The Canadian and Australian economies are the envy of the industrialised world. Both countries share the common feature of benefiting from booming demand for their resources driven by emerging market economies. In Australia we have an abundance of resources but it is iron ore bound for Asia that has driven our economy.
It stands to reason that tremors in the iron ore market would send shockwaves throughout our economy, beginning with the share market. And there is no denying our share market has been in shock for well over a year. Here is a two year chart of the ASX Materials Sector Index the XMJ, telling the sad story in a single image:
Have we truly gone from boom to bust?
A few days ago Economists at Deloitte Access announced that the boom will end in two years. As evidence they cite the decline in resource project investment and rising production costs. At roughly the same time the Deloitte experts were offering their prognostications, a study from US based business research firm Fast Market Research came to a completely contradictory conclusion. These people see iron ore output increasing from 2011 totals of 481 million tonnes to 758 million tonnes by 2016.
A few days later an economist at CommSec confirmed that rosy outlook. Craig James calls our mining boom the "modern day equivalent of the gold rush” and says it is “only just the beginning.” He argues that industrialisation in China has a long way to go, with the Chinese population only beginning to own cars, washing machines, and many other consumer goods that require steel products derived from iron ore. In addition, the vastness of that country argues against the belief they have built their last bridge and their last building. However, despite what he sees as a continuing rise in demand, he acknowledges the price of minerals may drop.
With such divergent views about the fate of the mining boom, it is instructive to look to past history for some hint of future outcomes. So we return to our original question – what just happened? How did we get here?
At the heart of it all is the fact we live in a world of uncertainty.
In an uncertain world we rely on speculation about causes and outcomes. Unfortunately, when the volume of speculation reaches critical mass, it begins to pass as certainty. In addition, speculation can and very often does influence outcomes that later prove to be simply wrong.
With certainty in the share market, investing would be easy, but it isn’t. So we rely on what we hope to be intelligent and informed speculation. But global share markets have a peculiar feature in that investors can profit from failure as well as success. Here is a two year share price performance chart for two of Australia’s most storied companies – BHP Billiton and Rio Tinto:
Both these companies trade in the US under the ADR (American Depository Reserve) system. The chart looks horrible but for literally thousands of Australian and American investors it looks as sweet as a Monet landscape. They are making money betting against BHP and RIO, and the more they pile on, the lower the share price goes regardless of economic realities or company fundamentals.
All the while much of the speculation you have read for close to two years comes from less than objective sources. If your advisory service is long BHP and RIO you look for even the most obscure positive news to put forth. And if you are short those names, you put forth whatever evidence supports the view China’s economy is grinding to a full stop rather than a slowdown, and the Euro will die as the Eurozone collapses.
Short sellers have a reputation for “getting it right” so when legendary American short seller Jim Chanos goes public with the news he is shorting Fortescue Metals (FMG) big time, investors and other investment advisers pay attention.
While there is occasionally outright fraud with rumour spreading, the truth is the shorts most often base their positions on genuine economic issues. The GFC hit most of the world very hard but we were spared largely because China stepped in with a massive infrastructure effort that wildly fueled their demand for steel and hence our iron ore.
But that is over and China has faced new economic pressures which have ratcheted up speculation about a slowdown and a soft landing and a hard landing to deafening levels. In the face of uncertainty about what is going to happen in China, most share market participants assume the worst. So we have seen historic levels of volatility as the slightest bit of bad news drives share prices down and the slightest bit of good news drives share prices up.
Then you add the European debt crisis to the mix. Although we have little direct exposure, China does and now the new uncertainty has led to more speculation. When you add concerns about the US economy to the China-Euro stew, the pot bubbles over and critical mass is here.
We appear to have reached that point with mining stocks – especially pure play iron ore producers. Even good news is scrutinised with the eye of someone expecting that the worst will happen.
Australia’s fourth largest iron ore producer, Atlas Iron (AGO) released it quarterly production report on 25 July 2012. They shipped 1.5 million tonnes, a 25% increase over the previous quarter, and they expect to double total production by the end of 2012. Atlas is a low cost producer - with their costs at $50 a tonne - and some analysts feel they are in a good position to withstand any further downturn; yet the share price dropped in response to the report. Here is their one year share price performance chart:
First, if the demand for iron ore is drying up, who is buying this increased production? Instead of seeing this as potential evidence things might not be as bad as they seem, market participants shrug it off in the belief demand simply won’t hold up over time.
BHP Billiton recently reported increased shipments in the current quarter and forecasted a 5% rise in output by the end of 2012. Rio and Fortescue also reported higher production and the shares of all three continued their decline. Increased production right now doesn’t matter because conventional wisdom – which is nothing more than hopefully intelligent speculation – says demand destruction is based on fact, not speculation.
