There’s a bull market in everything these days it seems.
Market-watchers like to talk about ‘participation’. When the market is rising, it’s seen as healthy to see lots of sectors taking part in the rally, rather than just one ‘bubbly’ sector doing all the heavy lifting – like the tech sector in the 1990s, for example.
And right now, most sectors are doing well, from healthcare to utilities to property.
But one particular sector has been conspicuous by its absence – commodities-related stocks.
Why are commodities so detested? And is this an opportunity for contrarians – or a trap?
The trouble with the mining sector
Most FTSE 350 sectors have done pretty well over the past year. The top risers, up 30% or more, include the ‘fixed-line telecoms’ (which includes BT) and ‘aerospace and defence’ (including BAE and Qinetiq) sectors. But you don’t need to have been holding the biggest winners to have made money this year.
Indeed, only two sectors are significantly down on the year. ‘Mining’ – which includes the likes of Antofagasta, BHP, and Eurasian Natural Resources – has fallen by around 15%. And ‘industrial metals’ – which only contains two stocks, Evraz and Ferrexpo – is down by around 35%.
Those are pretty brutal falls at the best of times. Against the backdrop of a bullish market, they look plain awful. There’s no great mystery to the problem here. Commodity prices have fallen, and the price of mining stocks has taken a tumble too.
There are two big issues affecting the sector in general. First, there are concerns about demand. The global economy is hardly firing on all cylinders; more specifically, worrying about a Chinese hard landing has gone from being a minority position to being quite popular.
Analysts have been flocking to downgrade their expectations for Chinese GDP growth. As the Wall Street Journal points out, the new median analyst forecast is for 7.8% growth rather than 8%. That doesn’t sound like much of a drop, but it’s a big turnaround for a group that tends to change its mind very slowly.
And even if the Chinese economy avoids a hard landing (which I think is unlikely), the next phase of its development will be less commodity-intensive. Given that China is such a vast source of demand – it accounts for about 40% of global copper consumption, for example – that’s a problem for anyone who sells raw materials.
That’s got fund managers running scared. As Citywire notes, “allocations to commodities among global fund managers have fallen to their lowest point in four-and-a-half years”, according to Bank of America Merrill Lynch’s latest fund manager survey.
Of course, that’s the sort of thing that gets a contrarian investor pricking up their ears. And it might tempt you to buy into the sector. After all, falling Chinese demand is one thing, but if there are signs of a recovery elsewhere in the world, surely demand will pick up?
Falling commodity prices could make central bankers over-confident
The trouble is, this ignores the second reason for the commodity price tumble – the question of supply. As we’ve mentioned several times before, the cure for high prices is high prices. When the price of resources shoots up, companies have an incentive to produce more raw materials. They also have an incentive to find and use cheaper alternatives (shale gas is a classic example).
So while demand is dropping off, the supply picture is much healthier than it was before the ‘supercycle’ kicked off. In short, despite the fact that miners are not widely liked right now, we’d still be avoiding them.
However, we’ll be watching for a turning point, and that might come sooner than anyone quite expects.
You see, the danger is that falling commodity prices are seen to reduce inflationary pressures in the short-term, allowing central bankers more rope to hang us all with. We’re already hearing mutterings of ‘deflation’ in the wings. I suspect Ben Bernanke’s speech to Congress tomorrow might hint that weak inflation means they won’t ease up on quantitative easing quite as quickly as the market is hoping.
Yet, unless you work for the mining business, then lower commodity prices are a good thing. High raw material costs act as a tax on businesses, and ultimately on individuals. Lower costs mean lower prices, or higher profit margins, or potentially higher wages. So falling commodity prices, one way or another, are a boon for consumer countries.
In other words, falling commodity prices should act a bit like a tax cut – they should help to stimulate demand. That’s good news, but it’s also potentially inflationary in itself.
If monetary policy remains too loose as well, then central banks might be taken by surprise at just how quickly inflation bounces back. But chances are they won’t pull back from loose money policies until it’s too late. And if inflation then becomes entrenched and starts to hit the headlines again, ‘hard’ assets might just come back into fashion.
One raw materials sector we are more bullish on right now, is the energy sector. We’ll be looking at some of the more interesting ways to play it in this week’s issue of MoneyWeek magazine, out on Friday. If you’re not already a subscriber, subscribe to MoneyWeek magazine.
• This article is taken from the free investment email Money Morning.
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