Resources Collapse: A False Alarm

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Oct 26, 2014
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Contributing editor Gavin Graham is back with us this week with some thoughts on the recent meltdown in resource prices and what it portends for the future. Gavin is an expert in international securities and has held senior positions in financial organizations in London, Hong Kong, and Toronto. He is currently chief strategy officer at Integris Pension Management, a provider of personal pension plans for incorporated individuals. He divides his time between Toronto and the U.K. Here is his report.

Gavin Graham writes:

Stock markets around the world have fallen between 5% and 8% in the last couple of months since reaching new all-time highs. This reflects concerns over mounting global problems such as the takeover of much of Iraq by ISIS (The Islamic State in Iraq and Syria), continued fighting in eastern Ukraine, and the rapid growth in the number of Ebola victims in West Africa. There have also been signs that U.S. GDP growth is slowing and that Europe is falling back into recession, with the IMF putting the chances of that happening next year as high as 40% at its just concluded meeting in Washington.

Perhaps the major worry for stock market investors has been the slowdown in the Chinese economy, which is the driver of much of the world demand for commodities such as coal, iron ore, and oil and gas. Official Chinese GDP figures, which should always be treated with caution, forecast that China's GDP will grow by 7.5% this year, the slowest pace since 2008. The World Bank lowered its forecast for China's GDP growth in 2014 to 7.4% from 7.6% and for next year to 7.2%, from 7.5%. Some private sector forecasters, who look at such measures as electricity consumption, rail freight, and container shipments, believe China's real rate of growth so far this year to be nearer 4%-5%. Either way, China has experienced a sharp slowdown from its double-digit growth in 2010-11.

This is unsurprising, given that the new Communist leadership, led by Premier Li Keqiang, has been attempting to rein in over-rapid domestic growth, including lavish expenditure and the associated corruption by local and regional governments. That has resulted in a dramatic fall in luxury goods sales such as spirits and prestige gifts, like watches. China's home sales fell 11% in the first eight months of 2014 and home prices fell in 68 of the 70 major cities tracked by the government including Beijing and Shanghai. That was the most since the beginning of 2011. The property sector, including housing, which accounts for almost 20% of Chinese GDP, is one of the principal users of commodities such as steel, copper, and cement, and indirectly of coal, oil, and gas.

Following the National Day celebrations at the beginning of October, Premier Li made it plain that the government will use targeted measures to tackle financing costs and difficulties and support economic growth. China's economy, Li noted, "was in a reasonable range"; even though "downward economic pressure"; both domestically and globally was big. This is code for the government relaxing its austerity measures to counteract the slowdown in the economy. It was reinforced by the announcement that Chinese citizens were now to be allowed to invest their savings in overseas stocks and properties. This would take place through a Qualified Domestic Retail Investor (QDRI) scheme, which would allow Chinese nationals to directly buy stocks in such markets as Hong Kong.

This is similar to a scheme proposed in 2007, nicknamed the "through-train";, which was later abandoned. But the Chinese central bank, the Peoples' Bank of China (PBOC), announced in January 2013 that it had started preparations to allow Qualified Domestic investors to be permitted to invest overseas. Singapore and London were awarded quotas by China last year to invest in Chinese yuan assets and clearing banks were appointed. The yuan began direct trading versus the pound sterling in June 2014, and the Singapore dollar is expected to do so later this year. This means Chinese nationals could begin investing in these markets once permission is granted.

Meanwhile, the PBOC also announced that Chinese companies could begin issuing yuan-denominated shares in London and Singapore. The world's biggest bank in asset terms, Agricultural Bank of China, announced in early October it would issue yuan-denominated Global Depositary Receipts (GDRs) in London. All of these measures are directed towards giving Chinese citizens an alternative to domestic stocks and property. Neither has performed well over the last couple of years, although the Shanghai Index is actually up 10.6% so far this year.