If that is so, why would another pure play iron ore producer -- Northern Iron Limited (NFE) -- be a takeover target from India's resource giant Aditya Birla Group? And why would this group want to increase its offer by 14% after NFE rejected their initial offer? The shares of NFE got a nice initial pop, but already they are dropping. Here is a one month chart:
There is real evidence of real problems in global macroeconomic conditions. But today it seems there is a greater reluctance to consider the contrarian point of view – that she'll be right mate. What is going on? Market historians in the distant future may look at events like these as examples of the Lehman Effect.
When American investment bank Lehman Brothers failed in 2008, almost no one saw what was coming. The global financial world had become such a tangled web that it took months to figure out who owed what to whom as a result of the complicated financial hedging products across the world. The resultant credit freeze had disastrous consequences as companies lost the ability to raise the life blood of all corporations – cash.
So a big part of what has happened to our mining boom could be attributed to the Lehman Effect. While Atlas Iron’s results are impressive, their plans for three new mines and the development of both rail and port infrastructure projects has sounded the alarm over how they are going to pay for all this. Investor panic over debt levels and capital raises reflects an underlying concern about a company’s viability in the event of what we now refer to as a Lehman-like event.
Our big three miners played into this with their insistence they would pursue huge capital expenditures to increase production capacity to meet demand going forward. Some investors cited this as evidence not to fear the worst. But when BHP began to waiver in its commitment to further investment, they played right into the sky is falling scenario. Rio Tinto and Fortescue Metals Group also hinted at a possible slowdown in their expansion, but remained firm in their overall expansion plans.
On July 17 2012 Rio released its quarterly production report showing record setting production and reaffirming yet again its commitment to expansion. The shares continued to drop. Commenting on the results, RIO CEO admitted global economic conditions and sentiment had “dropped markedly in the second quarter.” He listed three conditions that serve as good explanation for what just happened to our mining boom:
The pace of the US recovery;
The continuing Eurozone crisis; and
The impact of efforts to stimulate the Chinese economy.
As yet, there is no certainty about these conditions, one way or the other. However, one could look at share market performance in general and the materials sector in particular and conclude investors have made up their minds on the equally important issue of sentiment.
What is more important – economic conditions or sentiment about them? Negative sentiment in the face of sound or unsound speculative reasoning can lead to increased unemployment, cost-cutting, and reduced investments; all of which serve as self-fulfilling prophecies for the very economic malaise about which we are so concerned. Negative sentiment can be and often is overdone.
There is one final point about what has just happened to us that bears some discussion, and that is that sentiment is colored by things as they appear to us right now, not as they might be in the future.
Some of you may be old enough to remember the oil crisis in the 1970’s. At that time conditions and sentiment were filtered through our understanding of technology as it then existed, not as it might be in the future. Alarmist predictions about when the last drop of oil would be extracted from beneath the earth failed to even consider the possibility of deep sea exploration and other enhancements that have actually boosted the world’s proven oil reserves.
Today the death of the mining boom is again and again linked to troubles in China and by extension to trouble in Europe. Do they not need steel in India and throughout Asia? Is urbanisation a phenomenon unique to China or are other emerging markets ready to begin constructing bridges and buildings and warehouses and more factories? And what of the global sleeper – Africa? Africa has over 30% of the world’ mineral resources and is in the dawn of its own mining boom. Large international mining companies are casting covetous eyes on Africa. Their infrastructure needs represent billions of dollars in investments, and that means lots and lots of steel.
There are investors everywhere who believe share markets are essentially rational and over time will accurately price their listed companies. You know there has been for some time an irrational disconnect between the rising price of gold and the falling share price of many gold miners. Yet that is not the only example of market irrationality we could cite as a final explanation for what has just happened to our mining boom.
If sentiment about the death of the miners has any truth to it at all, one would expect a corresponding decline in the share prices of mining services providers. And indeed many like Leighton (LEI) and Downer EDI (DOW) and Forge Group (FGE) and others have suffered; but there is one standout exception that defies logic and rationality. That company is Monadelphous Group Limited (MND). Here is their two year share price performance chart compared with one of their biggest customers, BHP:
A sceptic could easily dismiss this performance by citing MND’s diversification across sectors. Yet their success stems from the long term relationships with Australia’s cream of the blue-chip resource and energy companies, and the share prices of their customers from BHP to Woodside have been crushed of late. BHP has dropped 20% over two years but so has Woodside. MND is joined at the hip with the resources and energy sector here and both sectors are victims of negative sentiment. So if investor sentiment says the growth of companies like BHP and Rio are levelling off, why does that negative sentiment not extend to Australia’s leading provider of services to those very companies? So much for rational markets.
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