The first signs of a correction between banks and miners are showing, as miners have started to rally on better-than-expected US jobs growth, supportive Chinese trade data and further Central Bank stimulus.

Ronge says the RBA rate cut and commentary confirms that the Australian economy is growing below trend and that credit growth will be challenging moving forward, a definite head-wind for banks.

“Banks and miners largely traded in-line to the end of 2011, and as before, ASX banks rallied from the end of 2011 to hit a 5+ year high with investors chasing yield in an environment of falling cash rates and bond yields,” says Ronge.

“Conversely, resources have continued to fall to be at or near GFC lows.”

“Any degree of normalisation between banks and resources from these levels will see a significant re-rate in miners in an absolute and relative sense versus banks,” he says.

“While it is difficult to time markets or ring a bell at the bottom, clients should be made aware of the severity of dislocation between these two sectors and the potential risk to returns by having an underweight position in resources, overweight financials,  especially from such extreme levels.”

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BREE makes the claim that “the total committed expenditure on Australia’s oil and gas projects is comparable to the total cost of the Apollo Moon Program in 2012 prices.”

What does it all mean?

• The Government’s chief resources forecaster wanted to give some sense of the enormity of all the committed oil and gas projects, and they have concluded that it’s like landing man on the moon. More specifically, BREE noted that “the total committed expenditure on Australia’s oil and gas projects is comparable to the total cost of the Apollo Moon Program in 2012 prices.” In other words, it’s a big deal, and the enormity of the work to be done is probably not recognised by the average Australian.
• Anyone claiming the China boom is over had better think again. There are 87 committed resource projects in Australia – greater than the average number of projects recorded over the past eight years. And the value of committed projects has hit fresh record highs. In short, there is a lot of work to be done. And most countries would give up almost anything to be in Australia’s position.
• The big change is that work has become more concentrated into “mega” projects – projects with an investment value above $5 billion. And the work is further concentrated on the type of project (largely LNG) and concentrated by region (largely Western Australia, Queensland, NSW and Northern Territory). While the resource regions will benefit in the construction phase, they will also be significant beneficiaries of on-going income, employment and activity for the regions in the longer-term.
• It’s important that Australians get over their short-term focus and instead concentrate on the investment and production implications of the resource projects over the next 5-10 years.

What do the figures show?

• The Bureau of Resources and Energy Economics (BREE) has estimated that there are 87 committed resource or energy projects as at October 2012 valued at a record $268.4 billion.
• There are also 106 Publicly Announced projects valued between $91.0-133.2 billion; there are 171 projects at the feasibility stage valued at $291.9 billion; and 24 completed projects totalling $11.9 billion.
• BREE notes: “The $268.4 billion investment value consists of 87 projects that have received a final investment decision including 51 minerals projects, 18 gas and petroleum projects and 18 infrastructure projects.”
  “There are 11 ‘mega projects’ identified in the report that account for $201 billion, or 76 per cent of the total committed investment in resources and energy major projects. Most of these are LNG projects located in the Pilbara region of Western Australia and Gladstone in Queensland.”
  “In the six months to October 2012, 10 projects worth $13.2 billion were committed to after receiving a positive final investment decision. The largest of these was for an additional LNG train at the Australia Pacific LNG plant at Gladstone, Queensland.”
• To be expected, there has been some scale back of investment plans. Paraphrasing BREE: There have been 10 projects, worth $13.2 billion, that progressed to the Committed Stage of development. By comparison, in the six months from November 2011 to April 2012, 21 projects were committed to with a combined value of $45 billion. However that included the Ichthys LNG project in the Northern Territory which alone accounted for $33 billion of this total in the April 2012 listing.

What is the importance of the economic data?

• The Bureau of Resources and Energy Economics (BREE) provide estimates of committed resource and energy projects in Australia every six months. The information is useful in tracking workflow for mining, engineering and construction sectors.

What are the implications for interest rates and investors?