These measures are especially aimed at diverting investors from buying products issued by the so-called "shadow banking system";, which has been soaking up China's enormous savings by offering high interest rates.
Some of these shadow banks or trusts have run into difficulties due to the financial tightening the government introduced. Earlier this year, China Chaori Solar Energy became the first Chinese company to default on its domestic bonds. On Oct. 8, China Great Wall, one of the government banks set up in 1999 to buy bad (defaulted) assets from state-owned financial institutions, agreed to guarantee US$128 million of China Chaori's defaulted bonds, a sign that the government is willing to begin relaxing its financial tightening measures.

This should be reassuring to commodity producers and investors generally. However, that has not been reflected in the share prices of resource companies, which have plummeted between 10% and 30% over the last month. For example, West Texas Intermediate (WTI) oil has fallen to US$82.92 a barrel and Brent crude is nudging US$86. Both are close to four-year lows. Coking coal is at a seven-year low of US$77 a tonne while iron ore is down 40% this year to US$80 a tonne, In sum, resource stocks have been beaten down severely, principally driven by fears of a prolonged Chinese slowdown.

Amongst major Canadian base metal companies for the month ending Oct. 10, diversified miner Teck Resources (recommended by my colleague Glenn Rogers) was down 24%, nickel producer Sherritt (an Income Investor recommendation), was off 30%, and First Quantum had lost 23%. My IWB pick, coal and metals royalty company Anglo Pacific, is down a smaller 9%. This is partially due to its illiquidity but it shows that royalty plays hold up better due to having no exposure to rising costs, only to revenues.

Amongst energy stocks, Penn West and Talisman (another Income Investor pick) are down 26% and 23% respectively, as are my other Income Investor resource selections: oil driller Ensco (-19%) and Canadian Oil Sands (-15%). Oil majors Suncor, Husky, and Canadian Natural Resources are also off 14%-15%.

The sector ETFs, iShares Capped Energy and Capped Base Metals, are down 16% and 14% over the same period, as increased oil supply from Libya and Iraq has combined with reduced demand from China and other emerging markets to drive down stock prices.

Even economically sensitive stocks such as auto-parts makers Magna and Martinrea are down 19% each in the past month. Linamar (one of my IWB picks) has given back 15% in that time.

Interestingly, gold shares, while also down over the last few weeks, have performed better. While Barrick Gold is off 18%, my IWB recommendations Agnico Eagle, Franco-Nevada, and Goldcorp are only down 13%, 6% and 2% respectively. The iShares Global Gold ETF is off 12%. It may be that investors are looking for a safe haven amongst the geopolitical worries, although presumably that should have helped the price of oil and gas as well.

There are some signs that Chinese growth is reviving. On Oct. 13 it was announced that exports for September were up 15% from a year earlier, with imports up a smaller 7%, leaving a trade surplus of US$31 billion. While the growth in exports is mainly driven by external rather than domestic demand, with imports for processing and re-export up strongly this at least helps offset the domestic slowdown.

With the Chinese authorities giving the signal that monetary conditions and lending are being relaxed, and allowing the outflow of Chinese savings, it is reasonable to assume that China's GDP will be able to grow around 7% next year. This means that commodity prices should stabilize around present levels and then rebound somewhat as resource companies benefit from higher prices and increased demand. Combined with the cost cutting measures these companies are undertaking, earnings should be higher next year, as should share prices.

If IWB readers are feeling adventurous, they could look at the iShares China Large Cap ETF (NYSE: FXI), which gives exposure to the 25 largest Chinese companies. With an expense ratio of 0.74%, it sells at a p/e of 13.2. The fund has a dividend yield of 1.9% and is up 0.7% over the last year, but 7.5% per annum over the last three years, despite the slowing Chinese economy. While most of the companies in the ETF are listed but state-controlled banks and oil companies, there several private companies such as e-commerce stock Tencent Holdings amongst them. I'm adding this as a Buy to the IWB Recommended List based on my view that Chinese share prices will be higher in 12 months thanks to the loosening the government's financial and monetary policy. The units closed on Friday at US$38.24.

