Weekly Broker Wrap: Commodity Forecasts Cut

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This story features RIO TINTO LIMITED, and other companies.
For more info SHARE ANALYSIS: RIO
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

– Europe forces reductions in global growth assumptions
– Cuts to base and bulk metal price forecasts follow
– Industrial and financial sectors also hit
– Gold remains a winner

By Greg Peel

The Australian stock market began on a weak note last week, carrying on the August-September theme of European uncertainty driving fear and widespread reductions to global growth forecasts. However an apparent newfound agreement among leaders that they must act swiftly to recapitalise European banks ahead of a more severe restructuring (or “orderly default”) of Greek sovereign debt sparked very solid rallies through to the end of the week.

There is little disagreement that Europe holds the key to market direction from here. Forecasts are largely binary in that continued dithering equals bad and definitive action equals good. However economists around the world have cut global growth forecasts on the assumption European growth will be difficult either way. Thereafter, the US continues to walk the tight rope between low growth and recession, while it remains difficult to find solid agreement on just how China will fare.

The problem for analysts is that they don't like to move forecasts around too often. Given changes in commodity and currency price forecasts can magnify into substantial changes in resource stock valuations, shifting price assumptions too often simply leads to confusion. Better to be more resolute about forecasts for periods of a quarter or more such that valuations can come with some level of conviction. But when prices move significantly analysts are reluctantly forced into action. Last week saw analysts bowing to weak market pressures and taking a knife to forecasts, albeit by week's end the mood had brightened with the potential for Europe to finally get its act together now in the sights.

The RBS commodity analysts in Hong Kong decided to reassess commodity price forecasts over a week ago, reverting to a bear case scenario in which both Europe and the US fall into recession. Under this scenario, RBS sees the weak commodity price levels of September carry through the fourth quarter and into 2012. The Hong Kong team acknowledges, however, their global commodity analyst colleagues are more “constructive” on the 2012 outlook.

RBS Hong Kong believes price to book value ratios are more relevant in a cyclical downturn than either PE or enterprise value measurements. Applying the PB ratios reached in the 2008 trough suggests the potential for significant valuation downside for global steel and base metal companies. Coal companies on the other hand have more stable earnings streams.

Credit Suisse also decided early last week it was time to address commodity price forecasts and mimicked the IMF in suggesting forecasts had entered “a dangerous new phase”. Summarising their views ahead of what we might call the “light at the end of the tunnel” of European agreement mid-week, the analysts suggested the short-term risks remain firmly to the downside and prices would remain highly volatile. Once the panic subsides, nevertheless, the trick will be to assess just how much longer term damage has been done to the real economy.

Clearly any failure to resolve the European situation would mean further weakness, but Credit Suisse is happy to note that while eurozone economic data have weakened considerably, the same is not true in China or even in the US. Assuming a European resolution is not far off, the analysts are looking for commodity prices to trough in the fourth quarter before resuming their decade-long upward trend in 2012.

Importantly, CS suggests China will take the opportunity of much weaker commodity prices, particularly for industrial metals, to undertake aggressive inventory restocking once the fear in the North Atlantic subsides.

BA-Merrill Lynch also believes the December quarter will provide the nadir for the current commodity price downturn. Merrills has held a positive view on commodities since 2009 but has been forced to cut price assumptions three times since March this year, with last week prompting the third cut. However, the analysts believe that as the dust settles in Europe the fundamental conditions which existed post-GFC will reemerge to set the rally in train once more.

Low central bank cash rates and quantitative easing in developed markets have meant negative real interest rates, as was the case post-GFC. Emerging markets such as China have the capacity to also cut rates if necessary and some, including Brazil, already have. As some form of rescue package is finally engineered for Europe, Merrills sees an attractive entry point into resource sector stocks, with lower commodity currency (eg AUD) levels attracting near term investment flows.

On the base metal front, and remembering that commodity analysts like to keep their price forecasts mostly below spot for industrial commodities, Merrills sees a copper price of US$2.40/lb as the trough this quarter before rebound potential to US$3.80/lb in 2012. The current spot price is US$3.30/lb. In copper the analysts like OZ Minerals ((OZL) and PanAust ((PNA)).