• The Reserve Bank will be encouraged by the record pipeline of resource projects as well as other data today showing record construction spending. The chances of a December rate cut have been downgraded.
• It’s clear that some investors listened too hard to the “China boom is over” school of thought when they should have been doing their own homework. The pipeline of resource projects remains significant. But the onus is also on mining and engineering firms not to drop the ball and ensure that costs are contained so the significant projects can go ahead as planned without deferral or scaleback.
• The Aussie dollar will be supported over coming years by the large investment pipeline.
• The extent of scaleback of plans over the past six months has only been modest once account is made of the Ichthys LNG project.

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“The resource sector has again outperformed on a yearly basis with investors in our Metals & Mining ETF enjoying returns of 21%, almost double that of the ASX 200 index,” said Annmaree Varelas, Aii CEO.

This is consistent with the long-term trend for resources, with the Metals & Mining, Resources and Energy sectors all outperforming the ASX 200 over a five-year period.

Local ETF researcher, PennyWise Investment has for the last 12 months taken an overweight position in resource-based ETFs within their model portfolios, and their view isn’t likely to change in the near future.

“Although commodity prices are likely near their peak for the next year or so, the demand profile facing Australian resource companies remains strong and valuations are far from expensive.  The local resources sector also retains good relative price momentum in global markets, and remains among our preferred ETF exposures within our satellite model portfolio,” said David Bassanese, Managing Director of PennyWise Investment.

“Sector ETFs can maximise portfolio returns with income and growth opportunities. An investor seeking higher income could look to invest in the Aii Financials x-A-REITs ETF with a grossed up yield of 8.22% or capitalise on long-term growth with the resource ETFs,” said Ms Varelas.“In both instances, it takes away the guess work for investors over which stock to pick, minimising the stock specific risk in portfolios.” said Ms Varelas.

“Research has shown 70-80% of a stock return is generated by the market and the sector, not the stock. So taking a market view by picking the right sector, you are 70% of the way there,” said Ms Varelas.

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Many investors buy gold producing companies to gain a leveraged exposure to movements in gold prices. The S&P/ASX All Ordinaries gold index increased just 38% over the three years to May 2011 while the US dollar gold price rose 73% and the Australian dollar gold price was up 55%.

“Among the 47 stocks within the Australian index, only 22 rose by more than the rise in the Australian dollar gold price,” said John Robertson, E.I.M. Capital Managers.  Only 19 rose by more than the rise in the US dollar gold price.

The stock prices of gold companies can perform poorly against movements in the physical gold price because:
gold stocks are exposed to equity market conditions which might be less buoyant

• operational risks can affect output adversely
• development risks can delay production starts
• the financial condition of the company may retard market valuations

All or some of these factors can detract from a company’s share price compared to the gold price.

“The range in stock returns can be enormous.  Over the three years to May 2011, the weakest performing gold stock in the index lost 79% while the strongest returned 1900%.  The largest and best known stock in the sector, Newcrest Mining, delivered a sub-par return of 25%.

“Investors seeking the leverage equity investments can deliver need to structure the gold segment of their portfolios to take account of the high probability that the share price of a gold producer, no matter how well known, could fall short of the gold price rise thy are seeking to capture,” said Mr Robertson.

E.I.M.’s Emerging Resources Company Share Fund has delivered an annualised rate of return after fees of 16.7% over the five years to 31 May 2011 putting it in 4^th place in the Morningstar rankings of over 2,000 retail investment trusts in Australia.

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In its first quarter update to investors, the AAIC has decided to maintain a neutral stance on Australian equities, hold an overweight to income securities and maintain listed property allocations at zero across all of Implemented Portfolios’ individually managed accounts.

According to AAIC member Jon Reilly, Australian Equities will be supported by continued demand for resources from China, India and other emerging markets, whilst the banks may have slow growth but will still provide solid returns underpinned by their dividends.

“This quarter we have determined to move towards a lower allocation in international equities, but will do gradually, taking advantage of further strength to lock in returns.”

“This is consistent with our investment strategy of buying when we view classes as fair value or undervalued and selling incrementally as they become more expensive,” Mr Reilly said.

