Historically low government bonds and property yields, equity prices that continue to edge higher impervious to any geopolitical news, such as the war in Crimea, and a local currency that sustains itself at high levels despite the fact that export prices have now contracted by 30 to 40%.

The charts below highlight iron ore in Australia and dairy prices in New Zealand.

Further, there is very low volatility and other risk metrics seem benign as we approach a phase of increasing long-term interest rates as QE programmes start to wind down and China enters a period of lower growth.  It appears that the monetary authorities have becalmed markets.

 CBOE Volatility Index (VIX) 2007-2014 

Despite this, there is no doubt that the tide is in fact at a turning point. The price action of different asset classes and industry sectors we have witnessed over the last few years is unlikely to be repeated going forward and will likely be very different over the next five years

This thought process is reflected in the composition of PM CAPITAL’s equity portfolios where we have sold down a number of positions over the last twelve months, with a view that opportunities to redeploy capital would be provided at some future point in time. The basic framework we employ at PM CAPTIAL has not changed, as we firmly believe that the risk reward from owning a business is far superior to that of owning government bonds, property or cash. How superior is difficult to determine because we have an abnormally low level of global interest rates, while the valuation discrepancies in Australia are limited, which combined with the elevated currency and the minimal offshore diversification by domestic investors, would favour the perusal of international equity opportunities. The investment opportunities we are finding most interesting in global markets at present is the evolving recovery in property prices that were disseminated by the Global Financial Crisis, originally in Las Vegas, but recently we have also made investments in Ireland and Spain. There is no doubt that valuations have in fact recovered, however they are still operating under industry conditions that are well below normalised levels and there is a strong prospect of solid earnings growth looking forward, which will drive further valuation expansion. The US housing market has recovered, yet yearly sales are still at least a third below normalised trends. Spain and Ireland are additional examples of the further recovery in property prices. Ireland bore their medicine early and is further advanced in the process, but what we have seen over the last 12 months is a decent recovery in rental levels– office rentals and housing prices in Ireland. A considerable amount of foreign money is streaming into the market and prices are beginning to bid up. Spain is lagging in the process, yet we expect since bottoming late last year, combined with considerable foreign capital starting to flow in, arbitrage opportunities are emerging.

We are also attracted to a number of consumer branded companies, Google, Heineken and Anheuser however price action has not afforded us the opportunity to add to this mix, yet we believe if we are patient some of the businesses we are finding will experience headwinds in terms of near term earnings, and that will create some short term disappointment, which investors will be able to take advantage of.

By Paul Moore, Chief Investment Officer, PM CAPITAL

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Mining: How deep is the hole?

Chart 1 shows that mining as a percentage of GDP is at record highs, although it has started to drop off. The rise in mining has resulted not only in mining capex rising as a percentage of GDP spending, but also that total capital spending has been boosted. We know that a sizeable decline in mining investment is approaching, with capex falling. However, the end of the investment phase of the mining boom is going to be partially offset by the increase in net exports as capital imports fall and exports grow, helping to support GDP growth as the production phase begins.

Nevertheless, the transition will entail jobs losses as fewer workers are required for the production phase. In addition, there will be an income shock for those transitioning away from mining since wages will be lower as non-mining jobs tend to pay less.

Exchange rate and interest rate sensitive sectors which have been hurt by the high Australian dollar and relatively high interest rates (such as housing, overseas education, and tourism) need to recover to help offset the drop in mining investment and they must grow to keep unemployment down. Low interest rates are currently helping housing and consumption but we also need a lower Australian dollar for tourism and education.

How does iron ore factor into the story?

The supply of iron ore has lagged the surge in demand for steelmaking in China, which has led to a quadrupling of its price over the past decade. While supply from India and Brazil has continued to lag, seaborne supply from Australia has increased due to production increases by BHP Billiton, Rio Tinto and, more recently, by Fortescue Metals.

Over the past five years, a lack of overseas iron ore supply to Chinese steel mills has meant that steel producers supplemented it with high cost, low quality domestic iron ore. This pushed up the iron ore price, which in turn gave strength to the AUD.

At the start of 2014, the market expected iron ore prices to fall, as has recently been seen, due to the removal of a large portion of this Chinese domestic supply. In addition, the iron ore market should transition from being in a deficit position to a mild surplus due to increased supply, largely from the lower cost producers in Australia, which will also help to subdue prices.

If iron ore prices drop, isn’t it bad news for the AUD?

