Over the last two years, one of the biggest factors driving financial markets globally has been the US-China trade war. Nowhere has this effect been more pronounced than in commodity markets. Iron ore and gold remain two of Australia’s biggest exports, and over that time they’ve rallied 60% and 72% respectively. With the first stage of the trade war escalation apparently drawing to a close in December and January with the signing of the phase one agreement, we thought it would be a good time to review the outlook for these commodities, the current fundamental drivers, and the implications for both investors and consumers.
Minimising exposure to behavioural biases
We believe people are generally motivated by short-term outcomes, overemphasise recent information and are uncomfortable having unpopular views. We aim to ensure we minimise our exposure to these behavioural biases and exploit misperceptions about risk and future growth prospects.
The first step is determining sustainable free cash-flow, with reference to qualitative considerations, macro and cyclical considerations and financial returns with as long-term and historic context as possible.
Commodity exposed stocks generally fare poorly in terms of undifferentiated product, high capital intensity and pro-cyclical capital allocation track record. In 2018, we argued a quick resolution to the trade war was unlikely, but the more important driver was unfavourable long-term supply / demand dynamics in our most critical export, iron ore.
The second step is to determine an unbiased and consistent measure of value based on sustainable free cash flow and franking, net of debt. This allows us to determine whether there is some chance other investors have become too concerned (or complacent) about risks and growth.
We then shift our focus to conviction, which recognises that to be a good investment, we need evidence that the market’s concerns are either priced in or invalid. One way we determine whether the market is overly pessimistic is to produce valuation scenarios focused on the risk of permanent capital loss relative to the best case or upside scenario. Again, commodity exposed stocks are well catered for in our process given the undifferentiated product and the long-term historical context available to assess a range of plausible valuation outcomes.
Figure 1: Trade war in the context of long-term pricing (real)
Source: Bloomberg, Calculations: Merlon Capital Partners January 2020
The trade war background and context
The trade war did not impact our assessment of sustainable free cash-flow or unbiased long-term value for commodity-exposed stocks. However, it did present downside risk to economic growth and might have resulted in higher conviction if investors became overly concerned and commodity prices sold off from their elevated starting point. This did not prove to be the case for reasons we will explain later.
President Trump rewrote the geopolitical narrative with his April 2018 declaration of tariffs on USD50b of imports from China. Since this time, we have seen an escalation phase, which only ended in mid-December. While the effect on commodities was broadly expected to be negative, we have seen significant divergence across the major industrial, energy and precious metal markets.
The December trade agreement, if confirmed at the stated 15 January ‘official signing’, would signal the end of the escalation phase of the trade war. The confidence this gives the global economy, coupled with the lower ‘cost of trade’, could see increased economic activity. Given the trade war was characterised by declining bond yields and oil prices, and rising gold prices and the USD, it is reasonable to expect some reversal of these trends. This could accelerate should the ‘phase 2’ talks prove productive.
Figure 2: Commodity price indices since trade war commenced
Source: Bloomberg, Calculations: Merlon Capital Partners January 2020
Gold: what are you buying?
Trade war impact: The trade war has had the most direct impact on gold, with Trump pressuring the US Federal Reserve into a more supportive monetary policy stance, to counteract the negative impact from the trade war. By lowering the opportunity cost of holding gold, measured in terms of the real risk-free rate of return (US treasury yield less inflation), gold has appreciated.
Longer term considerations: Gold is held for different reasons through time, rendering forecasts inherently unstable. Forecasting is complicated by the fact that gold has no yield to reward holders for risk, and hence possesses no inherent value on its own.
Demand for gold in 2018 was 4,400 tonnes. Of this, fundamental demand (primarily jewellery) accounted for two-thirds of demand, while non-fundamental demand (gold bars and coins, exchange traded funds, and central bank buying) accounted for the remaining third. Non-fundamental demand is more than three-times the levels of the early 2000s.
Figure 3: Components of demand
Source: World Gold Council, Calculations: Merlon Capital Partners January 2020
Non-fundamental demand for gold is considered speculative, as gold does not produce cash flow from which to value it. It is reliant on being able to sell it to someone else in the future at a higher price in order to generate a return. Estimating this non-fundamental component tends to be poorly defined, with a range of factors identified as potentially driving demand.
The risk in relying on this non-fundamental component of demand is that when monetary policy normalises, and the global economy proves it is robust in the process of normalisation (a process recently interrupted by the trade war, as previously noted) then this demand may become supply as the reasons for holding gold dissipate. The accumulated tonnage of post GFC non-fundamental demand represents more than five years of fundamental demand, and should be thought of as latent supply, should the prevailing views change.
Given these risks, it is worthwhile seeking to understand the nature of this non-fundamental component. As a framework for assessing these non-fundamental factors, gold can be thought of as a zero coupon, non-sovereign risk exposed bond. To this end, the appeal of gold is a function of its relative appeal to competing investments, namely sovereign bonds, based on yield, inflation protection and risk of repayment. Each of these elements is discussed below.