Continuing to favour income securities over cash, the AAIC has held its overweight position and maintains a preference for securities issued by the major banks.

The committee’s assessment of A-REITs last quarter was that they were expensive and the outlook was likely to remain subdued. This assessment has not changed in the first quarter, and the portfolios have now moved to a 0% allocation to listed property.

“The AAIC’s decisions this quarter reflect the continued need to be cautious. We have positioned the portfolios defensively but will add to equities allocations when valuations become more attractive. On balance the portfolios will continue to capture the growth from Australian equities, and consistent distributions from the income securities exposure.” he said.

“In 2011 we expect there will be continued sluggish economic growth in the developed world, and significant risks from managing the build up of debt in those countries. Whilst growth rates will be better in emerging markets we are conscious that valuations are no longer as attractive as they once were, which will likely suppress longer term returns.”

The AAIC is comprised of a team of professional managers that make implementation and investment decisions for Implemented Portfolio’s range of Individually Managed Accounts. The quarterly update is the AAIC’s long term assessment of each asset class amid the broader context of the economic environment and investment markets.

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“We are seeing increased interest from SMSFs, particularly in our two resources ETFs (ASX Codes: MAM and RSR).  SMSF trustees seem to be using our sector resource ETFs to bolster their existing share portfolios,” said Michelle Morgan, Marketing Manager at Aii.

Aii found that the average trade by an SMSF was around $25,000 to invest in its ETFs.

“Quite often SMSF portfolios hold major mining and banking stocks but when seeking to add a tilt towards mining/resources, trustees are caught in a bind between bulking up their BHP and Rio Holdings or using research to find the next star mining stocks.

“Buying a resource sector ETF allows a greater allocation to the sector without needing to sell down existing stocks or add individual mining stocks. This can be done for the cost of a single share trade on ASX and they have piece of mind knowing that their investment fully replicates the underlying index.

“By holding a basket of resource stocks via a resource ETF means that investors naturally increase their exposure to the major players but also pick up smaller miners/explorers who can provide capital growth opportunities over time.  SMSFs can achieve this outcome easily and cost-efficiently, without spending large amounts of time on research and stock selection.

“Mining is hot now but what about when other sectors start to shine? Investors can sell down their mining sector ETFs and buy into a Financials or Industrial ETFs as market sentiment turns to these areas.

“We believe that SMSF trustees are using our sector ETFs to not only get an overweight position is a sector but also make new investments without touching their core share portfolios that would trigger CGT events,” said Ms Morgan.

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Shoprite operates one of the most profitable supermarkets in the world because in the past 15 years it has built 71 stores exporting its high-volume, low-cost business model to 16 of Africa’s 53 countries, where organised, large-scale retailing is mostly a new concept.1

The example showcases the 21st century investment potential of the world’s second-largest continent by landmass and population. The gains made in Africa over the past decade hint of the rewards that could await investors.

The quadrupling in oil prices over the past 10 years, for instance, has enriched the region’s oil exporters such as Nigeria and Angola. Foreign oil companies have boosted investment, while taxes on oil have swelled government coffers and allowed for public spending on infrastructure and basic services. At a macro level, oil-producing countries have reduced public and external debts and bolstered foreign-exchange balances.

Not all African countries have oil, but many boast other resources, from aluminium and bauxite to phosphate rock, coal and uranium, not to mention gold in South Africa or the 10 diamond-producing nations behind Africa’s US$8 billion (A$8.9 billion) a year diamond industry.

The Chinese have noted this mineral wealth. To improve its energy security, China has invested in the oil producers, in Niger for its uranium and Tanzania for its copper, among other places.

China, in total, provided about US$33 billion in aid and investment to Africa between 2002 and 2007.2 Given China’s energy needs, it seems likely that Chinese money will propel African trade, investment and economic growth for a while yet.

Strong consumption

One reason why Africa is overlooked by investors is a perception that domestic demand is constrained, a view reinforced by frequent images from the continent of poverty, famine and conflict.

