Commodities | May 10 2006
By Greg Peel
When considering the rise of China as an economic giant in the new millennium, many analysts compare the Chinese situation with that of Japan in the 1950s and 60s. Citigroup analysts calculate that commodity prices have returned to the levels of the 50s and 60s in real terms, which means the market is factoring in that China will do as well as Japan, such that it will rise to be equivalent to half the US economy.
This may well occur, says Citigroup, and the rest of the world may continue its growth in a low inflation environment in order that this can be accommodated. However, it will definitely need to occur for current commodity price levels to be justified.
The Citigroup analysts interpret the situation as suggesting we are coming to the end of rapid nominal increases in commodity prices. While prices may yet continue to rise for the next couple of years, the momentum is slowing. A moderate fall should then ensue running down to 2010.
Citi forecasts that resources sector earnings momentum will also slow as a result, slipping from 2005’s dizzy heights of 70% growth to a more modest 17% in the twelve months to May 2007.
Global fundamentals in general, and Australian fundamentals in particular, have increased optimism in the Australian stock market which has helped to push it over the 5000 mark. But more importantly, as Citigroup notes, the main driver has been liquidity. Market inflows have far outweighed new issues.
Surplus cash in the market has increased from $12.8bn in 2004 to $24.7bn in 2005, and Citi estimates $33.8bn in 2006. The biggest contributor for 2006 will be managed fund inflows, which Citi suggests will be $71.5bn in 2006 compared to $46.3bn in 2004, and dividends ($28.2bn compared to $14.7bn). Issuance of equity or equity-related products will fall from $32.8bn to $26.9bn, on the other hand, assuming no T3.
The resources sector is, of course, where all the action has been, and Citi suggests everyone now believes in the so-called "super cycle".
In the 50s and 60s the world was enjoying low inflation under the gold standard, high productivity growth and "extremely" low oil prices. This allowed a newly industrialising Japan to be easily absorbed into the world economy. In 1950 Japan’s economy equated to 13% of that of the US. It peaked in the 90s at 50%.
China’s economy at present is about the size Japan’s was in the 50s, and about as big as Germany now. China’s economy is, however, nowhere near Japan in the 60s, and this is where the Citigroup analysts see the problem – real commodity prices in 2006 are suggesting that China’s economy already is.
Or at least that it will be eventually, which, again, may well happen, but this doesn’t exactly leave much room for further price hysteria. That’s Citigroup’s theory.
Citigroup believes prices can continue to rise slightly in nominal (not accounting for inflation) terms, but not much in real terms. Prices at these current levels can be maintained, but only if everything goes the way the world is predicting – and that is that everything is "just right".
This is the popular "Goldilocks" scenario. It suggests that all is in place to provide a continuing Chinese emergence and nothing will go wrong. It doesn’t allow for any bears to upset the equilibrium.
The Citigroup analysts forecast that the Reserve Bank of Australia basket of commodities will rise in price by 6% to December 2007, and then decline by 20% to the end of 2010. This, says Citi, is a very bullish scenario. It means that commodity prices will only fall 14% in nominal terms in four years.
The problem the analysts have is that the market has been factoring in this bullish scenario for months now, and as such it just can’t keep going ahead in leaps and bounds without getting ahead of itself. Citi believes that Goldilocks is the case at the moment, but there has to be risks.
The acceleration must come out of commodities prices, says Citi. Resources sector earnings rose 40% in 2004 and 70% in 2005, but Citi is forecasting 17% for twelve months from here. The analysts suggest that the ASX300 Resources index is presently 19.4% overvalued (applying 12 month earnings forecasts and a 6% bond yield).
Comparing this to the industrials, Citi suggests that sector is 11% overvalued.
One commodity that is not necessarily overpriced, in Citgroup’s opinion, is gold. While the oil price has also reached close to all time highs in real terms, gold hasn’t. Citi suggests that "If global [monetary] policy errs on the lenient side gold will rise further".
How should investors respond to Citigroup’s analysis? Well for starters, it is not suggesting it’s time to bail out of resources. Whichever way you look at it the scenario is still bullish – just with a lot less momentum. Another consideration is the recent interest rate rise.
Citigroup believes Australia cannot have any serious difficulties with a sharply rising Terms of Trade, and that there are modest signs of reacceleration in economic activity. Inflation has, however, risen to the top of the RBA’s 2-3% range. The RBA has attempted to stay ahead of the inflation problem.
Australian rates are on the rise, says Citi, because of the strength of both the Australian and world economies. A rate rise is not necessarily negative for cyclicals generally, or for resources in particular. But the rate rise will hurt the consumer, hurt housing, and will also affect bond prices such that long duration stocks (such as infrastructure) will be impacted.