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China is probably the most important factor in the economic outlook right now. While the U.S. is clearly recovering from the downturn and Europe is still mired in recession, China is a tougher read since its growth rate is still slowing down and has yet to bottom out. While most investors expect a ‘soft landing’ (i.e. growth slows down without a recession), the data continues to weaken as we work our way through 2012 despite some economic stimulus programs and lower interest rates. China’s economic condition is important because it has been the largest buyer of commodities over the last decade and has been the marginal buyer for most basic resources. They have also been acquirers of companies directly, with the $16 billion bid for Canadian oil major, Nexen Inc, being its most recent deal. The chart below shows how closely the performance of the Global Materials Index (red line) has matched the growth of industrial production in China (blue line). The recent gains in that index could be at risk if Chinese growth continues to weaken over the balance of the year.
Our view continues to be that Chinese growth will bottom in the current quarter in the 7.5% range and then start to increase again in the 4th quarter. But feedback from some interviews with larger, cyclical companies in a variety of industries in China did little to support our confidence about a near-term rebound in the economy. Companies are seeing slower order flows and are running down inventory levels as opposed to increasing production. Recent Chinese economic data has yet to confirm any rebound either but it does at least show some stabilization at these lower levels. But economic data is often somewhat ‘backward looking’ and corporations are somewhat like individuals in reflecting current conditions as the outlook as well. We tend to look at actual physical activity such as commodity demand/flows/pricing as better indicators of future growth. That is the one area where we are seeing some serious evidence of a recovery. Copper inventories continue to decline and that has supported copper prices moving back towards their highs. Zinc prices have increased by over 15% in the past month as inventories get wound down. Steel production has also picked up recently as inventories have been wound down and this has lead to a rebound in iron ore prices, which had collapsed from over US$160 per tonne to almost US$90 per tonne, which is very close to the production cost for iron ore in most Chinese mines. The other important point to remember about commodity demand from China is that economic growth in the 7-8% range leads to a similar physical demand for commodities that 9-10% growth did in the 2003-2008 period, due to the larger size of the Chinese economy today versus the earlier period.
Another key positive point in the commodity story comes from the supply side. With poor mining stock performance over the past 18 months and falling commodity prices, companies are feeling less optimistic about the outlook and have therefore cut back on some major spending initiatives. BHP’s deferral of the expansion at Olympic Dam, a huge mining centre in South Australia is an example of this. It is the site of an extremely large iron oxide copper gold deposit producing copper, uranium, gold and silver. It is the 4th largest copper deposit and the largest known single deposit of uranium in the world, though uranium represents only a minority of the mine’s total revenue. There were plans to expand the mine, but this has now been postponed indefinitely pending investigation of a “new and cheaper design”. Alpha Natural Resources also announced the closure of 16mm tonnes of coal production due to lower prices and higher costs. Mining giant Xstrata has also deferred over US$1 billion in capital spending while Canadian miner, Teck Resources, has postponed over US$6 billion in capex at their Quebrada Blanca copper mine in Chile. These supply reductions have more than offset any demand losses due to slower global growth and will support yet higher commodity prices once the rebound takes hold.
While economic issues are the main headwind to stronger markets, stock valuations in general are not. The chart below shows the average price-earnings (P-E) ratios for stocks in various countries/regions versus their historical averages. Outside of Brazil and Mexico, all the regions are trading at P-E valuations well below their historical levels. While China is trading at the largest discount to its long-term levels (followed closely by Europe), the global index is trading at under 12 times earnings, about 25% lower than the long-term average of 15.8 times.
