The Next Commodities Bull Market

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

In this week's Weekly Insights:

– The Next Commodities Bull Market
– The Flatline Recovery
– ANZ Bank: Problems That Can Be Solved
– National Australia Bank: In Need Of A Fix
– Presentation at PhillipCapital in Sydney

By Rudi Filapek-Vandyck, Editor FNArena

Never let fundamental facts get in the way of a bullish story. After all, who can predict the mindset of tomorrow's traders and investors?

By now, I assume, just about everyone in Australia has come to terms with the fact that equities are enjoying a bull market phase, but very little in this process seems "normal", easy or straightforward. Nothing today looks even remotely like the experience of 2003-2007.

While it is easy to point at the recovery in the index, and funds managers are about to declare FY14 another year of mid-teens pre-fees investment gains, it is also a fact that BHP Billiton ((BHP)) shares are trading around $36, which is where they were in mid-2009, and even in June 2007. And while it can be argued the shares have been as high as $50 -twice- in the meantime (and as low as $20), the current sideways trek between $31-$39 -for everyone to see on price charts- has been in place since August 2011 -34 long months ago- and it really takes a brave soul to predict a break-out soon.

I am probably inflicting quite some pain and agony with this observation, knowing full well BHP's share price performance has been superior to that of many smaller sized peers. At least, BHP has kept on paying increasing dividends throughout those years.

None of this has stopped funds managers and other experts trying to call a revival for the resources sector at various times since March 2009. And they're back at again it in the middle of 2014.

Admittedly, any of their bullish arguments in favour of resources stocks today carries more weight than at any other point in the past years, if only for the simple fact that prices for many commodities have revisited post-GFC lows and the Australian share market seems desperately in need of a different story.

And there are some convincing arguments there for everyone to see. Commodities as a group of financial assets have outperformed all other assets over the past six months (return in excess of 9%). Commodity indices have broken out of their downward trending channel, in place since 2011. Global economic growth is widely anticipated to accelerate in the second half of 2014 and throughout 2015 on the back of US recovery and stabilisation in Europe and in China. And the Commodities Investment Clock (see below) is finally pointing towards a more favourable time ahead.

(Source: Lion Selection Fund)

Of course, it is not difficult to come up with a few striking counter-points:

– Recent outperformance has been largely on the back of oil and various agricultural products. Base metals have so far moved sideways this year, except nickel for which there has been an obvious supply-constraint due to the Indonesian ban on raw materials exports

– Apart from crude oil, those commodities that matter most for the Australian share market (copper, coking and thermal coal, gold and iron ore) are either facing excess supply, or at the very least require more time to rebalance and rediscover better market dynamics

– China's economic data might be improving, but the bigger problem now is Chinese property markets and the current outlook suggests more weakness for longer

Above all, most industrial commodities markets seem well-supplied in 2014, though higher growth globally (pushing up demand) and pressure on supplies can potentially begin to make a difference in 2015. And here is where this story becomes interesting.

Assessing supply-demand balances for commodities always comes with caveats. With so many moving parts, including dodgy financing deals in China with commodities as collateral, analysts more often than not have to re-adjust at regular intervals. Right now, the key question mark hanging over the mining sector is whether the ongoing drive by management teams to reduce costs and delay spending is pushing assets, and equipment, dangerously close to the point where break-downs and interruptions can only be next. Some observers who have been keeping a close eye on engineers, contractors and equipment providers believe the major miners already have pushed their stringent cost control policies too far.

It goes without saying that in a context of growing demand, and hopefully of growing investor optimism, any serious interruption on the supply side is likely to have serious (positive) ramifications.

Such operational break-downs are near impossible to predict, however, and if we stick to what is currently available in terms of data and predictions we can make one general forecast with a large degree of confidence: the new up-cycle for commodities will not be a repeat of the 2003-2008 period. Given the strong divergence in supply-demand dynamics that is characterising today's markets, it looks like another fairly safe bet that the next upswing won't be universal in nature at all.

In other words: successful investing in commodity stocks will rely on picking the right markets and the right companies plus getting the timing right too.

A few things to keep in mind are:

– more greenfield projects in 2014 increases the odds for supply restraints and delays for copper, but 2015 looks like a wall of supply coming on stream, meaning 2016 looks more likely to be the year of copper's genuine medium term turnaround

– supply growth for iron ore will stall in H2 this year, but it will pick up again in 2015 and following years. Don't fight the Fed in financial markets is akin to don't fight the big supply response in any commodity market

– the switch to more aluminium usage in developed world heavy vehicles might well lift demand, but ultimately too many Chinese smelters will determine the metal's price potential, and too many Chinese smelters look like they're staying in business

– despite the woeful experience in recent years, market dynamics show little sign of improvement for thermal coal in the foreseeable future

On the positive side:

– what looked like the advent of an era of lower prices for crude oil has now been delayed, at the least, due to the return of supply risk and geopolitical unrest

– enough pain seems to have been inflicted upon producers of metallurgical (coking) coal and the global supply response (reduction) is building, opening the door to better prices in quarters and years ahead

– nickel should finally move into deficit next year if Indonesia keeps its ban, which is likely

– the Century mine will close in 2015, boosting market dynamics for zinc and lead

– tin remains a finely balanced small market with a lot of upside potential in case of supply disruption, on the back of growing demand for consumer electronics

– alumina prices should also benefit, on a delay, from Indonesia's export ban

– uranium prices really cannot stay this low indefinitely

– early signs are appearing for a better environment for zircon, while titanium dioxide should look a lot better in 2015

All of the above then leads to a diverging price outlook as illustrated by the overview taken from a recent sector update by Credit Suisse:

First observation to make is: do not be underwhelmed by the rather benign looking forecasts for most of the commodities mentioned. As shown on the left hand side, in most cases we're talking 10% or more upside forecast for the year ahead. Secondly, the mentioning of thermal coal on the positive side does not align with specific commentary inside CS' latest report. I suspect someone made an error and that should read metallurgical or coking coal, which is otherwise absent from the table.

