China’s gross domestic product (GDP) growth is slowing – it might even have stalled completely. That means China’s demand for all industrial commodities is falling and is going to keep falling. And that means you shouldn’t invest in any of the big mining companies ever again.
Without China importing 50% of every commodity produced everywhere to build its millions of miles of super-fast railways, prices cannot rise, profits cannot rise and share prices cannot rise.
Sounds like a familiar argument? It should do. It’s been in every paper and on every analyst’s lips all year. If you look at a couple of charts of commodity demand and prices you can see why.
China’s global metal imports were flattish until the late 1990s. They then soared into 2009 (the 10% a year “miracle” growth period) before slowing and flattening again into 2011, when growth started to slow.
Prices did the same. The benchmark CRB Commodities Index peaked in 2011; since then, it has fallen by nearly 50%. This year alone, the prices of copper, palladium, platinum and iron ore are all down by around 20%. Nickel has fared a little worse (down by just over 30%), but there is no doubting the general direction: down and down again.
Clearly, commodity prices need Chinese demand to soar again if they are ever to rise again. It won’t, so they won’t. The commodity supercycle we all loved so much in the noughties (me included) is dead.
That’s the market’s story anyway — and it is sticking to it. Sentiment towards commodity investments is at an extreme low. But here’s the thing: it might be the wrong story. What if the prism of Chinese demand is not the correct one through which to view the market?
I am currently reading a collection of essays from Marathon Asset Management called Capital Returns: Investing through the capital cycle, a money manager’s reports 2002-14 . (Apologies for this, but I have an advance copy. You’ll be able to buy your own – and you should do just that – at the end of the month.) Marathon reckons the rest of us are missing something when it comes to investing: we aren’t paying enough attention to the capital cycle.
The cycle, as described by Edward Chancellor, who has edited the essays, works like this: you own a company which makes widgets and is doing well. The widgets are in demand and the new middle class in the emerging markets has a particular love for them. You expect strong demand growth to continue. Why wouldn’t it?
You decide to build a new factory to expand your manufacturing capacity by 50%. Your bankers suggest a secondary share offering to pay for it. You issue the shares (explaining to the market as you do so about the never-ending rise in demand). No one points out that there is now also fast-rising supply. Your shares rise.
Another widget-maker builds a factory. Then another. And another. Widget prices collapse. It turns out that you and your competitors just ruined a fabulous demand situation by overlaying it with a miserable supply situation. Your shareholders are furious. Whoops.
The widgets in question could have been any number of things at various points over the last 20 years — Spanish houses, Damien Hirst paintings, fibre optic cables, ships, buy-to-let flats in Manchester, gin distilleries (a cycle that hasn’t peaked yet?). But the commodities sector is clearly at the end of a classic capital cycle.
When China started to go nuts for urbanisation and infrastructure, commodity prices rose alongside this frenzy, and so did the profits of the big mining companies. Then the spending started: annual mine production rose by 20% a year from 2000 to 2011. Banks doubled and then tripled the size of their commodity teams. New players poured in (small- and medium-sized miners were raising $30bn a year on the equity market by 2011).
Mining capital expenditure rose from $30bn a year to $160bn. By 2014, a cumulative $1trn had been invested. Supplies soared — global iron production rose by 125% in a decade, says Marathon. And then commodity prices and mining share prices duly collapsed (this is why people say that the cure for high commodity prices is high commodity prices), just as Marathon said in one of the essays in the book (dated May 2011).
So what next? The next part of the capital cycle involves investment being pulled and production falling back so that supply is constrained and prices can rise again (that is, the cure for low commodity prices is low commodity prices).
If the miners want to make real money for their shareholders again, they need to note that nearly all the metals they are flogging are currently priced below their marginal cost of production. Then they need to stop digging. For the past three years there has been precious little sign that the big players have recognised this (despite prices falling for three years).
But there are now a few happy hints of change. Glencore has announced major production cuts for zinc and copper in an attempt to increase prices (it is mothballing two mines in the African copper belt, for example, and is closing down 500,000 tonnes a year of zinc capacity). Freeport is cutting too. Capital Economics even reckons that the zinc market will fall into deficit (more demand than supply) in 2016 as more mines are closed, and BlackRock is forecasting that mining capital expenditure will fall 50% between 2013 to 2016.
That doesn’t make it time to buy yet. New capacity commissioned in the boom years is still coming on stream and some firms are even planning more — in Australia, Hancock Prospecting has a huge new iron ore project on the go. But the bottom won’t be that far off now.
Watch for more mine closures, more mothballing and more cuts to capital expenditure. Then start to buy back into the miners. The commodities supercycle was, in the end, just a slightly exaggerated version of an ordinary commodities cycle. It has ended in the same way as pretty much every cycle has — and its next wave will begin in the same way too.
You might say looking at cycles like this is a bit obvious and simplistic — analysis any old intern could do. But it clearly isn’t. Or any old intern would have done it in 2008, 2009, 2010 and 2011. That intern would have sounded the alarm, pointed out the behavioural biases that keep extreme credit cycles going (over confidence, extrapolation). And investors wouldn’t have fallen for it.
• This article was first published in the Financial Times