Basic Materials: Metals and Mining Firms Substantially Overvalued

• On a market-capitalization-weighted basis, our basic materials coverage trades at a significant premium to our estimate of intrinsic value, remaining the most overvalued sector. Our bearish perspectives on most metals and mining companies are the primary drivers of this outlook.
• Miners and industrial metals companies we cover remain substantially overvalued, reflecting our expectation of a structural change in demand growth from China as its economy matures and makes the transition toward less commodity-intensive and more consumption-driven growth.
• Gold is among the few mined commodities that isn't directly tied to the fortunes of Chinese fixed-asset investment, but as the U.S. Federal Reserve has continued to pursue rate increases, prices have fallen to roughly $1,200 per ounce from roughly $1,350 earlier this year.
• After unfavorable weather conditions weighed on first-quarter results for many of the ag companies we cover, volumes rebounded in the second quarter. Through the first half of 2018, demand for nearly all crop input categories was roughly even with the first half of 2017. Fertilizer, nitrogen, phosphate, and potash prices all rose sequentially during the second quarter amid lower supply, which has supported higher profits. We expect prices for these commodities to remain elevated through the second half of the year.
• While new home construction has softened during the second and third quarter, our long-term outlook remains positive. Builder confidence remains high and demographic conditions are favorable. However, lumber companies look fairly valued following short-term supply disruptions. We remain optimistic on long-term infrastructure spending, leading to positive outlooks for aggregate and cement companies.

Ongoing concerns about a trade war between the U.S. and China continue to affect valuations for industrial metals companies. We expect near-term U.S. steel prices and the U.S. Midwest aluminum premium to remain elevated, as they have been since a flurry of tariffs were enacted around the world earlier this year. However, we maintain a negative long-term outlook for both industries. Substantial global overcapacity will cause most industrial metals companies to generate ROICs below their cost of capital once the pricing environment weakens. Additionally, with the tariff program now in place, we contend that all near-term positive catalysts have been exhausted. Metal margins remain near multiyear highs, marking a period of unusually favorable market conditions that is unlikely to persist.