Not necessarily. Although prices may fall slightly, the increase in volumes that Australia supplies to China should help to prop up the AUD, which in the past had been driven to some extent by the iron ore price (see chart 2). However, we can also note from the chart that the iron price started falling in September 2011 but this had little effect on the AUD.

Will iron ore exports help Australia’s current account position?

Australia has historically experienced current account deficits as the norm. Moving the budget from a deficit to a current account surplus will require, among other things, a shift to a trade surplus. There should be a significant rise in resource export volumes as the mining boom transitions from the investment to the production stage.

Despite the drop in iron ore prices, export values are increasing due to these greater volumes.  This is expected to continue since Australian iron ore is a low cost, high quality product and is replacing current production of high cost, low quality products in other major export markets. As a result, iron ore now represents nearly 30% of Australian total exports measured by value (see chart 3).

This added around 0.5% to December quarter 2013 GDP growth as the balance of trade went from a deficit to a surplus. The trade account has been largely in surplus from 2008-2012 due to the impact of higher terms of trade. Although the terms of trade remain high, they have fallen from the peak reached in 2012. However, the trade account has not returned to a deficit, like it did in 2009, because capital imports have fallen and volumes of iron ore exports have increased.

Will a current account surplus be positive for the AUD?

The trade account is likely to remain in surplus as the volume of iron ore exports accelerates. Additionally, this increase is currently offsetting the fall in the iron ore price so we should see the AUD more stable going forward. This impact from iron ore should be compounded as the liquid natural gas (LNG) projects are completed and proceed to the production phase, which should further underpin the currency.

What does this mean for the Australian bonds and the cash rate?

Australian government bonds are currently experiencing sustained low yields due in part to the current economic environment and offshore buying. 10-year bond yields are now sitting at around what we view as the new neutral rate of 4.00%, but 3-year yields remain much lower. In our view, we should expect lower rates for longer, which may keep a lid on yield rises. With the recent budget announcement of a reduction in bond issuance, there may also be a small positive effect on our bond market due to reduced supply.

In our view, the Reserve Bank of Australia (RBA)  is at the end of its easing cycle and our base case is that the RBA will keep rates on hold at 2.50% for some time to allow historically low rates to help the economy rebalance and that the next move in rates will be upwards.

However, the timing of rate hikes will not be as early as in previous easing cycles over the past two decades as the present shock to the economy, with the mining boom shifting from the investment to the production stage, requires low interest rates to help smooth the economy’s transition.

The drag on growth this year and next year from the budget is unlikely to be that great due to the government’s back loading of cuts, but it won’t help a fragile economy that is in the process of transitioning from the mining boom. Infrastructure spending will take a few years to come through and announced job cuts won’t help the unemployment rate.

If the budget measures negatively affect consumer sentiment for a prolonged period, then this could also be a drag on economic growth, as could any strength that it gives to the AUD.  All this is likely to keep the RBA on hold for at least this year and perhaps now for longer than previously expected.

Tyndall has launched Bonding with Income – an information kit which aims to help advisers educate their clients about investing in the asset class. Aimed at financial advisers, the guide explains how bonds work and how fund managers choose which bonds to buy, as well as outlining the risks and rewards of adding an active fixed income manager to an investor’s portfolio. Advisers can earn 3 CPD points towards their professional standards by taking the accompanying online quiz. Visit the Tyndall site to access the Bonding with Income guide and do the CPD quiz.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual.  The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

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Significant investment has been made in infrastructure and housing, which has driven the considerable growth in demand for steel and, as a result, for iron ore. James Eginton, Research Analyst at Tyndall AM, provides an outlook for both of these markets and explains why 2014 is set to be a year of transition as these supply and demand dynamics change.

The iron ore market

Whilst steelmaking capacity in China has kept pace with the surge in demand, it has been the supply of iron ore that has lagged and has, as a result, led to a quadrupling of the iron price over the past 10 years.

Key to the supply issue of iron ore has been the inability of the Brazilian producers to add incremental new supply to offset mine maturity, as well as the environmental and political challenges that have faced the world’s largest iron ore miner, Vale. Chart 1 highlights the inability of Vale to deliver net new tonnes.

The seaborne response to the Chinese demand for new iron ore has been led by Australia. It has been dominated by production increases from the incumbent majors, BHP Billiton and Rio Tinto, but has also been supported by the successful growth of Fortescue Metals which is now the fourth-largest iron ore producer globally. Chart 2 highlights the seaborne response from Australia versus Brazil, which has continued to find it difficult to add additional net tonnage to meet the ever-increasing demand from China.

