Rudi On Thursday

This story features RIO TINTO LIMITED. For more info SHARE ANALYSIS: RIO

I know it is a highly unfashionable statement to make amidst widespread market euphoria about what has already been dubbed “the deal of the century”, but if I were a shareholder of Rio Tinto ((RIO)) I would have sold my shares today. All of them.

If, for reasons unknown to me right now, I would have held on to them  -maybe I was in coma, maybe I simply forgot to think about selling amidst the general market excitement- I would sell them first thing tomorrow morning.

Surely I must be barking mad? There are people out there talking about the New World Order wherein commodities will outperform most other asset classes despite a downward spiral in the US economy!

I will not necessarily dispute that claim, neither am I preparing a case to declare the end of the Commodities Super Cycle, but economic data in the US have again highlighted that the world’s largest economy is most likely in recession. If it’s not, it’s more than likely it soon will be.

Tuesday’s release of the ISM Non-Manufacturing Index for January in the US is simply one of those cornerstone events that brought this fact -in a raw, undistinguishable manner- to the attention of a market that was about to forget what started January’s mayhem in the first place. If the US is in recession (or very close to) the Federal Reserve could potentially cut official interest rates by another 125 basis points tomorrow and it would still not be able to prevent it from happening. I am adding this last sentence to emphasise my point.

However, I called Tuesday’s data release a cornerstone event because it was so bad, no doubt it will have pulled tens of hopeful doubters among economists and other experts across the globe over the line in that they too now believe a US recession is in the making. It is this shift that is likely to weigh on the markets in the short term. And as we’ve seen in January, it doesn’t take that much to push everyone in a negative state of mind. How about some more bad data? Another write-down anyone? What about an unfashionable profit warning?

Economists at Citigroup in New York didn’t need Tuesday’s Index, they joined Merrill Lynch, Morgan Stanley and Goldman Sachs hours before the event in that they too now believe a US recession will become a fact, if it isn’t fact already.

All eyes are now focused on January retail sales in the US, on the calendar for next week Wednesday (February 13). Given Tuesday’s earthmoving shock experience, expectations (or is that fear?) will be for another very bad figure. Now is probably the right time to remember that negative developments are most likely to bring out more bad news, just as positive developments are likely to do the opposite. In my humble view this puts the onus on probably more disappointing data from the US. If this proves to be the case, investors better prepare for some heavy selling kicking in. As seen since the release of the ISM Non-Manufacturing Index on Tuesday, commodities will be among the first to leave the building.

So let’s summarise the situation briefly: I (hypothetically) bought some shares in Rio Tinto a while ago. Timing undefined. As long as I bought them in the past I am sitting on a profit today. I know there’s speculation in the market that another bidder might emerge, or that BHP might be talked into raising its offer further, but I am also looking at potentially some heavy weather ahead, especially for base metals and oil. A full scrip bid by BHP doesn’t offer me any protection in case of falling spot prices. Assuming the current proposition is to be endorsed by the board of Rio Tinto, I will simply receive 3.4 shares of BHP Billiton, even if they trade at $10 at that particular point in time.

Now let’s look at some positives: market consensus seems to be growing towards a 60% increase for iron ore contract prices this year and for at least a doubling in coal prices. This will have a massive effect on all producers, including Rio Tinto and BHP Billiton. Problem is those negotiations are still ongoing and will take at least weeks, if not longer to conclude. Apparently, the big three producers are pushing for price increases of 100% for iron ore. Nice try, the Chinese are reportedly not prepared to accept anything beyond 50%.

In the meantime, anything can happen. But what I do know is that if I’d sold my shares today, there would have been no shortage in interest to buy them off me. Tomorrow I may not receive the same price anymore, let alone next week. And while I am sitting behind my pc at home, reading the newspaper, spotting the market, but above all, with a big smile on my face because my profits are in the bank and will still be there if the US goes into recession next week, I have all the time and luxury in the world to assess my options.

Shall I buy into some dedicated coal or iron ore producers instead? I know that most securities analysts have so far only put a price increase of circa 35% in their valuation models. Citi upgraded every single coal producer under its coverage to Buy today. Hell, I might even decide to buy back into Rio Tinto, if the price is right and depending on what the overall market context looks like.

I don’t think I will buy into BHP Billiton, though. Any suggestion they may have to raise their offer is bound to push the share price back from here. And BHP is less exposed to bulks than Rio. Same goes for aluminium, the only one among the base metals for which price expectations have actually improved recently.

A recession in the US is not going to end the Commodities Super Cycle, but it definitely can cause some intermediate disruption. It’s easy to stick to the “believe in China” religion, especially when you’re talking about other people’s money. Fact remains (and even the market bulls cannot deny this):  the Super Cycle thesis is about to experience its most serious test since the start of it in 2004. Part of this test will be the answer to the question: is the worst behind us or still ahead for the US economy and for financial markets?

I know, if it was my money, what I would do. But hey, that’s just me talking.

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always supported by the Fab Team of Sophia, Grahame, George, Greg, Chris, Paula, Joyce and Pat)

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