Key Points
- The basic materials sector continues to trade very close to our fair value at a median price/fair value of 0.98 compared with a market price/fair value of 1.02.
- Improved headline GDP in China comforted many investors. It shouldn't have. While China's GDP figures don't yet reflect real estate's troubles, they are likely to soon.
- Lower corn and soybean prices in North America will put some near-term pressure on crop input producers. The long-term outlook for these companies looks more promising given our view of food consumption in emerging markets.
- Declining recycled fibre prices will probably result in further weakness in containerboard prices.
China’s Real Estate Slump
As China goes, so go many industrial commodities. The country consumes massive amounts of many globally fungible commodities, making China's economic activity—particularly its fixed-asset investment—a good gauge for commodity market health.
According to the consensus narrative, Beijing's recent "mini-stimulus" succeeded in pulling the economy out of a cyclical trough, as evidenced by the sequential uptick in GDP growth to 7.5% from 7.4%. Consensus credits infrastructure spending for the improvement, which offset a weak real estate market. Although headline GDP has improved, fundamentals have worsened. With physical capital that largely exceeds the country's needs across manufacturing, real estate and infrastructure, China doesn't suffer from a deficit of investment. Stimulus solves little other than the problem of politically unpalatable GDP figures. Meanwhile, it exacerbates China's far more serious problem: debt.
Contrary to the consensus narrative, real estate was not a headwind for GDP in the first half of 2014. Based on our analysis of China's fixed-asset investment figures for the first six months of the year, real estate added 3 times as much to GDP growth as spending on rails, roads, airports, water and pipeline transport combined. This is a function of how real estate's contribution to GDP is counted.
While China's GDP figures don't yet reflect real estate's troubles, they are likely to soon. Leading indicators for real estate, which have a lagged impact on GDP, continue to signal trouble ahead. July’s year-to-date date revealed real estate construction starts were off 13% and sales were down 8%. Prices have taken a turn for the worse in 79% of China's major cities and are likely to remain under pressure: The pipeline of new supply remains ample despite falling demand.
Impact on Commodities
The impact for commodities is significant. Real estate has been the single largest driver of China's demand growth. In the case of steel, real estate directly accounts for half of China's usage, which in turn accounts for half of global usage. The slowdown in real estate has already put significant pressure on prices for globally fungible commodities, including iron ore and copper. We do not expect that pressure to abate.
What looks to be a bumper corn and soybean crop in North America has put pressure on prices and should lead to some near-term headwinds for crop input producers. With US farmer income expected to be down roughly 25% year over year, growers will have less money in their pockets. However, estimates for 2014 are still above 10-year averages, and we expect the big harvest will have minimal effect on seed and fertiliser producers. We doubt farmers will cut back meaningfully on inputs that help improve yields, and thus revenue.
Tension in the global potash market seems to have abated, with large Eastern European producer Uralkali announcing that it would cut production by 8% this year in an effort to maintain prices. This marks a step back toward its former price-over-volume strategy—a practice that supports potash prices above marginal costs of production. With price pressure from Uralkali's actions last summer dwindling, we think potash prices bottomed mid-2014 and will move up from here.
Over the long run, we think fertiliser and seed producers will benefit from growing appetites in emerging markets. With limited opportunities to meaningfully increase global planted acres, yield gains will need to account for the vast majority of increases in food production.
On July 21, benchmark North American containerboard prices fell for the first time since 2009. This took many in the industry by surprise, as the industry had enjoyed greater pricing power following industry consolidation that better matched supply with demand. The main drivers behind recent weakness in containerboard pricing are new recycled fibre-based containerboard capacity entering the North American market along with tepid domestic box demand.
In recent months, recycled-fibre prices have been falling due to weaker-than-expected Chinese demand, which should provide an additional benefit to the new recycled-fibre market entrants relative to the larger producers. The combination of new capacity and lower recycled-fibre prices will also likely put further pressure on North American containerboard prices and may require some of the larger producers to take economic downtime in the fourth quarter.
Harsh weather during the first quarter disrupted rail traffic and, subsequently, coal deliveries out of North America’s major coal-producing Powder River Basin. The resulting backlog of coal deliveries continues to hang over PRB coal prices in the third quarter. Many utilities have reached low levels of coal and are seeking additional tons beyond their contracted amounts. As these customers are still waiting on delayed contracted tons, they are hesitant to purchase more coal in the spot market given the uncertainty on delivery timing. Until regular spot purchases return to the market, we don't expect pricing to improve. While rails have been working to expand capacity and work through delivery backlog, progress has been slower than expected.
