Resources Are An Investor’s Best Option

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

“Sit back. Relax. Observe.” If I had to create my own imaginary investment guru, this is what I’d imagine my personal oracle of wisdom would have told me over the past few weeks, not once but on every occasion whenever I cast one of my questions into his direction.

“Sit back. Relax. Observe.” If investors would have done so they would have noticed the overall landscape for Australian shares has changed dramatically in less than two weeks. In fact, things are moving so fast it’s almost like one key turning point follows after another one in a near breakneck pace.

First we had the Reserve Bank surprising friend and foe with a reinvigorated war on inflation. This has not only led economists to dramatically increase their interest rate prognoses for the years ahead (to much higher than 7% and much higher for longer) but also to widespread expectations the Australian consumer, and thus the Australian economy, will be worse off than previously anticipated in the medium term. If my observation is correct, Macquarie analysts have been the first to contemplate whether the official cash rate in Australia can possibly reach as high as 8% (their answer is affirmative, implying the standard variable mortgage rate in Australia could run up to double digit levels again).

Imagine, for a second, the impact on Australia’s exporters as the Australian dollar should logically climb further and further against the US dollar.

The second key event was that Commonwealth Bank’s ((CBA)) interim result fully lived up to expectations prior to the event; the release heavily disappointed the market with the bank forced to increase provisions for bad debts much higher and faster than even the more gloomy banking analysts had been expecting. Following on from more than a decade of absolute great sector performance, investors in Australia have understandably become attached to their banking shares. However, the question has to be asked whether banks, even despite their above average dividend payouts, are the place to be for the foreseeable future?

One analyst put it as follows this week: not every sector performs equally bad in a bear market. Mostly there’s one sector in particular that underperforms significantly, like internet and technology stocks in the bear market of 2000-2003. Following on from this observation, would it then be logical to assume that this time around the worst performers will be property trusts, investment vehicles and all companies that took on too much debt and leverage, followed by the ones who facilitated and organised this debt and leverage, the banks? (Especially since, on an international scale, the bear market relates to finance stocks above anything else).

Until this week it had become clear that few investors in the Australian share market had been asking the above questions. And thus it took another shock announcement, this time by ANZ Bank ((ANZ)) on Monday morning, to force investors to re-think their traditionally engrained reflexes and perceptions about Australian banks. The importance of this week’s shock $325m provisions announcement by ANZ Bank can hardly be exaggerated, with ANZ achieving what subprime, CDOs and a global credit crunch, as well as the Reserve Bank and CommBank failed to do: stockbrokers have now started to remove banking stocks from their model portfolios and preferred lists for the year while banking analysts are dropping their Overweight sector calls.

Sector analysts at GSJB Were and Macquarie put it firmly on Tuesday morning: don’t expect any noticeable improvement for banking stocks on at least a 3-6 months horizon.

Not everybody is convinced though. When I discussed the matter with a market strategist at a stockbroker this week (who’d just advised one of his clients to purchase some banking stocks), he responded with: once the negative tide turns, banking shares can easily rally up to 30% given how low valuations have fallen. I would not disagree with this logic, it’s just that I believe the key to the banks’ share price performance lies in the first part of that sentence: once the negative tide turns. It can easily be argued that the negative tide for banks has only just begun now that the RBA has signalled it will put the brakes on the Australian economy, one way or another.

The loss of the banks as an obvious safe haven, or even as a relatively “defensive” oasis amidst daily volatility and regular turmoil on the Australian share market, has no doubt rattled many an investor. It raises the obvious question: is there anything left that can be regarded “safe” or “defensive”?

If you sit back, relax and observe, like my imaginary guru would advise you to do, then add some clear thinking plus some personal analysis, and you’ll find the Australian share market has quickly become anything but a “safe” place. In fact, it would appear that every segment of the market, every sector carries at least one deadly chip. Property trusts and utilities have taken on too much debt and leverage; banks are in a negative spiral; consumer stocks are enjoying peak sales and profit margins; exporters will be battling an even dearer Australian dollar on top of slowing global growth; small caps are still being derated against large caps; nature is unfriendly for insurers and wealth managers are facing the prospect of a range trading stock market.

The answer, some experts say, is resources – they have already been dubbed today’s “new defensives”.

Alas, there is nothing, but absolutely nothing intrinsically “defensive” about resources. It starts with the whole process of mining, transporting and processing metals and minerals -under all circumstances these activities are fraught with dangers and uncertainties- and ends with daily movements of demand and supply dynamics which can have a more than proportionate effect on spot prices. In between we have problems with machinery, staff, the weather, politics, ports, shipping – you name it. I’d like to instantly dismiss the idea that resources companies, even when they are as large as BHP Billiton ((BHP)) and Rio Tinto ((RIO), can ever be regarded as “defensive”.

However, under the current circumstances the sector definitely seems like an investors’ best option. As a group, resources companies are the stand out growth sector with average earnings estimates actually moving up (while estimates for the rest of the market are still falling, the banks in particular). This element was again highlighted this week with early indications that contract iron ore prices will rise at least 65% from April onwards. Soon annual contract negotiations for all sorts of coal will be concluded as well, and expectations are the result will be for a doubling of last year’s prices.

But we, sort of, knew all that. The key turning point for the sector over the past three weeks was when China and South Africa announced they had large scale problems in their power supply. Both countries are major suppliers of resources. (In fact, what is rarely ever mentioned is that China is the world’s largest producer of every base metal, with the exception of nickel). So far, the impact has been for a rapidly improving price outlook for aluminium and for record prices for platinum. But other countries are facing similar challenges, and some, like Chile, are poised to announce similar cut backs and structural power limitations. This will keep the brakes on this year’s supply, implying the risks to price forecasts are now to the upside.

Ironically, what has been the source of constant criticism about securities analysts -the fact that their product price estimates have been lagging actual price developments- is now likely to provide the sector with positive momentum unlike all the other sectors in the market. Moreover, it is my personal observation, from reading analyst reports and media analyses, as welll as from talking to professional investors, that this change in dynamics has yet to sink in at most market participants.

To put it in another way: if I were a hedge fund trader I would have positioned myself short resources and resources stocks until early this month, as that seemed but the most logical thing to do in the face of a slowing global economy, including China’s. Over the past ten days, however, I would have radically reversed that position into long resources as the risks now seem skewed to the upside. I would delight myself in the knowledge that most of the rest of the market has yet to catch up to this major reversal.

CommSec Equity Economist Craig James appears to have come to a similar conclusion. Taking a three month horizon James advised in this week’s CommSec market update that investors should be Overweight Materials together with Healthcare and Telecommunications stocks. CommSec forecasts the S&P/ASX 200 index will reach 6,000 by mid year.

Click to view our Glossary of Financial Terms