The importance of the supply response is the main driver in reducing the key input cost into steel making – iron ore. The slow response of the supply of iron ore versus the more timely increase in steelmaking capacity has caused sharp spikes in the iron ore price and has led to low profitability of steel mills.

Supplementing iron ore over the past five years has been the high cost, low-quality domestic iron ore from within China. Ore grades in China are as low as 15% (versus the global benchmark of 62%) and require significant beneficiation (refinement) in order to be useful in the steel making process. As a result, a large proportion of Chinese iron ore sits high on the iron ore cost curve. Chart 3 highlights where the Chinese ore currently is assumed to sit at around USD 130 per tonne CIF (costs of production, insurance and freight).

In order for the iron ore price to fall, this low-quality tonnage needs to be removed from the market and replaced by lower-cost Australian and Brazilian iron ore.

2014 marks an important year in the supply-demand balance for iron ore, as it’s likely to be the first year since 2004 that the iron ore market will move towards a small surplus. The size of the surplus or deficit depends on assumptions surrounding Chinese steel consumption, but it is clear that 2014 will see significant additional iron ore produced at a lower cost than Chinese domestic ore. Iron ore supply additions will total close to 200 million tonnes with Rio Tinto, BHP Billiton, Fortescue and Vale contributing approximately 120 million tonnes of this new supply.

The expectation is that the iron ore price will fall from its current price level of around USD 130 per tonne towards USD 110-120 per tonne, with significant declines likely after the second quarter of 2014 and following the cyclone season in Western Australia and Brazil, which has the potential to cause significant disruption to seaborne supply.

Currently, 270 million tonnes per year (on a 62% iron content equivalent) is sourced from Chinese domestic suppliers. Morgan Stanley forecasts that within four years, 70 million tonnes per year will be removed and supplemented by seaborne supply (source: Global Metals Playbook: 1Q14, research paper, 22 January 2014). This is despite Chinese steel consumption growing by 2-2.5% per year in the same period (which should necessitate more iron ore consumption). Thus, the seaborne market, in particular Australia, will be important in displacing this domestic Chinese tonnage.

Looking to the medium term, the iron ore price is also likely to exhibit significantly lower price volatility than it has displayed in recent years. Chart 4 highlights the reason for the lower volatility and it surrounds the flattening of the iron ore cost curve.

Chart 4 highlights that in order to displace 200 million tonnes of iron ore demand in 2013, the iron ore price will need to fall by USD 70 per tonne due to the steepness of the cost curve. However, looking to 2018 and assuming forecasted supply comes to the market, the same 200 million tonne move in supply will only result in a USD 20 per tonne movement in the iron ore price. This will make the iron ore market far more stable in terms of pricing and should assist steel maker margins in the long run.

Nearer term, however, the steepness in the cost curve has the potential to create a volatile iron ore market. The current cyclone season in Western Australia and wet season in Brazil has already seen Port Headland and Cape Lambert closed for two days and Vale declare force majeure due to heavy rains in the south east of Brazil which lasted for approximately a week after Christmas.

The impact was seen in the iron ore prices which ran up to USD 139 per tonne and subsequently moderated back below USD 130 per tonne in mid-January on the resumption of normal supply. The cyclone season in Western Australia and wet season in Brazil will normally run through the first quarter and into the early part of the second quarter.

After this period, new iron ore supply and the potential for Indian iron ore stockpiles in Goa to hit the market threaten to force prices lower through the second and third quarters. The impact will depend on the strength of Chinese steel consumption and inventory levels.

Restocking of iron ore inventory by Chinese steel mills is unlikely to provide a catalyst to promote further buying in the spot market as levels appear to have returned to normal for this time of year, steel mill profitability is low and credit remains tight for steel mills and steel traders. Chart 5 highlights that despite restocking taking place over the second half of 2013, iron ore prices have been relatively stable. This also adds support to the view that the iron ore supply is finally catching up to Chinese demand.

India remains a potential catalyst for pricing volatility in iron ore in the immediate term. Whilst we do not expect the key exporting region of Goa to begin mining within the next 12 months, the issue is what happens to the 11.5 million tonnes of iron ore inventory that is sitting at the port, which the courts have recently approved for sale but had been previously been banned by the government. If this floods the seaborne market in the second and third quarters, it will materially affect the price of iron ore and is a key downside risk.