Yield: Recently, the dominant narrative for holding gold is the decline in real yields available on benchmark risk-free assets, namely the 10-year US Treasury bond. The argument in favour of holding gold is that the lower the interest rate available on US Treasuries, the more attractive a zero yielding alternative risk-free asset such as gold.
While this argument has played out over the short term, particularly as real bond yields have gone below zero, for most of the period under analysis, the gold price declined at the same time as real yields. In this sense, the ability to rely on this relationship is tenuous.
Figure 4: Gold vs yield (adjusted for inflation)
Source: Federal Reserve Bank of St. Louis. Calculations: Merlon Capital Partners January 2020
Inflation protection: Inflation erodes the value of savings, with gold’s apparent scarcity making it seem a useful hedge against inflation. This effect is clear when comparing gold with oil, historically a key driver of inflation.
Figure 5: Gold vs oil
Source: Bloomberg, Calculations: Merlon Capital Partners January 2020
Oil and gold represent a much stronger relationship than that between gold and real yields. While the linkage between oil and gold dislocated in 2014, as the surge in US supply from unconventional sources (discussed below) surged.
Over this period, gold prices have become negatively correlated with real interest rates (rather than positively as they had been for several decades). This is in part due to the opportunity cost of holding gold being lower.
Figure 6: Gold vs US real interest rates recently
Source: Federal Reserve Bank of St. Louis, Calculations: Merlon Capital Partners January 2020
Yet this relationship is still relatively new, and brief in the context of longer-term analysis. And with gold already looking expensive on this basis, and relative to oil as noted, the risks are growing that should interest rates begin to normalise on easing trade tensions, gold could retrace.
Counterparty risk: While gold can be thought of as a type of nil-coupon bond, the counterparty is the market rather than a sovereign, with the principal being the price paid. Unlike a bond, there is no fixed maturity or amount receivable upon maturity. A holder of gold is at the mercy of the market’s pricing of gold at the time of selling.
That said, with the counterparty to US treasuries becoming increasingly indebted, the appeal of gold’s counterparty risk is evident. Gold’s appreciation is consistent with the rise in US government debt following the GFC. Again, however, this relationship is not a constant one. Should the Fed return to its process of monetary policy normalisation, the arguments for holding gold reduce.
Figure 7: US Public debt vs GDP
Source: Federal Reserve Bank of St. Louis, Calculations: Merlon Capital Partners January 2020
Gold as a currency: People buy gold as if it were a currency, or directly exchangeable as a currency (as it had been for many years prior to the creation of fiat currencies), if they expect the value of their own currency to decline (due to a rise in the prices of goods and services, or due to a rise in the supply of that currency seen throughout the phase of Quantitative Easing policy).
Printing money in excess of the growth of an economy reduces the value of a unit of that currency, making the price required for goods rise to compensate. This was the theory behind Quantitative Easing. Except inflation did not eventuate (or maybe it warded off deflation). Yet the value of the USD as measured by other currencies, has yet to fall.
Conclusions: Our philosophy recognises people tend to over-extrapolate recent conditions. Gold is currently trading 72% above its inflation-adjusted long-term average, so on face value it is difficult to have high conviction that prices will rise further. Gold’s strong recent linkages to real interest rates on risk free assets provide the best guide to the short-term outlook. Should we see the negative effects of the trade war reverse, and the Fed’s accommodative interest rate policy unwind, then gold’s outperformance should reverse. Gold’s inflation protection role is also a factor, should inflation re-emerge, yet gold is trading well above long term averages. We believe oil may prove a better exposure to inflation given its role in the global economy, and the structural factors that may support pricing.
Iron ore: disruption reversing
Trade war impact: Iron ore is perhaps the commodity least affected by the trade war. While global steel production (excluding China) has experienced an average -2% growth rate, consistent with the effect on oil markets, China bucked the trend with an average of 7% growth, albeit having recorded a negative year on year growth in October. The net effect on demand has been consistent with oil markets with continued growth, but at reduced rates. Also consistent with oil markets over the trade war escalation phase is the dominance of supply factors, with the key driver of iron ore price being the disruption experienced by the world’s top supplier Vale.
Supply considerations: Supply growth seems set for more than recovering the outages experienced in 2019, with long term production from the majors 8% higher than levels of 2018, based on recently stated production targets.
Figure 8: Supply evolution (major producers)
Source: WorldSteel Association, Company Guidance, Calculations: Merlon Capital Partners January 2020
China’s steel production in the first half of 2019 was driven by strong 2018 steel spreads following the closure of ‘illegal’ induction furnace recycling capacity. Yet the chart below shows that this growth may now be tailing off as the effects of oversupply impact producers’ ability to sell product. Importantly, it appears that 40% of this growth came via recycled steel, evidence of the growth of recycling within China. Production outside of China is down 2% vs pre trade war levels. Should production continue to follow these trends, the stated iron ore production growth from major producers looks set to push the market into surplus.
Figure 9: Monthly steel production, China vs rest of world (ROW)
Source: World Steel Association, Calculations: Merlon Capital Partners January 2020
Yet this growth is clearly excessive, particularly when looked at in the context of the health of the steel industry, as measured by the Steel Purchasing Managers Index (PMI) index. This index shows that while steel production has grown strongly, it has done so in the absence of demand, leading to poor conditions.
