Feature Stories | Dec 22 2020
If the virus has achieved one thing, it is to prompt governments across the globe to pour stimulus into new technologies and renewability that will drive strong demand for Australian resources
-China tariffs not significant
-Commodity demand will build form a weak northern winter
-A new commodities super-cycle?
-Aussie dollar strength inevitable
By Greg Peel
A week, they say, is a long time in financial markets.
FNArena’s 2021 Investment Outlook Part I published last week (link below) incorporated two underlying assumptions with regard to the economic outlook for Australia and the US. Firstly, that it had appeared Australia had all but conquered covid, reflected in the reopening of state borders. Secondly, that there was a distinct possibility US Congress would not be able to agree on a stimulus package before inauguration.
Less than a week later we have a new Sydney outbreak that has re-closed borders and killed Christmas for many Sydneysiders planning to join family interstate. At the time of writing, there remains a strong risk Sydney will go into hard lockdown, Melbourne-style, and kill off Christmas altogether.
And Congressional leaders have agreed on a US$900bn stimulus package (yet to be passed at time of publication).
For the Australian stock market, the two developments net each other out.
This is not to suggest one must now dismiss the analysis provided in Part I, for these assumptions were not taken as gospel, rather they remained as “risks”. The otherwise positive tenor of Part I’s investment outlook is unchanged.
One source of positive market expectations for 2021 is that of the commodities market. Part II drills down on this theme.
Selective Pain
It is perfectly clear to all and sundry Beijing’s attack on Australian trade as retaliation for various Australian government actions is only targeted at exports China can either live without or source elsewhere, but not at anything China can’t do without.
Wine, barley, beef, lobsters et al are soft targets. Coal, on the other hand, is perplexing. China can indeed source coal for power generation (thermal) and steel-making (coking) domestically and from other export countries, but Beijing faces a conundrum. Despite Australia’s coal being the highest quality in the world, the low marginal cost of Australia’s bulk mineral production ensures Australian coal is actually cheaper than lower quality coal from other sources.
China’s steel industry is already reeling from surging iron ore prices – a result of increased demand from China’s infrastructure stimulus meeting supply curtailments in Brazil – and now coking coal is costing more as well, and is less efficient.
A particularly cold winter to date in China has led to rolling power outages, as coal-burning power generators struggle to keep up with demand. Supply issue?
The assumption is Beijing will soon be forced to back down on its coal bans. For starters, Beijing is yet to admit there even is a ban. And secondly, it’s a ban – not a tariff. Pundits suggest it is likely Australian coal will be found to have surprisingly overcome the quality issues, or whatever issues are being used as the excuse, early next year. Perhaps after Chinese New Year.
Meanwhile, China is welcoming Australian iron ore with open arms. There is simply no other source beyond Brazil that has the scale, the quality, and the price point of Australian iron ore, even as prices surge.
T.RowePrice does not believe China’s actions will have a meaningful impact on Australia’s broader corporate earnings over the next few years. Aside from iron ore being Australia’s primary export and GDP driver, agricultural exports currently represent only a very small proportion of Australia’s outbound trade to China.
Bulk mineral exports dominate – of which coal is one – but base metals and LNG exports are also significant.
Looking to 2021
Heading into 2021, the global economic outlook is bifurcated, Citi notes, on the balance of an “exuberant” economic and pandemic recovery in East Asia, especially China, against sagging economic growth in most of the rest of the northern hemisphere as covid rages on. Citi foresees a difficult winter for impacted countries before mid-year, when it is hoped vaccine availability will facilitate a rebound in global growth.
Even as the commodities complex looks likely to enter a period of potential pause this northern winter, the outlook across commodities looks robust for 2021, Citi suggests, sustained by tightening market conditions across the industrial metals complex.
There is a more neutral “tinge” for some metals nonetheless, given investor exuberance as we entered the December quarter, especially for copper.
That said, Citi still sees copper reaching higher prices by the end of 2021, and more so aluminium. The analysts are neutral on most of the rest of the metals complex.
