Value in Aussie miners despite China challenges

We returned from China with a view that broad commodity demand looks reasonable in the near-term. Base metals, which have suffered under trade war concerns, are already at low levels and a recovery in FAI should see demand fundamental supported, though sentiment may take longer to rebound. Bulks (particularly iron ore and coking coal) look supported by expanded winter capacity cuts on solid property and recovering infrastructure investment. 

However, longer-term, China's steel production is likely to decline as the economy moves away from steel-intensive growth, combined with the ongoing replacement of blast furnace capacity with scrap consuming Electric Arc Furnaces (EAF). This is why we are comfortable with our longer-term price assumption of about US$55/t for iron ore, which places BHP (ASX: BHP) and Rio Tinto (ASX: RIO) profit margins more in line with multi-decade historical trends.

Nikko AM's current active exposure in the mining and metals sector is via investments in Iluka Resources (ASX: ILU) and BlueScope Steel (ASX: BSL). Iluka remains attractively valued due to declining long-term zircon supply and solid demand driven by Chinese property strength. BlueScope is a direct beneficiary of solid Chinese steel margins, which drove regional spreads higher, as well as improved US steel profitability due to protectionist policies of the current administration. The trade-war/emerging market sell-off has seen value emerge from several resource stocks in our market, which are looking attractive under our long-term intrinsic value style of investment.

What a difference a day makes: Beijing on day one, left, and day two

On my last trip to China, we were a little cautious despite the optimism displayed by China’s primary industries — a flow-on from the stimulus-led recovery of 2016. Our caution proved warranted. Money supply tightened and key macro indicators weakened, which hit bulks in particular. This time around there are more divergent views, tending towards caution among the industry experts we met.

It's no surprise China is slowing, but the concern around an escalation of trade conflict with the US has Chinese industry worried (as well as the local stock market). However, China's giant steel industry is very profitable. As a major supplier of steel-making raw materials, this has benefited Australia. For the rest of 2018 we expect China to try to find a balance between the environment and economic stability.

A look back to last year

If we look back to this time last year, when the proposed "winter cuts" were set to take place, we thought, like most, that lower steel production would equal a lower demand for iron ore, and indeed, prices did fall more than 20 per cent in the weeks leading in to the winter period. But once the cuts started, steel prices strengthened on solid demand outside the affected areas. Mill margins lifted and benchmark iron ore prices along with it.

Steel mills became less conscious of the price of their raw materials and more concerned about efficiency and productivity, feeding in higher grade and lower impurity ore, and lifting scrap input, all to maximise production while adhering to capacity restrictions. This boosted profitability. Low-grade iron ore producers suffered as demand for their products fell. The likes of Fortescue Metals Group (ASX: FMG) price realisations fell to about 65 per cent as a result.

China steel production and steel mill margins (using spot prices)

Expanded cuts, but greater efficiency

The 2018/19 winter period is likely to see an expanded round of cuts, involving more cities than last years’ 26+2 regime, but with more flexibility. The plans look to be outlined under two key policies: one covering another round of winter cuts in the 26+2 cities, albeit over six months of official winter heating season instead of last year’s four months. The other seems to involve policies at a more local level, covering a larger regional scope for production curbs, but potentially allowing for more flexibility, which could depend on the prevailing pollution conditions. Some we spoke to thought up to 46 per cent of China's +1Btpa steel capacity could be affected versus the 2017/18 cuts, which affected 24 per cent. This is just an estimate put forward by some of the experts and doesn’t represent how much steel could actually come out of supply.

The other side of the equation, being demand and the impact winter season policies may have on it, was uncertain, though we sensed the flexibility to be put in place on supply would also be placed on downstream construction. This does ease some concern that any step-back from environmental-based policy leading to greater steel production will likely also apply to demand, potentially helping maintain mill profitability.

In our view, FAI growth is likely to come from renewed investment in infrastructure, which had been stifled by a clamp-down on non-bank funding sources for local governments and slow approvals. With the Central Government approving special bond issuances to improve liquidity, and speeding up approvals processes, there was a broad expectation among market commentators that spending in infrastructure would lift, which could help offset cooling in the more commodity intensive property market.

The one caveat to any positive view given by the experts we saw was the potential for an escalation in US-China trade tensions, which could crimp demand, though by how much is unknown. Steel, and therefore iron ore, looks to be the most resilient given environmental policy support and a very low level of exports with healthy domestic demand. The negative trade war sentiment is being reflected in base metal markets – aluminium, copper, zinc and nickel. For longer-term value investors, this can create opportunities, particularly in those metals with positive longer-term fundamentals such as copper, where spot prices do not reflect the cost of new supply required to meet growing demand in the long term.

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Stefan Hansen is senior research analyst, equities, at Nikko Asset Management.

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