The boom in mining has been driven largely by a voracious Chinese demand, which in turn has boosted metal prices. As the Chinese economy matures with an increasing proportion of growth coming from domestic consumption, rather than investment in infrastructure and property there is a risk that demand for minerals is waning. Given that China consumes around 50-60% of the main industrial minerals; this sounds like very bad news for mining investors.
There are some reasons to be positive however. Firstly, commodity prices may be at a minimum because of the closure of higher cost mines. In certain commodities (like iron ore for example) there are large disparities in cost of production between mines driven mainly by the quality of assets – although miners like Rio Tinto can maintain large margins at current prices a significant volume of output is barely breaking even and some are even making cash losses. As we have seen recently higher cost mines are closing which are balancing the market and supporting prices.
Secondly, we believe that China has the tools and the incentive to maintain relatively high GDP growth this year. Stability is essential as a once every decade change of senior communist partly leadership takes place. The slowdown in the first quarter was policy induced and designed to reign in inflation and cool the property market.
Thirdly, miners may benefit from an improving cost outlook due to lower energy prices and currency depreciation. Inventory build and uncertainly about the economic outlook has resulted in some oil price weakness in recent weeks. In addition, ‘commodity’ currencies like the Australian dollar, Canadian dollar and the South African rand tend to depreciate when commodity prices fall (indeed all these currencies have depreciated in recent months versus the US dollar).
Finally the mining sector is pricing in a very pessimistic scenario. Due to the cyclical nature of earnings, the sector tends to overshoot on the downside at times of risk aversion and on the upside when sentiment is positive. We appear to have overshot on the downside right now.
Divisional Director - Equity Research