Miners Back In Favour With Strategists

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By Greg Peel

A quick recap: Large broking houses employ both equity analysts and equity strategists. Analysts apply “bottom up” valuations from the micro level in forecasting an individual stock's earnings and other metrics. Strategists apply a “top down” approach, using macro forecasts to determine Buy-Hold-Sell style ratings to the sectors of the Australian stock market.

For some time Australian strategists have been negative on the local resources sector from the macro perspective of the risk of a hard landing in China. The basis of that risk is the Chinese property bubble and Beijing's policy attacks thereupon, prompting fears of a property crash, a debt crisis, and a pullback in economic growth. BA-Merrill Lynch, JP Morgan and UBS are three houses who have all had Sell or Hold ratings on the sector for the past several months, and in October last it appeared as those ratings were vindicated when Chinese property prices took a big dive and lending dried up.

This morning all three houses simultaneously upgraded those ratings, with Merrills and JPM moving to Neutral (Hold) and UBS moving to Overweight (Buy).

Merrills notes risks around the Chinese property market have been the key driver of Australian resource stocks in recent years. If China is not building, it is not consuming steel at the rate we'd come to know and love, meaning less demand for iron ore and met coal. The same goes for many other metals and minerals, including everything from copper for electrical wiring to zircon for glazing tiles. Late last year, this was the fear.

Merrills points out, however, that in the interim mortgage lending has risen in China leading to a stabilisation of property prices. Lending has reopened, allowing property developers to access funds again. 

Many an economist has often made note that only a low level of privately owned property in China is mortgage-financed, compared to the developed world, reducing the risk of a household-based crash were property prices to collapse. This property ownership slash mortgage game is all a bit new to those who once were Maoists. It also provides for solid potential upside in mortgage lending, which in turn provides upward pressure on housing prices.

While the risks may have eased, they certainly haven't gone away, and Merrills warns of a large inventory of newly built apartments remaining as yet unsold. This inventory will need to be absorbed before developers can feel confident in building many more apartments, so the sales trend needs to be positive. There also remains limited scope for banks to lend to developers.

Yet the Australian market has continued to price in risk, thus pushing down resource stock multiples leading to sector underperformance. A combination of Merrill's view of easing risks and underperformance is enough for the strategists to upgrade their sector weighting to Neutral. Yet despite low stock prices, the strategists note actual expectations for company profits, commodity prices and steel production are already high, leaving limited scope for upgrades to earnings. Hence the rating is Neutral and not Overweight.

The strategists maintain a model stock portfolio, and (noting that it must be zero-sum) they have added to their BHP Billiton ((BHP)) and Rio Tinto ((RIO)) positions and added Atlas Iron ((AGO)) and Wesfarmers ((WES)), the latter for its coal. To fund these increases/additions they have cut back OZ Minerals ((OZL)), WorleyParsons ((WOR)) and Amcor ((AMC)).

JP Morgan's view on the matter is very similar to that of Merrill Lynch. Noting the same sector underperformance, JPM has moved its sector rating on bulk and base mining to Neutral from a long-standing Underweight. 

After five consecutive quarters of underperfomance, beginning from when the Fed introduced QE2, valuations are now set at a “low bar”, JPM suggests, meaning more bad news is needed to keep the underperformance going. While the strategists' one-year view remains negative on Chinese property, real estate sales are not as weak as they might have been and developers are not yet facing funding pressure, they concede. Lending is holding up and Beijing's expected policy easing will be supportive.

JP Morgan cites the same property inventory issues as to why the view cannot be more positive, and further notes uncertainty over Chinese infrastructure funding. Were sector valuations to recover meaningfully from here, the strategists would downgrade to Underweight once more.

Again, it has to be a zero-sum game. To make way for the upgrade to resources, JP Morgan has downgraded the banks to Underweight. Despite a lack of earnings growth the banks appear to have been the recipient of funds flowing out of resources and have thus outperformed.

UBS is the more positive of the trio, raising its mining sector rating in its model portfolio to Overweight from Neutral.

UBS suggests that despite the apparent weakness in China's March GDP result (8.1% to 8.3% expected), leading indicators suggest potential for a modest pick up in Chinese growth in the June quarter.

To balance the sector upgrade, UBS, too, has cut back on its bank positions and has also removed Woolworths ((WOW)) from the model portfolio.
 

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