Basic Materials: A Real Estate Cloud Over China--and Many Commodities
Chinese real estate, a big driver of demand for industrial commodities, is likely to weigh on the country's GDP growth in coming quarters.
As China goes, so go many industrial commodities. The country consumes massive amounts of many globally fungible commodities, making China's economic activity--particularly its fixed-asset investment--a good gauge for commodity market health.
According to the consensus narrative, Beijing's recent "ministimulus" succeeded in pulling the economy out of a cyclical trough, as evidenced by the sequential uptick in GDP growth to 7.5% from 7.4%. Consensus credits infrastructure spending for the improvement, which offset a weak real estate market. Although headline GDP has improved, fundamentals have worsened. With physical capital that largely exceeds the country's needs across manufacturing, real estate, and infrastructure, China doesn't suffer from a deficit of investment. Stimulus solves little other than the problem of politically unpalatable GDP figures. Meanwhile, it exacerbates China's far more serious problem: debt.
Contrary to the consensus narrative, real estate was not a headwind for GDP in the first half of 2014. Based on our analysis of China's fixed-asset investment figures for the first six months of the year, real estate added 3 times as much to GDP growth as spending on rails, roads, airports, water, and pipeline transport combined. This is a function of how real estate's contribution to GDP is counted.
While China's GDP figures don't yet reflect real estate's troubles, they are likely to soon. Leading indicators for real estate, which have a lagged impact on GDP, continue to signal trouble ahead. Year to date by July, starts are off 13% and sales are down 8%. Prices have taken a turn for the worse in 79% of China's major cities and are likely to remain under pressure: The pipeline of new supply remains ample despite falling demand.
The impact for commodities is significant. Real estate has been the single largest driver of China's demand growth. In the case of steel, real estate directly accounts for half of China's usage, which in turn accounts for half of global usage. The slowdown in real estate has already put significant pressure on prices for globally fungible commodities, including iron ore and copper. We do not expect that pressure to abate.
What looks to be a bumper corn and soybean crop in North America has put pressure on prices and should lead to some near-term headwinds for crop input producers. With U.S. farmer income expected to be down roughly 25% year over year, growers will have less money in their pockets. However, estimates for 2014 are still above 10-year averages, and we expect the big harvest will have minimal effect on seed and fertilizer producers. We doubt farmers will cut back meaningfully on inputs that help improve yields, and thus revenue.
Tension in the global potash market seems to have abated, with large Eastern European producer Uralkali announcing that it would cut production by 8% this year in an effort to maintain prices. This marks a step back toward its former price-over-volume strategy--a practice that supports potash prices above marginal costs of production. With price pressure from Uralkali's actions last summer dwindling, we think potash prices bottomed mid-2014 and will move up from here.
Over the long run, we think fertilizer and seed producers will benefit from growing appetites in emerging markets. With opportunities to meaningfully increase global planted acres limited, yield gains will need to account for the vast majority of increases in food production.
On July 21, benchmark North American containerboard prices fell for the first time since 2009. This took many in the industry by surprise, as the industry had enjoyed greater pricing power following industry consolidation that better matched supply with demand. The main drivers behind recent weakness in containerboard pricing are new recycled fiber-based containerboard capacity entering the North American market along with tepid domestic box demand.
In recent months, recycled-fiber prices have been falling due to weaker-than-expected Chinese demand, which should provide an additional benefit to the new recycled-fiber market entrants relative to the larger producers like International Paper (IP), Rock-Tenn (RKT), and Packaging Corporation (PKG), which use a larger percentage of virgin-fiber in their containerboard production. The combination of new capacity and lower recycled-fiber prices will also likely put further pressure on North American containerboard prices and may require some of the larger producers to take economic downtime in the fourth quarter.
Harsh weather during the first quarter disrupted rail traffic, and subsequently, coal deliveries out of the Powder River Basin in North America. The resulting backlog of coal deliveries continues to hang over PRB coal prices in the third quarter. Many utilities have reached low levels of coal and are seeking additional tons beyond their contracted amounts. As these customers are still waiting on delayed contracted tons, they are hesitant to purchase more coal in the spot market given the uncertainty on delivery timing. Until regular spot purchases return to the market, we don't expect pricing to improve. While rails have been working to expand capacity and work through delivery backlog, progress has been slower than expected, with PRB producer Cloud Peak Energy (CLD) reducing its full-year delivery outlook in early September.
|Top Basic Materials Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
| Consider |
|Newcrest Mining||AUD 22||None||High||AUD 13.20|
|Alumina||AUD 2.60||None||High||AUD 1.56|
|Rayonair Advanced Materials||$49.00||Narrow||Medium||$34.30|
|Data as of 09-18-2014|
Newcrest Mining (NCM)
Newcrest Mining is engaged in exploration, mining, and development of gold and gold-copper concentrate in Australia, Indonesia, and Papua New Guinea. Its projects include Cadia Valley, Telfer, and Lihir, among others. Newcrest's long reserve and resource life is a key differentiator and supports future growth. The market is disinterested in the large reserve base, but it provides valuable long-term options.
Alumina is involved in bauxite mining and alumina refining, with some minor alumina-based chemicals businesses, aluminum smelting, and the marketing of those products. Five of Alumina's eight refineries are in the lowest-cost quartile globally, and the company is firmly in the bottom half of the cost curve. Meanwhile, the ongoing move toward spot alumina pricing after the gradual breakdown of aluminum-referenced alumina contracts should underpin solid price growth.
Rayonier Advanced Materials (RYAM)
Rayonier makes cellulose specialties for cigarette and other end markets. Shares have endured a rough ride in the past year, battered by lower prices and missed production objectives. Many expect more bad news. The bears underestimate a structural backstop to further price erosion: high switching costs. The acetate that goes into cigarette filters is not a commodity: smokers can actually taste a difference between a cigarette that uses Rayonier's special blend of cellulose in its filter and one that doesn't. A chemical company that switches from Rayonier to pick up a few pennies a pack in cost savings risks altering a cigarette's flavor profile--a cost that can far exceed any savings from switching.
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Jeffrey Stafford does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.