* We believe a number of factors are coming together that could potentially deliver a secular shift in returns from the mining sector:
In the near term the Chinese government’s “guarantee” of 7.5% GDP growth for 2014 implies further stimuli and a strong H2 recovery. Likewise for the US, where we expect GDP to accelerate into H2. Further out, a European recovery is in the offing and last, but not least, the “Modi effect” which could be the most powerful of all. Meanwhile price risk has diminished in bulk commodities with the 40% fall in iron ore price and coal prices seemingly finding support. The outlook for base metals is exciting following capex withdrawal. We are on the cusp of a cash harvest for the sector in 2015 and valuations look interesting, plus concern over iron ore is prevalent leaving many of our clients underweight (á la the Oil sector in March). As such we upgrade our sector view from Negative to Positive.
* A trading buy for the iron ore producers: We continue to favour base metal exposure
over iron ore in particular on mid to long term basis. However there is a strong chance, if
we’re right about macro conditions, that we could see a bounce in the iron ore equities,
which are all trading on material discounts to the sector. So, on a six months basis, we are
upgrading Rio Tinto (EW to OW) and Vale (UW to EW) of the big caps and London Mining
(UW to EW) among the small/mid caps
* Macro outlook promising: The recent Chinese PMI survey reached 50.8 from 49.4,
surprising positively. The May FAI figure rose to 17% YoY with state-led FAI up to
16.7% from 14.2%. Premier Li’s guarantee of 7.5% means growth needs to increase to
9% QoQ SAAR in H2 from 5.8% in Q1 (see More easing to achieve c7.5% target). US
economic conditions are also likely to improve in H2. European growth has stopped
accelerating for now, however the combination of accelerating bank recapitalization
and liquidity injection could lead to improvement and at least there is some rebalancing
with peripheral capital markets outperforming. A weaker euro would be a strong boost.
Of course the real excitement for our space would be an investment led secular growth
story in India which is clearly more likely under Modi, albeit a long way off. Any inflation
fear in this mix is also positive, plus any trends in increasing capital spend by public and
private sector alike.
* Our base over bulk preference remains but has played out a lot: Our index for base
metals (+21%) has outperformed our bulk commodity index (-15%) by 36% in the last
year. We are at or below the marginal cost for virtually all commodities and certainly
below the greenfield incentive prices.
* Valuations remain attractive: Despite a strong re-rating YTD, the diversifieds’ average
PER multiples are the second lowest of any sector in the UK market. P/NPV is below par
and the Price/Book at 2003 levels. It is extremely rare to have a combination of
improving economics and low valuation metrics in this space.