November 21, 2017

Mining rally causes conundrum for investors

The strong rally in the South African stock market in the first quarter of this year was underpinned by the unlikeliest of pillars – the beleaguered mining sector.

Mining stocks, recovering from a perfect storm of low commodity prices, high costs and emerging market aversion, have made a remarkable recovery.

Just a few months ago, poorly performing commodity stocks, and emerging markets, were no go areas for investors.

But the tide has turned quickly, and a question being asked with increasing frequency is whether now is the time to invest in, or increase exposure to mining stocks.

The Johannesburg Securities Exchange (JSE) outperformed global developed and emerging market indices in the quarter as a ‘risk on’ rally over a four week period from mid-February saw investors return to both emerging markets and mining companies”, according to Tom Elliot, international investment strategist for the deVere Group.

Many emerging markets investors have turned their attention from India and China to invest in companies that will benefit from higher commodity prices in countries whose currencies will benefit from a weaker dollar resulting from the lower interest rate outlook from the US Federal Reserve.

The MSCI South Africa index rose 13.8% in US dollar terms and 8% in rand terms.

The S&P/TSX Global Mining index rose by just under 13% in US dollar terms in the quarter. On the JSE, the all share rose 3.07% in the quarter. In the February rally, gold mining stocks were up by over 45%, platinum and precious metals over 18% and general mining over 17%.

“The gold price rose 17% over the first quarter, helped largely by the downward pressure on the dollar, Elliot said. “A heightened fear of international terrorism has also contributed to the demand for gold as a safe haven.”

“However, while ETF gold funds have sold well, there has been little pick-up in physical demand from China, India and other large gold-consuming countries. Industrial use of gold has similarly been flat. Many gold analysts look to the demand for gold in the ‘real world’ as a backstop to the gold price, and the lack of any improved end-user demand is therefore a warning to some investors not to chase the metal too high – unless, of course, geo-political risk increases and/or the dollar appears set for a further bout of weakness.”

The strong recovery in mining stocks globally reflects both investor sentiment and industry-specific factors that have resulted in higher metal prices said Elliot.

“These include an industry shake-out of high cost supplies over the last 18 months, which has reduced supply forecasts. The global demand picture has also improved, thanks in large part to a more dovish US Federal Reserve and assurances by the Chinese government that a looser fiscal policy will be implemented in order to protect the economy from a hard landing,” Elliot said.

It has taken mining companies, with long investment cycles, some time to adapt to change, but the results are starting to become evident.

They have made sweeping changes including selling assets and streamlining to focus on core metals and minerals. They are cutting production and bringing costs in line with lower production targets, and they have cut dividends

Debt-ridden Glencore, for example, is selling assets – including the recent $2.5bn sale of its agricultural business – to bring down debt and has scrapped its dividend. Anglo American is selling more than half its mines in a bid to focus on diamonds, platinum and copper and raised funds. Although the companies are not out of the woods by any means, Glencore’s share gained 75% this year, while Anglo is up more than 150%.

The changes are equally evident in South African and global mining companies, but the optimism expressed by investors for local stocks is somewhat surprising given the low growth outlook for South Africa, its political leadership crisis, power supply issues and labour challenges. Investors are also concerned about the glut of mining assets up for sale, with few willing or able buyers at decent valuations.

“Although it is unlikely the share price momentum can be maintained at current levels, there is certainly a feeling amongst global investors that if base and precious metal prices can stabilise, and the US Fed refrains from unnecessary monetary tightening, the mining-led rally in emerging market stocks has further to go. If it does, we can expect further out performance from the South African stock market,” said Elliot.

“While the multi-year sell-off may be coming to an end, few investors expect a strong multi-year bull market given the ongoing uncertainties in the global economy. There is also the risk that higher metals prices actually put off the very plans for mine closures that have helped support the rally.”

“We will be looking to the sector as a diversifier and as provider of dividends. A lot of the uncertainty concerning dividends from miners has been reduced after recent adjustments to pay-out policies, reflecting acceptance that the current era of relatively low metal prices may be with us for a long time to come.”

While there has been positive change, sentiment remains bearish in some quarters with concerns over valuations.

Rating agency Moody’s Investors Service, which has downgraded companies like Anglo, said earlier this year that a fundamental shift in the operating environment requires “a wholesale recalibration of ratings”. The same could be applied to valuations.

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