6th May 2021: This month’s commentary has been written by Devon Portfolio Manager, Tama Willis.
Recently I attended a UBS hosted virtual China Commodity Tour. In light of the observations that I had made back in a research note to you all in December 2020, I thought it would be useful to provide an update to those views given recent positive trends.
China is not only the world’s second largest economy, it is also Australia’s and New Zealand’s largest trading partner (c. 30-40% of both countries’ exports) and its economic performance influences investor sentiment in both economies. In recent times navigating a more assertive China under President Xi Jinping has been a key factor to monitor for investors in Australasian equities. China in particular has proven itself to be very effective at managing COVID-19, which allowed a strong recovery to develop. More recently the pace of vaccinations in China has picked up reaching 200 million shots with the government targeting 40% of the population by July. In terms of macro developments, Q1 2021 GDP growth jumped 18.3% (relative to a year earlier) whilst sequential growth slowed, as expected, to about 2% (quarter-on-quarter). UBS expect this to stay at around 6% for the balance of the year, resulting in a full-year GDP growth forecast of 9%. This mirrors a strong growth recovery in the US being driven by policy stimulus and progress towards a normalization of activity– Goldman Sachs is forecasting over 7% US GDP growth for 2021. Other growth metrics in China remain robust; Fixed Asset Investment rebounded 25.6% in the first quarter, Industrial Production grew by 28% and Retail Sales rebounded 34% (8.5% higher than the first quarter of 2019). Similar trends were evident in property with sales up 64% from where we were this time last year. With Chinese stimulus beginning to recede, growth rates will moderate but real consumption growth should remain robust in the period ahead.
Key presenters in the UBS tour highlighted a broadly positive demand backdrop but one where the authorities are focused on moderating any excesses. The government is tightening credit availability to property developers to avoid overheating with forecasts of lower housing starts in 2021, although Infrastructure is expected to grow by 6.5-7%. This combination suggests positive steel demand this year (a recent CLSA survey estimated more than 3% growth). Policy makers in China are increasingly focused on restricting steel exports and limiting production due to pollution in a number of key regions, in particular Tangshan. During the past week China removed steel export tax rebates for 146 types of steel products and will increase the export tax on certain steel products from 15% to 20%. With steel exports in China currently annualizing over 60 million tonnes, the government is now clearly signaling a new direction in this area. China produced 271 million tonnes of crude steel in the first quarter of 2021, up 15.6% year-on-year. On an annualised basis this equates to 1.08 billion tonnes. If China maintained this level of steel output for the rest of the year, expectations were that annual production would therefore increase by around 4%. However, following the tour and recent news flow around the removal of export rebates, our base case has now been revised lower and assumes that China will reduce their exports through the balance of this year resulting in steel output growth of only 1.5%.
On the face of it this is a negative for iron ore demand in China with over 80% of output being produced from blast furnaces (a process that requires iron ore at a ratio of 1.7 tonnes of ore to produce a tonne of steel). However, with China withdrawing tonnage from the steel export market we expect other regions to increase blast furnace capacity utilization to make up the difference. Principally this will be evident in Japan, South Korea, Taiwan and to a lesser extent Europe. This shift in productive locations will help offset the lost tonnage of iron ore demand from China. In addition, it is worth noting that China’s focus on pollution is resulting in a higher demand for the best quality iron ore (lump and pellets). This works in favour of the large Australian miners, BHP and Rio Tinto.
The iron ore supply side remains relatively constrained but production from Brazil is gradually improving, as their COVID challenges improve. We forecast that major producer Vale will increase volumes by 30 million tonnes this year from their mines in Brazil. India remains a major uncertainty with rampant COVID infections potentially reducing last year’s level of exports. Overall the market still appears tight this year but particularly in the first-half of 2021.
Despite the iron ore demand / supply backdrop continuing in a state of flux, in late April its price hit a new record high of close to US$200/t. This ultimately demonstrated that with the world progressing through its recovery phase, and with massive amounts of development occurring in property and infrastructure, the scales are tilted in this commodity’s favour.
As we look forward there remains uncertainty across market commentators as to where the iron ore price will move to. Our central view is that the spot price will weaken over the course of this year to average US$165/t in 2021 and US$120/t in 2022. This appears to be a negative forecast, but such a price would still result in material earnings upside for the mining sector relative to consensus expectations and would also support substantial capital return opportunities. On the basis of the current iron ore price the sector is generating a free-cashflow yield of almost 20%. On our base case of a declining price, the free cashflow yield ranges from 10-19% in FY21 and 10-13% in FY22. Our top pick in the sector is Rio Tinto – we estimate Rio can return 35% of its market capitalization over the next three years and remain debt free. If it were to raise even a small amount of debt the potential size of a capital return increases materially. Both BHP and Rio Tinto are more diversified commodity exposures than Fortescue and with better quality iron ore, so this is our least preferred exposure in the sector.
Our core insight from the UBS-hosted event was that while the overall backdrop remains supportive for iron ore, there are a myriad of factors which need to be carefully navigated at an individual country and stock level. We believe this backdrop remains supportive for our active investment approach.