Citi also sees gold rebounding in 2021, and is bullish on agricultural commodities on seasonal and economic factors, and on LNG, in contrast to 2020.
Oil, however, is geopolitically tenuous.
Largely because, notes Citi, of the huge spare capacity in the system and political disputes at the core of OPEC-Plus producer group. Even if discipline is maintained into 2021, in the form of production cuts, Citi believes the disagreements between the United Arab Emirates and Saudi Arabia over production policy, which have simmered since mid-2020, can reignite at any time.
When producers were in a disagreement over production numbers back in March, oil prices swiftly plunged -25%, and that danger again looms large in 2021, Citi warns.
China’s post-covid growth plans are commodity-intensive, but Citi does not believe that alone is enough to pull all commodities out of the doldrums of the northern winter. That said, China’s centrality to commodities can go a long way. Commodity intensity is not as extensive as it was in the 20 or so years of China’s rapid industrialisation and urbanisation, accelerating from the early noughties to 2011, inclusive of GFC-inspired fiscal stimulus, but China still remains a disproportionately large buyer of commodities.
Security concerns in Beijing in 2020 have seen a new burst of strategic stockpiling. Typically China waits for periods of low pricing to build up reserves, but this year has seen copper being purchased at relatively high price levels. Chinese stockpiling in market that is structurally tightening should help assure limited downside in industrial metals. Beijing also plans to significantly increase its oil reserves.
Cobalt, rare earths and “row crops”, such as soybeans and corn, are also likely on the stockpiling radar, Citi suggests.
For gold, Citi foresees another push above the US$2000/oz mark in the first half of 2021, ahead of full deployment of a vaccine, on a continued slide in the US dollar, persistently low or negative rates, a return of Asian jewellery buying and emerging market central bank purchases.
On a wider note, Citi notes the growth of ESG focus should provide headwinds for oil & gas and tailwinds for many metals, particularly those in anyway related to EVs, batteries, renewable energy and other green themes.
A New Super-Cycle?
The aforementioned rapid period of Chinese industrialisation and urbanisation led to what was dubbed a commodities “super-cycle”, featuring “stronger for longer” pricing than typical commodity cycles. Looking beyond just 2021, portfolio managers at Ausbil’s Global Resources Fund see the potential for another super-cycle.
While China again will play its part, the early stages of this super-cycle are linked to stimulus-led global recovery. The difference between the early twenty-first century and now is that stimulus will be directed towards the inter-related themes of EVs, battery storage and renewable energy, and a more general trend towards electrification, in a demand-drive that has previously not existed.
Much of this secular demand will require Australian resources.
It won’t all be New World nonetheless. For a long time the US has been looking to pour money into upgrading decaying Old World infrastructure such as roads and bridges. The Biden election win assures this will still be a theme, alongside New World investment. A Trump win would not have brought about “green” investment.
Much has been said of the opportunity covid has provided to governments to direct stimulus required to drag economies back from the depths and reinstate full employment by investment in a more technology-based and greener future.
Ausbil sees three major long-term themes driving the demand for resources in the coming years: China, a recovering global economy and the development of new resources trends.
China is fundamentally driven by long term growth plans for property, infrastructure and technology leadership. While dependent on getting through the bleak northern winter and towards a vaccinated new dawn, the global economy will eventually recover, with the help of stimulus. New resources trends are tied to renewability, including growth in EVs, the development of better battery technologies and drive to increasing renewability across the energy complex.
There is a huge opportunity for natural resources companies in these trends, and for investors, Ausbil suggests, given the global picture of resources accessibility and supply constraints. Australia is in the box seat to meet multi-decade resources demand, given not just our wealth of natural resources but our efficient and transparent marketplace and our proximity to the world’s fastest growing nations.
Australia is a dominant world source, which strengthens our position among the leaders of the global resource market.
China’s ongoing commitment to sizable infrastructure spending and rapid urbanisation to fulfil its social contract, notes Ausbil, will continue to underpin demand for iron ore. China’s five-year plan to 2025 is promising to build the country into a technological powerhouse with a robust domestic market. China’s aim is to achieve breakthroughs in core technologies in key areas, to become a global leader in innovation, raise GDP per capita to the level of medium-developed countries, and reduce carbon emissions to zero by 2060.