Coal and iron prices will also continue to come under pressure but Merrills is expecting 7% growth in Chinese steel production in 2012. This should see a floor in the iron ore price at the US$140-150/t level, the analysts suggest, with Chinese cost inflation providing a backstop. In iron ore Merrills likes Fortescue Metals ((FMG)) and Atlas Iron ((AGO)).

Meanwhile Merrills has trimmed earnings forecasts for BHP Billiton ((BHP)) and Rio Tinto ((RIO)) by 10% and dropped base metal miner price targets between 10% and 20%.

Goldman Sachs is now assuming a recession in Europe and weaker growth elsewhere around the world, including in the US, China and India. Goldmans' global GDP growth forecasts have been cut to 3.8% from 3.9% in 2011 and to 3.5% from 4.2% in 2012. For Australia, GS now sees 2011 growth of 1.5%, down from 1.7%, and 3.0% growth in 2012, down from 3.5%. The analysts have trimmed their Aussie dollar assumptions accordingly.

Global growth assumptions translate into oil price assumptions, and here GS has cut its fourth quarter 2011 Brent crude price forecast to US$110/bbl from US$125/bbl and its 2012 forecast to US$120/bbl from US$130/bbl. The analysts note however that non-OPEC oil supply has disappointed again in 2011 while global demand has proved more robust than previously assumed. OPEC producers have less than one million barrels per day of excess capacity and demand should be seasonally stronger in the fourth quarter, so Goldmans suggests Libyan production needs to be reestablished quickly.

For Australian oil and gas producers, Goldman Sachs notes reductions in price forecasts are largely offset by reductions in currency forecasts. The analysts are attracted to Woodside's ((WPL)) heavily discounted valuation and are also keen on attractive prices for Santos ((STO)) and Origin Energy ((ORG)), however early execution risks for the latter two's CSG LNG projects keeps the broker on Neutral for now. On the other hand, Oil Search ((OSH)) boasts the most attractive LNG exposure in the region, Goldmans suggests.

Refining margins in Asia have remained strong which should have been good news for Caltex ((CTX)) this year, were it not for the headwinds of the strong Aussie. Thus with Aussie forecasts now reduced, Goldmans sees a brighter outlook for the local refiner in 2012.

Goldman Sachs' equity strategists have also been in on the act, reducing forecast earnings for both resources and industrial stocks in Australia and also reducing PE multiples to reflect weaker sentiment. A cynic might thus suggest the strategists have thus reduced their ASX 200 price forecasts yet again in order to catch up to the market.

GS has now set a December quarter target for the ASX 200 of 4075, down from a previous target of 4450. By mid next year the analysts see 4400, down from 4800, and by end next year 4725, down from 5000. That implies a 22% return over 12 months including 4% of yield.

Lower global growth forecasts and weaker markets do not only impact upon resource sector stocks. Goldman Sachs put New Corp ((NWS)) on its Conviction List given its recent phone hacking-related price plunge, but notes that gap has now reduced materially. Fallout from weaker global growth will include weaker advertising demand, so Goldmans has now taken News off its Conviction List.

In the first half of 2011 we spent our time wondering to what extent excessive disaster claims would have on Australia's insurers. In the second half we have had to worry about impact the insurers will suffer on the investments needed to pay claims, given significantly weaker markets. This week Credit Suisse warned of lower earnings and dividend cuts in the sector. (See Weak Market Hurts Australian Insurers).

Returning to our hopes that a resolution in Europe may be edging nearer, one might be forgiven for assuming a victim of any good news would be the gold price. Clearly gold has been carrying a premium in its role as safe haven against financial disaster. Yet for most analysts the opposite is actually true. European debt restructuring basically suggests quantitative easing in some form or another, and if you like we can be more basic and say it means money printing.

This means global monetary inflation, and that means expectations of a higher gold price. Hence analysts spent this week revising up their gold price forecasts – some quite substantially. (See Gold Still Shines).
 

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