This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, James Sutton, Client Portfolio Manager, J.P. Morgan Asset Management explains how resources have outperformed despite the emerging markets sell-off.
It has been a volatile start to the year. Developed world equity markets are flat to down. In the emerging markets, fears of a balance of payments crisis in Argentina and Turkey, and weaker-than-expected manufacturing activity in Brazil, Russia, India and China, has pushed the MSCI Emerging Market Index down 5%. More recently, the ousting of Ukrainian President Yanukovych and Russia’s occupation of Crimea have further diminished risk appetite.
And yet the resources sector, a segment of the market normally driven by increasing risk appetite and emerging market optimism, has outperformed. Commodity prices, as represented by the Dow-Jones UBS Commodity Index are up 7%, while the MSCI materials sector is the second best performing sector year to date within global equity markets.
So What is Going On?
Well, one simple explanation is that the resources sector had become oversold and that we have moved past the point of maximum pessimism. Fund manager allocations to the sector, as reported in industry surveys, had already reached record low levels by the end of last year and we have likely seen some short-covering of those positions. This has been most evident for gold equities, which endured a sustained sell-off in 2013—down over 50%—but up over 20% so far this year. Moving from pessimism to scepticism can have a powerful effect.
However, we believe there is something more fundamental going on. Companies have got the message regarding more disciplined capital allocation and greater shareholder returns, as evidenced in the most recent earnings updates. Rio Tinto (RIO), for example, reiterated cuts to capital expenditure and raised its dividend by 15%. BHP Billiton (BLT) announced $5 billion cost savings and hinted at a share buyback later in the year. And Glencore Xstrata (GLEN) announced additional synergies related to the Xstrata merger and also raised its dividend by 5%. Having talked the talk for much of last year, mining executives are increasingly walking the walk. This is leading to the first earnings upgrades to these stocks since the beginning of 2011.
And What About Valuations?
Relative to global equity markets, the sector has underperformed for three straight calendar years—the longest run since the early 1990s. Compared to the MSCI World Index, which now trades on 15.2 times 2014 forecast earnings, resource equities look cheap. Looking at our two largest holdings, Rio Tinto is currently on 9.7x this year’s earnings, while Freeport McMoran (FCX) is on 11.4 times. At the small cap end, energy and mining companies trade at a significant discount to their “proven & probable” reserves, leaving investors with a free option on exploration activity. With such distressed valuations, it is unsurprising to see private equity investors sniffing around.
Such robust performance in a challenging market begs the question of how well the resource sector could perform in more benign macroeconomic conditions should they emerge this year.
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