The consumption potential of a region or country is determined by demographics, income levels and economic growth rates, and Africa’s scores on these measures are improving.

The continent has over a billion people and the UN forecasts that number could soar to two billion by 2050.3 Because this population is relatively young, the continent has an estimated working-age population of more than 500 million people that is predicted to more than double by 2040. Other favourable demographics include a shift towards urbanisation (city folk generally earn and spend more) and a low dependency ratio (the number of dependants to the working-age population).

Income levels are rising thanks to strong economic growth that, as the graph below shows, has seen Africa outperform the global and advanced economies in the past seven years.4 GDP per capita for Africa more than doubled from about US$680 in 2002 to more than US$1,545 in 2008, according to the UN.5 If this growth rate is sustained, regional per capita GDP would double again by 2013.

More interesting from an investor’s perspective is the jump in the number of higher-income earners. According to McKinsey,6 Africa already outscores India on the number of middle-class households (defined as those earning more than US$20,000). Moreover, those with annual earnings of at least US$5,000 (a level above which consumers spend roughly half their incomes on non-food items) could jump to 106 million by 2014, from 59 million in 2000.

As Africa’s middle class expands, opportunities will arise for consumer companies, rather than just material companies – resources accounted for nearly a quarter of Africa’s GDP growth between 2002 and 2007. McKinsey projects that consumer goods and services will generate sales of US$1.4 trillion on the continent in the next decade, compared with US$540 billion from resources over the same period.

Investors can benefit from Africa’s consumption growth because a lack of competition, solid economic growth and cheap labour allows consumer companies to enjoy high margins, notwithstanding the region’s challenging business environment. Stocks that give investors exposure to African consumers include Guinness Nigeria and the South Africa-based media conglomerate Naspers.

Guinness Nigeria benefits from that country’s robust economy and having industry-leading profit margins for its core product beer. Naspers is a more diversified operator that has significant exposure to the fast-growing satellite and cable TV markets of some of sub-Saharan Africa’s 47 countries. In June, Naspers said it had gained 634,000 additional subscribers in sub-Saharan Africa in just 12 months.

Risks

Naturally high risks surround such potential. Political risk is often elevated, if not a deal stopper, as many African countries are susceptible to conflict or sudden changes of government.

Many countries are under one-party or military rule so there is no rule of law to protect businesses or investments. Corruption can be endemic. Foreign companies tend to confront vested interests, weak regulations and poor corporate governance.

These risks, however, vary among countries. South Africa in many ways resembles western markets. At the other extreme are chaotic examples such Zimbabwe, whose economy has collapsed since President Robert Mugabe came to power in 1987, and Zaire, which was plundered by its President Mobutu during his reign from 1965 to 1997. The task for investors is to find those countries that may offer high returns for the risk.

Even when viable markets are identified, there is often a lack of investable instruments for investors as Africa’s financial markets are underdeveloped. Equity and bond markets suffer from liquidity constraints and sometimes regulations discriminate against foreigners. However, once again, these flaws vary across the continent.

At the same time, the case for investing in Africa is bolstered by low correlations with developed markets owing to the region’s aloofness from the global economy.

But while the risks are higher than elsewhere, so too are the potential rewards. Just ask Shoprite. It intends to have 50 stores in Nigeria within the next three years.

Regional versus global growth comparison

IMF Africa Regional Economic Outlook, April 2010

1 http://www.shoprite.co.za/pages/127416071/About.asp
2 McKinsey Quarterly, June 2010 edition
3 UN Department of Economic and Social Affairs, http://esa.un.org/unpp/p2k0data.asp
4 IMF Africa Regional Economic Outlook, April 2010
5 UN Statistics Division, http://unstats.un.org/unsd/snaama/downloads/Download-GDPPC-USD-regions.xls
6 McKinsey Quarterly, June 2010 edition

Important information

Investments in small and emerging markets can be more volatile than other more developed markets

References to specific securities should not be taken as recommendations.

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