Rudi's View | Oct 20 2011
(This story was originally published on Tuesday, 18th October, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).
By Rudi Filapek-Vandyck, Editor FNArena
On Friday UBS made a big switch in its investment view on commodities and commodities stocks and the investment banker made it clear it wasn't joking, issuing multiple documents and strategy advisories to its clientele across the world. The move would have caught many an expert's attention as, unlike peers at Goldman Sachs and Macquarie for example, UBS had been negative on commodities all year.
What makes UBS's switch even more remarkable is that "economic growth" inside or outside China does not feature prominently in any of the motivations to explain the change. So what does?
One of the key motivations for UBS analysts to turn more positive on prospects for commodities and commodities stocks is an unwinding of the short USD/long commodity carry trade that has caused so many headaches to many investors in August. It was always UBS's view that such a cathartic event was hanging in front of the sector, but now that we've gone through the inevitable clean-out in excessive market positioning, the analysts believe the market is en route to a new upswing. Mind you, the unwinding of these market positions is probably going to take a few more months to complete, but that's enough improvement for UBS to start preparing for a change in direction.
Other factors that have been taken into account are cheap valuations, overall market positioning, China's policies, the inventory cycle in the Western economies and dollar fund flows. Let's examine all these factors.
Shares in energy companies and miners have sold off quickly and relentlessly in the past months. The observation that many of these equities are now trading at significant discounts to net present value or on earnings and cash flow multiples not seen for many years is an observation that virtually enjoys universal support among all kinds of experts, across the world. Many also believe that as long as general risk appetite remains low on the back of slowing economies into 2012, this situation may not change anytime soon.
On the other hand, the gap between defensive stocks in the share market and commodities has now grown so wide that some experts believe a short term bounce for commodities stocks has become almost inevitable, if only for pure technical reasons. This may well be the bounce we are witnessing this week and last.
Interestingly, banks had started underperforming about three months earlier than resources stocks this year, but they recently outperformed ahead of the local banks reporting season. This has left miners and energy stocks behind as the laggards, as shown on the chart below which compares shares in Westpac ((WBC)) and BHP Billiton ((BHP)) on a relative comparison since October last year.
Note: UBS is not predicting an immediate recovery rally for commodities stocks is in the making. Instead, the analysts argue the outlook overall is improving and they continue to see further improvement so that the balance will gradually tip in favour of such a recovery rally. The only factor that is currently firmly on "green" (in traffic lights terms) is the fact that overall valuations now look decidedly cheap. Other factors such as market positioning, China policies and the inventory cycle are improving, but not flashing "green" as yet.
UBS suggests we will be much closer to an all green lights situation by December or early next year.
As part of the excessive market positioning, dubbed the "mother of all carry trades", UBS analysts refer to the significant reduction in speculative market positions in commodity markets since May this year, as well as the net outflows of capital in Emerging Markets and the reduction in speculative long positions in commodity currencies such as the Australian dollar. In May, point out the analysts, investors had built up the largest net short positioning in USD ever and -surprise, surprise- this was matched with the largest ever net long positioning in commodities. Both positionings have been significantly re-balanced since.
All the while, note UBS analysts, the escalating bank funding stress in Europe is forcing a profound deleveraging process which has been acting as a further negative for commodities demand. This ongoing deleveraging process is straining short-term financing in markets – both commercial paper and trade finance. This will further encourage weak industrial and commercial credits across all regions to run their businesses for cash, and to destock. Initially, this is a clear negative, but, notes UBS, these businesses will at some point have to start restocking again. That's the positive.
In the words of UBS: "The more it goes on, the more it pushes our signal towards green".
Ultimately, however, it is the trend and veracity of global money flows that determines the underlying direction for commodity prices and thus for share prices of commodity companies. Says UBS. As you can imagine, for someone who has been saying exactly that since I made my Big Calls, first on oil and then on resources stocks back in 2008, this is like music to my ears. I have been telling everyone who cared to pay attention that "we", the investors in these sectors, have now become so important and influential that we might as well consider ourselves The Market when it comes to commodities.
In UBS's words this becomes "we believe that trends in global capital flows are the principal driver of tactical and structural bull and bear markets in the commodities".
What has happened, in UBS's view, is when the Federal Reserve ran QE2 we all went maximum-excited (or should that be "overly exuberant"? "ultra herd comfortable" anyone?), but when the stimulus program ended we were confronted with a deflationary shock. In simple terms: US bonds and the USD landed back in favour, commodities were out.
Which brings us to the obvious question: what is going to pull us out of the present quandary?
UBS suggests it'll be the same as what pushed us earlier into the positive zone: policies by either central bankers, or by governments, or by both.
If you're now thinking "QE3" you are on the right track, but less than half-way. UBS does believe there remains a chance the Federal Reserve might decide to trigger another round of quantitative stimulus (QE3), but only if deflation in the US re-announces itself. This is at present not the case.
It is far more likely, suggest the analysts, that the required policy change will come from China. UBS had earlier formed the view that Chinese authorities would remain in tightening mode for longer than was commonly assumed. Since weakening exports have now joined the domestic property market in exerting downward pressures on the Chinese economy, UBS suggests the question is now how long the Chinese authorities will wait before they start stimulating their economy again. UBS anticipates economic conditions will continue weakening further in the months ahead, implying Chinese policies will increasingly turn green.
In support of UBS's view that economic conditions will get worse still in China, Macquarie analysts recently returned from a visit to the Yangtze River Delta bringing home the conclusion that things seem much tougher on-the-ground for smaller companies than suggested through official statistics. Macquarie analysts observed rising costs (including an appreciating RMB), falling demand and ever tightening financial conditions, despite the fact there have been no changes to interest rates or bank's reserve ratio requirements since July.
More worrisome, perhaps, is that Chinese banks seem to grow increasingly cautious and more conservative in their lending. This acts as a dampener on economic activity and further feeds into the popularity of the shadow lending system and other alternative sources for funding. Macquarie does acknowledge the banks' reluctance can disappear instantly on the central government's command, but thus far a general policy of "targeted tightening" remains in place.
Combining all of the above, it seems the best investors can hope for is for further deterioration in economic growth as well as in inflation. The combination of the two might convince authorities in Beijing sooner rather than later it's time to loosen up a bit and start stimulating overall activity again. It certainly puts the "disappointing" Q3 GDP growth read of 9.1% in a different perspective.
UBS's favourite commodities are thermal coal, iron ore and gold. Its list of most preferred stocks globally is a direct reflection of these preferences. Two Australian-listed companies made it onto the global top ten: Rio Tinto ((RIO)) and Fortescue Metals ((FMG)) – though that's not necessarily a view unique to UBS (understatement). Where UBS differs from (some) other experts is in its choice of least preferred commodities: aluminium and nickel. Many an expert would probably agree with the first choice, not necessarily with the second.
(This story was originally written on Tuesday, 18th October 2011 and published in the form of an email to paying subscribers on that day).