Australian resources are central to China achieving this plan, Ausbil points out.
Despite the trade tensions noted at the beginning of this article, Ausbil is not concerned. China is unable to fulfil its iron ore needs domestically and would need to develop other supply chains to substitute supply away from Australia, which would take years to scale.
In the technology, EV, battery and alternative energy thematics in which China is seeking to take a leading role, copper, lithium and rare earths remain critical, and here Australia’s market share and supply chain is the world’s most complete and reliable for producers in China and other markets.
Lithium, as is the case with iron ore, is needed on a short term basis, notes Ausbil, and there are no short term supply alternatives. On the flipside, battery manufacturers are seeking to dilute their reliance on Chinese supply chains, thus providing a further opportunity for Australian producers.
Given that Australia is an essential supplier of bulk minerals, base metals and rare earths, Ausbil believes that other than through temporary disruption, China is unlikely to cut the supply of resources that are essential to their property and infrastructure development plans.
In the more global themes of EVs, battery storage and renewable energy, Ausbil suggests lithium is the most critical for EVs. The main winners from increased global rechargeable battery demand are likely to be lithium, graphite, nickel, cobalt, and potentially manganese.
Pure-play cobalt exposures are thin on the ground. The largest global cobalt producers are diversified miners and cobalt is typically found alongside base metals (eg copper, nickel). Graphite is readily substituted for a synthetically produced version that is currently relatively cheap.
Much faith has been placed in the requirement for nickel in an electric future, but the primary driver of nickel demand is stainless steel, at least until nickel demand for batteries fires up longer term.
To that end, Ausbil believes the best opportunity to leverage the EV thematic is though lithium exposure.
The take-up of EVs has reached an inflection point, Ausbil believes. While first China, then Europe, boosted EV demand by offering government subsidies, with zero emission goals in mind, such demand has led to the cost of manufacture now falling to the point that with subsidies, the cost of an EV is about the same as its internal combustion engine equivalent.
As is the case with all new technologies, demand increases scale, and scale reduces costs. Government subsidies have kicked off demand, but there are already subsidy scale-backs underway as costs decrease further.
The current Australian government’s plan is to go the other way and tax EVs, in order to recoup lost tax on petrol/diesel used to fund the country’s roads. But Australia is a small market.
The Headwind
The Aussie dollar is currently up some US20c from a short-lived nadir of US55c in the depths of the downturn in March. With US and Australian benchmark ten-year bond yields at similar levels, due to relatively similar central bank monetary policy initiatives, two main elements have driven this rebound: ongoing weakness in the US dollar due to the sheer extent of US monetary and fiscal stimulus on top of existing debt, and commodity prices increases, particularly in iron ore and copper.
If we are entering a new period of “stronger for longer” commodity prices then the Aussie, too, will by default be stronger for longer.
A strong Aussie acts as a counter to strong commodity prices for exporters. But not to the extent of cancelling out, because there actually is more to the Australian economy than iron ore. And it works the other way too – when commodity prices are in a down-cycle, a subsequently weaker Aussie helps offset.
Thus the currency acts more like a natural hedge. But commodities are not all that Australia exports.
UBS is one of many expecting the Aussie to continue to rise through 2021. While only dragging on mining super-profits, the impact will be more definitive for offshore earners in other sectors, such as healthcare. UBS notes this sector suffers significant price sensitivity to currency movements.
A stronger Aussie is nevertheless positive for retailers that import their products or parts, dependent on currency hedges in place.
A stronger currency is typically negative for Australian tourism as an export, but as we enter 2021 that’s a moot point. There is no end in sight for international border closures. And as far as the travel industry in general is concerned, recent events suggest 2021 will not see the end of potential domestic disruptions as well.
2021 Investment Outlook Part I (https://www.fnarena.com/index.php/2020/12/17/2021-investment-outlook-part-i/)
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