Figure 10: China Steel PMI
Source: Bloomberg, China National Bureau of Statistics, Calculations: Merlon Capital Partners 2020
The comparison of met coal and iron ore pricing shows that the underlying fundamentals for the steel market may less bullish than that implied by iron ore pricing. While the metallurgical coal market is also exposed to the deteriorating ex-China steel market, its trend remains consistent with China’s steel PMI data, which is noted as deteriorating due to excess production.
Figure 11: Pig iron input cost comparison
Source: Bloomberg, China Steel Logistics, Calculations: Merlon Capital Partners January 2020
Demand indicators: The contribution of property to the Chinese economy has been stable at 10% since 2010. Yet over this time debt levels have doubled, indicative of unproductive investment in this sector - a feature emphasised by the greater-than-20% vacancy rate. As a key driver of steel demand in China, the growing risk in this sector is a key issue.
Figure 12: China real estate contribution to GDP
Source: Capital Economics, Calculations: Merlon Capital Partners January 2020
Substitution risk: On a longer-term basis, if China’s dedicated recycling rates transition to reflect more mature markets, then the displacement of iron ore from the steel market could be a further negative factor.
Figure 13: China recycling rates low vs rest of the world
Source: World Steel Association, Calculations: Merlon Capital Partners January 2020
Conclusions: With iron ore, a non-scarce resource globally, trading 82% above its normal level, the downside risks are clear. Vale, being the key driver of supply disruption, is roughly half-way through restoring volumes. China, having been supportive of global demand over the course of 2019 following the positive margin effects of supply side reform, is now at risk of having to reduce the production of steel, seen in recent production data. On a longer-term basis, there is further downside risk from the maturation of its steel industry driving higher rates of recycled steel, and lower usage of iron ore in making steel.
Implications for investors
While the trade war has dominated the media, iron ore has been more driven by supply side factors. Gold has had the most direct exposure to the trade war given the use of monetary policy to cushion some of the contractionary effects of the dispute. Stocks have exhibited a range of leverage to these commodity price changes, as well as stock specific factors.
Figure 14: Commodity and stock returns since beginning of trade war
Source: Bloomberg, Calculations: Merlon Capital Partners March 2018 - January 2020
Most pertinent at this stage is to understand the reversion risk should the trade war shift to a ‘de-escalation’ phase following the Phase 1 agreement. Gold is the most exposed to this given it has been far more directly exposed as noted. Prior to the trade war, the US Federal Reserve had been seeking to normalise policy, with gold prices impacted. Higher global confidence and trade activity would enable the Fed to re-attempt this normalisation.
Figure 15: Reversion risk
Source: Bloomberg, Calculations: Merlon Capital Partners March 2018 - January 2020
Implications for consumers
Electricity: growing renewables contribution sees downside risk to prices
Wholesale electricity pricing increased strongly in 2017 following the closure of the large-scale coal-fired Hazelwood plant in Victoria. This closure of baseload generation created a tighter market for electricity and hence, higher prices.
This tightness has begun to unwind, with the growth in renewables capacity. Renewables now contribute 25% of electricity supplied, nearly twice the level five years prior. It is expected that renewables will continue to form a larger part of the electricity mix as further capacity is commissioned.
Figure 16: Electricity pricing (NEM average wholesale)
Source: Australian Energy Regulator, Calculations: Merlon Capital Partners January 2020
With more renewable energy comes greater intermittency of generation due to variable weather patterns. This is addressed through greater usage of gas-fired peaking plants, which effectively ‘fill the gap’ of this intermittency, and hence form the marginal cost producer and price.
Domestic gas prices are increasingly influenced by ACCC-calculated LNG ‘netback’ pricing (the price received by an LNG exporter in the spot market, less the cost of freight and liquefaction).
While initially gas prices spiked significantly as LNG production in Queensland was commissioned from 2015 onwards, there is now downward pressure on netback pricing, due to an oversupply of spot (non-contracted) LNG cargoes in the region. This is expected to flow through to lower wholesale electricity pricing, albeit typically lagged due to hedging activity. This pricing effect may be exacerbated by renewables capacity growth.
Figure 17: Domestic gas pricing vs contracted LNG pricing
Source: ACCC, Bloomberg, Calculations: Merlon Capital Partners January 2020
Savings: is gold a solution for low interest rates?
To complete the picture from the other side of the ledger, the ability to generate investment income to pay for these basic commodities has been complicated by declining interest rates. Income from term deposits has basically halved in just five years.
Figure 18: Term deposits vs gold
Source: Reserve Bank of Australia, Bloomberg, Calculations: Merlon Capital Partners January 2020
Some argue that with rates so low, gold becomes more attractive. Yet, a term deposit continues to offer income, relative to the guaranteed zero income provided by gold. To roll a term deposit into an investment in gold, therefore, an investor must implicitly expect the gold price to rise – this is the classic definition of speculation: buying something with the expectation of being able to sell it for a higher price. It is true that gold prices have been rising, however, the negative correlation with declining interest rates is not a consistent relationship through time and not necessarily reliable in future.
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