Of course, there are many more commodities that can be speculated upon, including rhodium, graphite and rare metals, but I thought I'd stick with the larger, and more important ones (for the Australian share market). One special mention goes out to crude oil for which the five year average now has reached US$100/bbl – for the first time ever in history. The big question for crude oil is whether the re-emergence of supply risk will lead to a more permanent pricing in of a larger risk premium. Credit Suisse is of the view this will not prove the case, which is why both WTI and Brent are on the negative side of the price outlook above.

While commodity forecasts do differ between various teams of analysts, the underlying movements in direction as shown in the Credit Suisse overview above (noting coking coal should probably be where it now) are pretty much consistent with forecasts elsewhere with the notable exception of gold/silver and crude oil for which forecasts right now seem to lack any sense of consensus. To a lesser degree, this also applies to copper.

All in all, and this should be obvious to everyone reading this story, the next bull market for resources stocks will look a lot like the current bull market for equity markets: make the right choice and thou shalt enjoy the gains and benefits, but pick the wrong option and you likely end up regretting it. An above average appetite for risk is an absolute necessity.

The Flatline Recovery

This bull market cycle continues to produce unexpected surprises. US equities continue to enjoy positive momentum supported by ongoing prospects of healthy margins and profit growth in the US. The stuff that makes investors in Australia feel as if they weren't born in the Lucky Country after all.

But let's spare a few moments to observe the latest calculation published by Citi analysts. The chart below depicts corporate profits for shareholders (earnings per share) worldwide throughout the cycles since the 1970s. According to the line in the middle ("current") global profits for shareholders have gone nowhere but sideways since 2010.

This triggers so many questions, I don't even know where to start. Suffice to say, this is an odd bull market, yes indeed. Or does the clue lay in the fact that Citi uses USD as the glue to bind it all together?

ANZ Bank: Problems That Can Be Solved

ANZ Bank ((ANZ)) has a few problems. For starters, its capital ratio, known as CET1, is too low on the calculation used by regulator APRA. Secondly, CEO Mike Smith is still targeting a Return on Equity (ROE) of at least 16% by FY16 but banking analysts have more than just a little doubt about ANZ Bank actually achieving it.

Last Friday, UBS analysts released a company specific report, outlining the pros and cons of ANZ's various dilemmas. UBS suggests ANZ should abandon the self-imposed ROE target and -the most surprising advice- stop pretending it can remain a dividend stock while further expansion into Asia remains on the agenda. No doubt, the UBS report has found its way to the ANZ headquarters and one can easily imagine the rolling of the eyes that has occurred amongst CEO Mike Smith and the rest of his team. Thanks a lot UBS, but no thanks.

A more constructive view can be found in Deutsche Bank's report issued on Monday. Deutsche Bank analysts acknowledge the same problems as do their peers at UBS, but they have a different take on it, with far more positive consequences for ANZ Bank shareholders. I won't bother you with the details, but Deutsche Bank believes ANZ Bank has several capital initiatives (including selling some partnerships in Asia) at its disposal that will allow it to meet APRA's CET1 ratio and achieve 16% ROE, if not more, by FY16.

Bottom line, says Deutsche Bank, achieving ROE of 16.3% would imply 17% upside to the share price. Under a more bullish scenario, ROE might rise as high as 17% which would imply 26% upside to the share price. Expressed in dividend yield, the difference between UBS and Deutsche Bank is an estimated yield of 5.7% or of 6.1% on last week's share price by FY16.

Will this be enough to keep Babyboomers and SMSF-investors happy?

National Australia Bank: In Need Of A Fix

One of my Twitter followers, David, summed up the options available for investors in banking shares as follows: You hold CBA if you don't want surprises. You hold NAB if you do want surprises. The latter, of course, is a reference to National Australia Bank's ((NAB)) potentially unexpected and left field announcement it has found a willing buyer for its troubled UK operations at an above bargain basement offer. But analysts at Morgan Stanley last week issued a report in which they claim views like David's, while widespread and common among investors and experts in Australia, are too simplistic. I think Morgan Stanley is correct.

Selling the UK operations and running down legacy assets will only provide shareholders with a temporary boost, predict analysts at Morgan Stanley. If NAB is desiring a more permanent re-rating, there has to be a solution to its underperformance in Australian business banking and wealth management. The arrival of new CEO Andrew Thorburn essentially offers the bank an ideal trigger point, say the analysts.

Morgan Stanley's tough medicine comprises of: (1) raise >100bp of capital via DRP underwriting and non-core asset sales (ex Clydesdale Bank); (2) strengthen the balance sheet; (3) create an Australian Bank re-investment provision; and (4) hold the dividend flat and revise the target payout ratio. The latter point sounds a lot like what UBS was suggesting ANZ Bank should do (see above).

If executed well, Morgan Stanley can see no less than 33% upside for the NAB share price. Alas, for shareholders and investors, the analysts have little faith in NAB management's appetite for tough decisions, hence why the rating for NAB remains Underweight with the extra comment that risks remain to the downside. (See also last week's Weekly Insights on NAB and the banks).

Presentation at PhillipCapital in Sydney

Next week, I will be presenting at a Seminar organised by PhillipCapital in Sydney.
Date: Wednesday 9th July 2014, 6.30pm until 9.30pm (my presentation is 6.30-7.30)
Location: PhillipCapital, Level 9/56 Pitt St, Sydney
Access is free, but registration is necessary. Send an email to info@fnarena.com

(This story was written on Monday, 30 June 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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