Why the iron ore rally is unsustainable

Tim Hannon: "Since the start of this calendar year 2016, we've seen a very material outperformance of the resources sector in Australia. It has outperformed industrials by 50% which is a big number. That's been driven by two key factors. The resource valuations were very depressed at the start of this year and then China embarked upon a major fixed-asset stimulus program, again, fueled by debt which wasn't expected. The expectation was that they would be re-balancing their economy more towards consumption. That was the genesis of the rally in the resources sector.

It's been further amplified by the recent Trump win and his statements about fiscal stimulus in the United States. We've got a very, very strong performance from the resources sector but we think caution is a little bit warranted. A couple of reasons. We look at the Chinese economy. It's an 11 trillion dollar economy. They spend 6 trillion dollars on fixed-asset investment, more than half their GDP. This is an enormous number and it's been this number for many, many years, 15 years almost. They do have their economy to a point where there's overcapacity across the board. In toll roads, in bridges, in real estate residential and commercial, imports and they've also built that overcapacity in their major industry groups such as paper and packaging, cement, steel production.

This overcapacity isn't a problem in and of itself but the problem is it's been fuelled by debt. We've got this situation in China where there's overcapacity and they're spending more than 6 trillion dollars on fixed-asset investment and it's starting to decline in terms of growth. Let's compare this to the U.S. fixed-asset investment program. Trump's talking about 100 billion dollars a year. Put that next to the Chinese fixed-asset investment program of 6 or 7 trillion, you can say how immaterial the U.S. growth is going to be. We don't think you should be looking towards the U.S. for commodity price moves. It should be what's going on within China.

Our concern around the Chinese economy is that it needs to re-balance and there is a major debt problem there so fixed-asset investment is declining. It's still growing at 4 or 5% per annum but is likely to go negative over the next 12 months and that's going to be very negative for commodities. China still consumes up to 50% of all major commodity groups with zinc, aluminium, coal, steel. The only one they don't is oil where they're more like 10%. You can imagine if China's fixed-asset investment program goes into negative territory, we're going to see a big fall in commodity prices.

To put the performance of commodities into some sort of context, iron ore has more than doubled now. The reality is we've spoken to a lot of traders and a lot of analysts in the iron ore sector. None can explain the move and what they bring it down to is rapid speculation by Chinese traders to push that price up to $90.

At $90 there's another 200 million tons of iron ore that could come onto the market, more than 20% of the seaborne market. That's not happening so it's clear the companies don't believe the iron ore price rise. We'd be very, very skeptical about joining the commodities rally and the resources rally. I’d be very careful in particular of the iron ore sector. We think it's unsustainable."