At this stage, it is expected that the majority of the tonnage will remain within India and be sold to Indian mills as they face concerns about iron ore supply going forward, particularly from the key producing region of Odisha. India has the potential to be a net importer of iron ore and steel in the next two years.

The steel market

The steel side of the story is a case of historically high input costs coupled with overcapacity, leading to margin compression and an industry that is seeing record steel production and consumption, but has been unprofitable for a number of years. China has been the key to global consumption growth but has also been the cause of significant capacity additions.

Market expectations on steel consumption growth for 2014 are around 3-4% in 2014, with Chinese steel consumption totalling approximately 800 million tonnes. By 2017, market expectations are for close to 1 billion tonnes of steel being consumed in China alone. To put this into context, 2013 world steel consumption was 1.6 billion (including 775 million tonnes from China).

Steel consumption is likely to shift during 2014 (and into the medium term) from infrastructure investment towards consumer products as Chinese consumers increase their spending on air conditioners, fridges and dishwashers. Infrastructure spending growth is beginning to moderate with significant investment in rail, roads and electricity having previously been made. This may also mean the shift in steel consumption from long products such as rebar used to support the steel structure in buildings and infrastructure projects to flat products including hot rolled coil used in products such as refrigerators. These two products are produced at different mills and at different quality specifications (with flat products being the higher specified product).

Despite the significant growth in steel consumption, profitability in the sector has been very weak. The key for steel spreads and steel mill profitability to improve in the near term appears to be input cost relief rather than steel price improvement. This is due to the low steel mill utilisation levels which are currently hovering just below 80%. It is assumed that mills need to operate utilisation rates above 85% in order to get pricing power. This is unlikely over the next 12 months. Chart 6 highlights how capacity additions have exceeded production over the past five years leading to weak utilisation levels.

As mentioned previously, there is some hope that iron ore prices will moderate over the next 12 months on the significant new, low-cost supply that is entering the seaborne market. This may lead to margin improvement for steel. Margin improvement is unlikely to be driven by significant price improvement for steel. In the near term, steel prices are unlikely to see significant upside as mill inventories have been high for this time of year, leading to lower levels of restocking and credit conditions in China for mills and traders remaining tight (see Chart 7). Growth in steel consumption above market expectations would be required for material steel price moves.

Looking to the medium term, one potential catalyst for a recovery in utilisation levels (and a subsequent recovery in steel-making margins) is Chinese environmental reforms which could have the effect of curbing capacity.

China has recently announced the closure of obsolete capacity with the plan to phase out 60 million tonnes per year of capacity in the Hebei region alone. A large reason for this push is due to the poor air quality in Beijing which has forced the government to act on air quality, particularly around heavily populated regions. The closure of the obsolete capacity could be the key difference. Past pushes by the government on environmental reforms have not been successful in improving air quality nor has it reduced new capacity.

The key issue in reducing capacity and pushing for environmental reform is that it runs counter to local government objectives on employment, with the steel industry being a large employer in many regions. For example, in the key steelmaking region of Hebei, 15% of workers are in the steel industry and it represents close to 30% of the region’s business income (which is taxable). This makes it a challenge and often puts the local government at odds with the central government. How the central government in Beijing is able to deal with this issue will have a significant bearing on whether net capacity closures are made or whether capacity closures in the region are merely replaced by new mills. It is too early to say which is likely to happen, but has the ability to be a significant upside to steel margins in coming years.

Conclusion

Overall, 2014 marks a transitional year for the steel and iron ore industry. It marks the first time since 2004 (excluding the global financial crisis) that the iron ore market will transition from being in a deficit position (where demand has exceeded iron ore supply) to a mild surplus. This is due to new supply, largely from Australia. At the same time, the Chinese central government has been pushing environmental reforms which could have the effect of improving steel mill utilisation through capacity closures. This is at a time when steel consumption continues to grow (albeit at a slower rate than recent history). As a result, the outlook for steel makers has begun to brighten with the potential for margin expansion and improved financial performance. India continues to remain unclear as to their position in the seaborne market for both iron ore supply and steel consumption. Political uncertainty makes it look increasingly unlikely that India will re-enter the export market with the supply of iron ore, whilst on the steel consumption side, growth in consumption is expected to be supported by internally produced steel. China too remains uncertain as to growth and the desire of the government to push environmental reform.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. TIML is part of the Nikko AM Group.

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