Material Matters: Equities and Commodities, Plus The End For Nexus?

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– Disconnect between equity and physical commodity markets
– Some evidence bulk commodity markets are close to cracking
– An assessment of potential Oz economic downside
– MD departure signals issues at Nexus

By Chris Shaw

Recent equity market moves imply both spot commodity prices and future expectations for these prices are sharply overdone, but this view is not shared by Macquarie. The broker continues to believe in at least a partial disconnection between the equity and physical markets, as the range of potential outcomes continues to broaden due to ongoing concerns about the future of European and US economic growth.

The key for Macquarie is how these events impact on Chinese raw material demand, as it is this that ultimately will drive commodity prices. Looking forward, Macquarie expects persistent Chinese inflationary pressures will ease in coming months, something that would allow for a relaxing of domestic credit tightening measures.

To factor this in Macquarie has revised its commodity price expectations, the biggest changes being sizable increases in Australian dollar, gold and silver price expectations. While copper price estimates have been trimmed from previously aggressive levels, Macquarie continues to see upside from current spot prices. The broker's long-run copper price estimate has been lifted.

Thermal coal forecasts have also risen but the increases have not been to levels above current contract levels. Other bulk commodity forecast changes are small, while Macquarie has lifted aluminium price expectations to account for lower US interest rate risk and increased nickel price forecasts from 2014 to account for nickel pig iron cost pressures.

For Macquarie, key exposures include BHP Billiton ((BHP)) and Rio Tinto ((RIO)), as the big diversifieds continue to offer strong long-term fundamental valuation support. This is especially the case given the expectation iron ore prices can be sustained at US$150-$190 per tonne through the next few years.

This positive view on iron ore prices also means Macquarie remains positive on the pure plays of Fortescue ((FMG)) and Atlas Iron ((AGO)). In thermal coal the key pick is Whitehaven Coal ((WHC)), while Macquarie likes Aston Resources ((AZT)) and Gloucester Coal ((GCL)) among the met coal plays. 

In the base metals Macquarie continues to recommend Oz Minerals ((OZL)) at current levels, while changes to gold price estimates suggest Newcrest ((NCM)) and Perseus Mining ((PRU)) are now even more attractive at current levels.

All the stocks mentioned are rated as Outperform, while Macquarie also ascribes Outperform ratings to Alumina Ltd ((AWC)), Iluka Resources ((ILU)), Independence Group ((IGO)), Panoramic Resources ((PAN)) and OceanaGold ((OGC)). Paladin has been upgraded to Neutral from Underperform. 

In contrast to Macquarie, BA Merrill Lynch reports there are accumulating anecdotes coming from the coal and property sectors in China increasingly suggesting bulk commodity prices are on the verge of cracking. 

If these markets do in fact crack the implications for Australian investors would be significant, as BA-ML notes many investors continue to see commodities as a safe haven in the current downturn.

Most at risk from a stock perspective in the view of BA-ML would be the major miners, the juniors and the mining services stocks. With this in mind, the broker has looked back to what happened in 2008 to determine the best course of action for investors.

In 2008 the sequence was the major miners actually rose for a few weeks even after iron ore prices peaked, as investors switched from juniors to majors. BA-ML sees scope for a similar outcome this time around.

Junior miners fell first and experienced the largest declines, then were hit again with more selling as liquidity in markets blew up and getting out of positions became harder. Mining services stocks saw steady declines through the initial downturn, then kept falling even after junior mining stocks started to recover.

Given these guidelines, BA-ML suggests the appropriate response from investors is to go underweight the junior miners now, while adopting more of a wait-and-see approach with the majors. This is especially the case as valuations are not as stretched as was the case in 2008. 

Finally, BA-ML notes mining services companies are unlikely to be immune to selling pressure, as while major miners have indicated projects won't be delayed, the impact on the services companies will be even greater when some projects eventually are delayed.

This week the International Monetary Fund (IMF) released new economic forecasts for global growth of 4.0% this year and in 2012 and Goldman Sachs notes these were broadly in line with its own expectations. But a key point is while financial markets are increasingly embedding in more pessimistic views for global growth, equity markets are not yet fully embracing the IMF's risk scenario. 

The broker's analysis suggests the global MSCI price index could decline a further 15% from current levels if the 'risk scenario' was fully embraced. On the flipside, if current economic forecasts prove correct then global equity markets could rally by as much as 30% from current levels by the middle of next year.

For Australia, Goldman Sachs suggests despite the Australian dollar's fall below parity against the US dollar, the sharp fall in equity markets and the inversion of the yield curve implies materially weaker underlying economic growth next year than is currently being forecast.

The tightening of financial conditions in the past few weeks is consistent with a 2% growth rate in Australia in 2012, which Goldman Sachs notes is about 75-basis points below its own growth estimate next year of 3.5%. Preliminary calculations for Australia using the IMF risk scenario is economic growth in 2012 of 1.5%, a cut in the cash rate to 3.5%, an Australian dollar rate of US88c and unemployment around 6.75%.

This would be a better outcome than most other developed nations, but at the same time it would still post a number of challenges to policymakers and local asset prices. Assuming there was a shock transmitted to the Australian economy, Goldman Sachs suggests the most likely transmission channels would be via confidence levels and financial conditions and wealth.

Confidence levels in Australia have fallen more sharply than in other major developed nations in recent weeks, while even more concerning in the view of Goldman Sachs is the decline in confidence indicators over the past month.

On Goldman Sachs's numbers, net household wealth in Australia has likely fallen by 5% in year-on-year terms to the end of the September quarter, while household gearing is again approaching the high levels seen in the global financial crisis. This suggests savings rates will again increase, which is not a positive for consumer spending.

Other potential transmission channels according to Goldman Sachs are commodity prices and credit market paralysis. In terms of policy response, while Australia has good scope to cut interest rates, a cut of more than 100-basis points would be needed to bring conditions back to an expansionary level. 

A discretionary fiscal package is also a possibility given relatively low levels of government debt, but Goldman Sachs sees monetary policy taking a lead role in supporting economic activity in Australia. 

Finishing with a stock specific update, Nexus ((NXS)) has announced the immediate departure of its MD, an outcome stockbrokers suggest means prospects for the development of the Crux field are now far diminished from what had previously been assumed.

Developing Crux had been a key element of valuations for Nexus, so on the news of MD Richard Cottee's sudden departure both Macquarie and BA-ML have been quick to slash valuations. This is reflected in cuts in price targets, Macquarie halving its target to $0.20 and BA-ML lowering its target to $0.11 from $0.31.

The uncertainty with respect to the future for Nexus has also prompted Macquarie to downgrade its rating to Neutral from Outperform. BA-ML had already rated Nexus as Underperform given the uncertainty of the Crux development even with Cottee at the helm, so there is no change in its view. 

Overall the FNArena database shows Nexus is rated as Buy once, Hold twice and Underperform once, though changes could come as Deutsche Bank and RBS Australia update their views on news of Cottee's departure.

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