“Don’t hyperventilate”

We reiterate our view that the Australian equity market has retreated into reasonable value territory. Of course, we make the usual disclaimers: no investor should be in any doubt that immense economic challenges continue to confront the world. The growth outlook across the developed world remains constrained and the fall in global equity markets is reflective of excessive prices in Europe and the USA. 

Based on intrinsic valuation metrics, world markets were somewhat elevated. So this week’s market corrections were overdue and are bringing equities back towards value in Europe and the US, while the Australian market is now offered at an attractive level.

Here’s the problem…

From this point, we can adjust our expectation of returns over the next 12 months. Simply stated, the Australian market is much more attractive at 5,000 points than it was in the 5,600 to 5,900 level. Therefore, we suggest that the Australian equity market forward return profile has lifted above 10%. Similarly, a pullback in income securities and hybrids suggests a forward return of about 6%. For the Clime International Fund (which remains 55% in international cash), we see a return of above 10% being possible given our expectation that the $A is now headed below 70 US cents.

The Australian dollar will reflect the sobering outlook for commodity prices

The low prices for iron ore and coal are well reflected and understood in the equity market, but seemingly less so in the market value for $A. Commentators rarely connect the outlook for the $A to our terms of trade and the outlook for the trade account. Commodity prices generally (and specifically energy prices) have declined to decade-low levels. The sustained decline in oil prices has benefited the broad Australian business and household sector, but it is a serious problem for the vanishing returns that should have been generated on hundreds of billions of investment in export LNG. The current oil price reflects into the LNG market, and has crunched expected returns from the third wave of Australia’s export boom. A lower oil price for a sustained period will add to downward pressure on the $A.

Australia’s major export commodities

The following represents observations on Australia’s major export commodities:

Oil

The US Energy Information Administration (EIA) thinks that in the near term, oil production is likely to decline as a reaction to recent prices and a significant reduction in rig count and capital expenditure. In the light of market developments, this makes sense. Inventories have built in the system, so price increases may be delayed. Annual demand growth for oil has been around 1-2% for the last 50 years, and expectations are that over the medium to longer term, demand growth of ~1% is the most likely outcome.

Figure 1. Oil cost curve
Source. Financial Sense

 

We suggest that oil prices are bumping along their lows, right on the global average cost of production ~$50, and are likely to head north in the next 6 months as production falls and inventories are consumed. Speculators are likely to re-enter the futures markets heading into the northern hemisphere winter.     

Copper

Figure 2. World copper demand
Source. AQM Copper; Data Source. CRU

 

While copper prices have been under pressure lately, the longer term demand for copper is sound largely dependent on the Chinese and Indian growth stories. Even at current spot prices, some 92% of the cost curve is making margins on copper sales. 

LEAD Technologies Inc. V1.01

Figure 3. Copper Cost Curve (2015)
Source. Wood Mackenzie, Credit Suisse estimates
 

It is well known that grades have been falling, and this will be supportive of prices over time. 

Figure 4. Average Grades for Copper
Source.  AQM Copper

 

The oil, copper, coal and iron ore forward prices are directly associated with prevailing expectations of growth patterns in China and India. These two countries are the swing players in the demand profile. Commodities generally have been under pressure due to short term weakening in demand, but actual demand profiles have so far held up quite well.   

The most pervasive thematic of industrial metals and particularly copper is the urbanisation of China and India, with the expected increase in urbanised populations over the next 10 years forecast at 1 billion. If you believe that, and the trends are indeed supportive, then combined with declining grades globally, copper over the medium term is likely to be re-rated.

Iron ore and metallurgical coal (used to make steel) are difficult to call; some think Chinese steel production has peaked, while others (for example, RIO) think it will peak sometime in the 2020s. With recent price declines, new capital expenditure is likely to be muted, however existing projects will probably complete and the peak in supply growth will likely be this year or next. It is hard to be overly bullish on either iron ore or met coal from a supply point of view, however demand will probably hold unless there is an unexpected further reduction in global growth.  

Iron ore

Figure 5. Iron ore cost curve
Source. Fortescue Metals Half-year presentation 2014

 

Figure 6. Metallurgical coal cost curve
Source. Macrobusiness

 

Thermal coal (used in power generation) is closer to the bottom of its cycle and is irreplaceable for base load electricity in many parts of the world, particularly the emerging economies. In 2011 and 2012, there was a surge in capital expenditure followed by supply (around the time New Hope Coal received their high bids). Since then, additional supply has hit the market and suppressed prices. Given growth remains around current levels, thermal coal is likely to be close to its bottom. There have been some exits from the market, however the low cost of debt is dragging the timeline for rationalisation; and the same goes for iron ore and oil producers.  

Figure 7. Thermal coal cost curve
Source. Macquarie