What it boils down to is that the commodities bust may finally be bottoming out. A year from now we may be looking back and wondering how the stock prices got so low. I'm not suggesting you should load up your portfolio with resource stocks right now but you may want to dip a toe in the water.

iShares J.P. Morgan USD Emerging Market Bond ETF (NYSE:EMB)

Originally recommended on April 9/12 (#21214) at C$21.16. Closed Friday at C$21.61, US$113.96.

This ETF invests in U.S. dollar denominated sovereign debt issued by emerging market countries. It has held up well given the tumult in financial markets in the last couple of months. For the Canadian dollar hedged version, this is partially due to the weakening of the loonie against the U.S. dollar, with the currency hitting a five-year low last week, as well as to the defensive nature of dollar-denominated debt issues at a time when government bond yields are falling and their prices rising.

The fund's top 10 holdings of bonds in relatively stable economies such as Turkey, Mexico, Brazil, Indonesia, Colombia, and China yield between 4.3% and 5.6%. This has enabled the ETF to ride out fluctuations in less well-regarded countries such as Russia (5.3% of assets), Venezuela (3.3%), and Argentina (2.2%). As all debt held is denominated in U.S. dollars there is no currency risk, although declining resource prices in commodity sensitive economies may pose an issue in the future.

The fund has a running yield (after an expense ratio of 0.73%) of 3.9% over the last twelve months. The weighted yield to maturity on its securities is 5.1% and the overall credit rating is BB (54% of the assets are rated investment grade by S&P and 65% by Moody's).

Action now: The fund remains a Buy. It provides a reasonable balance between yield and credit quality from countries of which the majority have good balance sheets and demographics. Investors who prefer the unhedged version may buy EMB on the New York Stock Exchange. It has a lower MER at 0.6% and slightly higher one-year and three-year average annual rate of return.

iShares MSCI Emerging Market ETF (NYSE:EEM)(TSX:XEM)

Originally recommended on April 9/12 at C$24. Closed Friday at C$25.92, US$40.72.

More aggressive investors may prefer to gain exposure to emerging markets through stocks rather than bonds. This ETF invests in the largest and most liquid stocks included in the MSCI Emerging Markets Index. It has made decent progress since being recommended, although it sold off in the last few weeks, with the Canadian version down 8.2% since reaching a 52-week high of $28.24 on Sept. 8.

With 18.4% of its assets in China and 7.1% in India, both of which have been performing well this year, the ETF has been able to overcome weakness in South Korea (14.3%), Brazil (11.4%), and Russia (4.5%).

The fund has been weighed down by a sizeable position (9.9%) in energy companies such as Russian giants Gazprom and Lukoil, Chinese majors Sinopec and PetroChina, and Brazilian Petrobras, all of which are among the top 15 holdings. However, the ETF's large holdings in technology stocks (16.7%) such as Samsung Electronics, TSMC, Tencent Holdings, Hon Hai Precision, and Infosys have delivered decent performance. So have the telecommunications companies (7.7%) like China Mobile, America Movil, and South African MTN.

Emerging markets banks and financial companies make up the largest sector in the ETF at 27.2%. Although there may be some longer-term concerns over the credit outlook for the Chinese financial sector, in general banks in developing countries tend to have fairly simple, profitable, and easily understandable business models. These consist of lending to individuals and companies at healthy spreads above their cost of funding and bringing banking services to the millions of consumers who are getting their first credit card, auto loan, or mortgage. Top 25 holdings include China Construction Bank, ICBC, Bank of China, Brazil's Itau Unibanco and Banco Bradesco, and India's HDFC.

Action now: The ETF remains a Buy for the likelihood of a recovery from the recent sell-off as the emerging markets' superior valuations (10.3 times 2014 price/earnings ratios versus 13.5 times for the MSCI World Index) and better longer term finances and demographics become noticed by investors.

- end Gavin Graham