China is key factor for commodities over Eurozone recession threat

The Investec Asset Management Commodities and Resources Team give an update on commodity markets and the opportunity they see in equity valuations, highlighting the importance of Chinese demand dynamics over the perceived effects of a European crisis on o

Commodity prices have generally fallen as global growth has slowed and many commodities have moved into oversupply, at least temporarily. This has also led to resource equities weakening as analysts reduce medium-term price forecasts and concerns increase of a prolonged slowdown. However, we believe that in some cases the assumptions being made are too bearish for two reasons as follows.

First, the effect of a European crisis on commodity demand may not be as large as the market perceives, as for many commodities, Chinese demand is far more important, in our view. Thus, with signs of China loosening monetary policy again and approving more fixed asset investment, demand for several commodities, particularly steel-making raw materials, could hold up and even strengthen again despite a European recession. For example, in the case of steel demand, whilst Europe’s steel demand has grown gradually from around 210 metric tonnes (mt) to 250mt over the last 15 years, its share of global demand has fallen from 30% to 16% as Chinese demand has grown far more rapidly. Thus even if one assumes that European steel demand were to fall 10% due to the crisis, this now only represents a 1.6% fall in world demand compared to a 3% fall 15 years ago. Similarly, for copper demand, Europe’s share of global demand has fallen from just over 30% to just over 16% in the same period, thus diminishing the direct effect of a European recession on world demand. The following chart shows how Chinese demand for base metals now dominates world consumption and will likely continue to increase its share as the economy grows.

Secondly, due to the rapid growth of commodity demand over the past decade, for many commodities the incremental production has been filled by higher cost marginal producers and this has led to steeper cost curves. As a result, many commodities are now already at prices which mean some of these marginal producers are losing money and shutting down, which will support price levels at much higher levels than in the past.

What now for investors?

Significant falls in April and May have made energy resource equity valuations appear very compelling, especially when compared to commodity prices and the rebound that occurred at the end of June. With rising commodity cost curves, our view is that the downside seems limited and we see an opportunity for longer-term investors to reap the rewards of what is a pause in a longer-term structural commodity story. However, with the lag time of European politics and what appears to be a staggering recovery in the US, combined with the uncertainty surrounding the regime change in China, we again find ourselves at the mercy of the political elite.

Although we believe resource equity valuations appear generally attractive across the board, certain commodities equity valuations look particularly compelling in the current environment: energy, certain diversified miners, iron ore miners, certain mid-cap gold miners and fertiliser companies. Many investors remain concerned that commodity prices are flat-lining while costs continue to rise thus squeezing company margins. While this margin squeeze is true in some cases, we see numerous companies who can improve margins from higher commodity prices by growing volumes and even reducing costs.

In the short term, persistent European financial issues should keep markets volatile, but over the medium term we believe that once China has destocked and starts cutting rates, world growth will not remain below trend and resource equities can re-rate to more normal valuations. We conclude that at current valuations resource equities are compelling when investors are willing to look beyond the near-term uncertainty surrounding the euro zone, Chinese slowdown and other macroeconomic factors.