It could be time to switch to cyclicals

By Simon Hudson-Peacock, Equity research analyst at Momentum Asset Management

Resource equities come with some degree of earnings uncertainty, a situation that is likely to persist in the short term as investors face a capricious world economy and volatility in the sector. A brief and admittedly superficial review of the major world economies suggests that, whilst some risks do persist, perhaps conditions are slowly improving after the hangover of the global financial crisis (GFC) of 2008 and the subsequent era of quantitative easing (QE). If so, it might be time to consider taking some cyclical risk in one’s portfolio by taking a portion of profits from the defensives and local interest rate-sensitive stocks that have performed exceptionally well in the last few years. It is worth contemplating that it has been more than three years since the resource sector out-performed its financial and industrial peers, the longest period of under-performance in recent history.

In the US, QE has proved effective, the Dow has raced ahead as the economy stabilises, house prices have improved and unemployment levels fallen. A stable, low inflation rate also signals that capacity constraints remain unchallenged and that further growth in the prevailing low interest rate environment is possible. The uncertainty in the European economy, whilst by no means resolved, seems to have settled. Aggressive monetary stimulus in Japan is resulting in a revitalisation of the stock market in that country and a re-energised consumer.

China is normalising following the contraction in its export-driven economy that ensued from the GFC. An emerging middle class will improve domestic consumer spending and a recovery in the US should re-stimulate Chinese exports. The resultant rally in economic activity will, in time, revive the country’s demand for commodities, although the intensity of consumption is unlikely to match the voraciousness of the previous decade.

When considering resource stock performance and outlook within the context of a stabilising global economy, gold becomes less important as a financial hedge. With inflationary pressures remaining contained, interest rates beginning to rise and stock markets rallying, the gold price could continue to slide as investors switch into other, more attractive, assets in the coming months. Some currency volatility remains and neither the US or Europe are totally out of the woods yet. Any meaningful renewal of QE or collapse of a major economy within the Eurozone would almost certainly re-ignite the demand for gold.

The platinum industry, on the other hand, has a much brighter outlook, due in large part to the metal being rare, highly concentrated (South Africa holds 75% of the world’s platinum reserves) and having unique, un-substitutable characteristics required for vehicle exhaust emissions control . Supply-side disruptions (electricity and labour) reducing capacity in our country, as well as delayed capital projects as companies wait for a revived European demand, mean that the fundamental market balance has moved from a surplus to a deficit during the last 12 months.

Auto-catalyst manufacturing demand for platinum, unfortunately, remains muted, especially in Europe, whilst available recycled metal continues to increase, thereby sustaining large ‘industry’ stockpiles. However, with emissions legislation set to tighten in Europe and China in 2014 and the uptick in the US economy and stabilising European outlook possibly pre-empting a consumer attitude change, the automotive industry could well turn a corner in those regions (and diesel cars require platinum). This is probably the most important sentiment changing driver for the sector in the short term.

The mining industry in general is currently in the midst of a vicious and drawn out turf war between rival unions, AMCU and NUM. With the political sensitivities around job losses in the run up to next year’s elections and the complicated relationships between the ANC, COSATU and NUM, it is hard to imagine an easy solution for the mining companies. The interference by government in recent company restructuring decisions does not bode well for the long-term sustainability of the sector. In the meantime, production is disrupted and company profitability impacted.

The country is, at the same time, dealing with an economic slowdown, increasing unemployment, a rising trade deficit and declining fiscal receipts. In the face of further downgrades in sovereign credit from the international rating agencies, it is unsurprising that the rand is as weak as it currently is. There is, however, a silver lining in a weak rand for commodity producers. With their revenues largely US$ denominated, a weakening rand mitigates against the working cost inflation that the companies are facing for a variety of reasons. The benefit may be temporary, but it will certainly help until commodity prices start to recover meaningfully.

There are very good reasons for the resource sector’s sustained underperformance relative to financials and industrials. Low commodity prices, high working cost inflation and an anchoring of sentiment to the financial crisis combine with the current heightened sovereign risk assessment to create a perfect storm of negative investor perception. Such negativity is duly reflected in share prices, as one might expect. The resource sector is reliably cyclical, however, and poor profitability self-corrects as capital allocation decisions right market imbalances. International investor sentiment towards the South African mining sector, in particular, is understandably at an all-time low for the reasons discussed. This won’t, however, always be the case and the weak rand becomes a welcome cushion for domestic investors. Good investments are rarely made when everything is going well and value investors with a medium-term view would therefore do well buying into this sector.