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Quarter-End Insights

Basic Materials: China-Led Rally of 2016 Rests on a Shaky Foundation

Commodity price gains are likely to prove temporary as stimulus exacerbates China's underlying problems and sets the stage for lower long-term growth.

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  • We view the basic materials sector as overvalued on the whole. On a market-capitalization-weighted basis, our coverage trades at a 25% premium to our fair value estimates.
  • The valuation disconnect largely reflects our bearish long-term outlook for Chinese fixed-asset investment. Many materials sector stocks enjoyed a stellar run in 2016 thanks to Beijing's renewed stimulus efforts, which buoyed demand and prices for commodities ranging from coal to copper to iron ore. The market appears to be valuing commodity producers as if prevailing prices are sustainable. We expect gains to prove fleeting, as we doubt the sustainability of the credit-fueled, investment-led growth model.
  • Amid the runup in metal prices, gold was an underperformer in 2016. We're more constructive on gold than industrial commodities in the long run, largely because of rising consumer demand from India and China. But the near term could prove challenging, as multiple rate hikes by the U.S. Federal Reserve in 2017 threaten investor demand for the yellow metal.
  • Outside the mining space, we see value in materials stocks tied to U.S. residential construction. We expect housing starts will continue to build momentum in 2017, thanks to a combination of favorable demographics and improved household finances. North American lumber producers, which should enjoy strengthening demand and rising prices, look undervalued. Following a hearty post-election upswing, we're less enthusiastic about materials companies that serve U.S. infrastructure markets. Our U.S. cement and aggregates coverage looks fairly valued. We think U.S. steel producers, which would benefit from stronger infrastructure spending and stiffer trade barriers under Trump, are overvalued.

 

Daniel Rohr does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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