risk aversion in markets generally. Precious metals have been an exception, as the increase in sovereign risk has seen strong inflows into physically backed Exchange Traded Funds (ETFs) in gold in particular.

This risk aversion trend may continue to create further headwinds for industrial metals in coming months in Deutsche's view, thanks to the deflationary risks stemming from fiscal imbalances in the western world.

While this suggests some near-term caution is appropriate, Deutsche takes the view this risk aversion is having a disproportionate impact on the commodities sector. This is reflected in its assessment some asset classes have been sold off indiscriminately.

Deutche backs up this view by noting while Chinese economic indicators have weakened there has only been slight weakness, most of the data remaining relatively positive. Loan growth and fixed asset investment have stabilised at fairly robust levels, while the decline in net import data in April was modest.

Given this Deutsche has retained its estimates for Chinese GDP growth of 9.8% this year and 9.0% in 2011. This is a clear positive for commodity markets given China continues to represent 30-50% of world demand in most commodities.

Even in thermal and coking coal, where China accounts for only about 10% of world demand, Deutsche notes the absolute volumes of Chinese demand in these two commodities can influence markets significantly.

As the traditional relationship between the Fed fund rate and commodity prices has been broken, Chinese demand for commodities is now more important than the level of US demand. As well, Deutsche points out commodities become a more attractive asset class in a low interest rate environment.

Such an environment should continue for some time given the European Central Bank has reaffirmed it will maintain interest rates at low levels at least through this year given concerns over growth and the lack of any inflationary pressures.

GSJB Were suggests as confidence in the global economy in general and in China in particular recovers over time, investment flows should again become positive for commodity markets.

How this plays out in terms of price activity across the industrial metals will reflect the supply and demand fundamentals in each market. GSJB Were suggests those for copper are most compelling as the market should be in balance this year and in deficit in 2011. Deutsche has a similar view on copper market fundamentals.

In contrast, aluminium is expected to experience large and persistent surpluses according to both GSJB Were and Deutsche, the latter noting this reflects both the commissioning of new smelters and the continued operation of old smelters due to higher barriers to exit the industry.

For nickel Deutsche anticipates a near-term deficit, though longer-term the broker expects the market will return to a surplus.

Applying this to stocks, Citi has estimated the market at present is pricing in a fall in returns for the mining sector to around the cost of capital of 10%. This is below both historical returns and its own forecast for long-term returns, both of which stand at 14-15%.

Over the last five years Citi estimates the mining sector, as depicted by metal, mining and steel companies under its European coverage, has generated returns o f 9% above the above the cost of capital. In comparison, the steel sector has delivered incremental returns of 1%.

In coming years large amounts of capital will need to be absorbed and higher taxes and costs dealt with, so mining sector returns should come down slightly in Citi's view. But even allowing for this, Citi's estimates of returns are not expected to fall to the levels implied by current share prices.

Citi's key picks among the large cap miners in the sector are BHP Billiton ((BHP)) and Xstrata, both of which are rated as Buys. Rio Tinto ((RIO)) is also rated as a Buy. The FNArena database shows Sentiment Indicator readings on BHP and Rio Tinto of 0.8 and 0.9 respectively.

UBS has turned its focus to the steel sector, pointing out while both the macroeconomic outlook and domestic demand have improved, the Australian steel sector is down 17% since peaking in August of last year.

Looking at the steel market now UBS notes there are some headwinds for steel stocks given weaker seasonal factors in coming months, the current economic issues in Europe and increasing concerns over Chinese growth. This suggests some difficulty for stocks in the sector outperforming in the shorter-term.

But taking a longer-term view UBS suggests Australian steel stocks are now at levels where there is valuation support. This means the recent sell-off has provided an opportunity to build positions at low levels, even though it will now likely take longer for normalised earnings to be achieved.

UBS rates both BlueScope ((BSL)) and OneSteel ((OST)) as Buys, with OneSteel being upgraded to Buy on valuation grounds. The ratings reflect respective valuations on the stocks of $4.24 and $4.38.

The tough short-term outlook sees the broker factor in discounts to valuation to reflect the time needed for each company to achieve what is regarded as a normal level of earnings. This means UBS has applied a price target of $3.10 for BlueScope and $3.95 for OneSteel, which compares to average respective price targets according to the FNArena database of $3.39 and $4.35.

Sentiment Indicator readings for the two companies according to the database stand at 0.8 for BlueScope and 0.4 for OneSteel. This matches the UBS view, as it prefers BlueScope over OneSteel at present.

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