Despite significant share price declines in recent months, the materials sector is not a land of investment opportunity. The average stock under our coverage trades at a 6% premium to our assessment of intrinsic value. However, the mean masks significant dispersion of valuation assessments.
Miners coping with poor Chinese demand and weak commodity prices are looking to sell assets and shrink
Morningstar analysts continue to forecast weak Chinese fixed asset investment and commensurately tepid demand growth for related commodities such as copper and iron ore. We remain relatively bullish on commodities oriented to the Chinese consumer but nonetheless expect Chinese household consumption growth to decelerate from the trailing 10-year average.
Companies are responding to tectonic shifts in the macroeconomic environment by reorganizing their portfolios. Miners coping with poor Chinese demand and weak commodity prices are looking to sell assets and shrink. Agricultural chemical companies have taken a different approach. Faltering crop prices have prompted many to seek mergers in a bid to cut overhead and grab synergies. We remain negative on the outlook for Chinese fixed asset investment, a view we’ve held since 2011. Overcapacity abounds across the Chinese economy, from real estate to manufacturing to infrastructure. Excess investment has manifest in a worryingly high debt-to-GDP at the macroeconomic level and struggling manufacturers at the company level.
Chinese Investment is Not Going to Rise
The recent slowdown in fixed asset investment is therefore more of a structural than a cyclical phenomenon. We expect, at best, 1.5% growth in Chinese fixed asset investment in the next five to 10 years. This will have profound implications for most mined commodities, since China’s investment-led growth model underwrote nearly all demand growth in the last decade.
For example, we believe China’s copper demand has peaked and should shrink as real estate activity fades to a level more commensurate with underlying urbanisation trends and power infrastructure spending pivots from copper-hungry distribution outlays to copper-light transmission outlays. We expect copper prices to slip below $2 per pound in 2017 and, in contrast to most forecasters, do not expect a sustained recovery to the $2.50– $3.00 range in subsequent years.
We remain relatively more bullish on commodities oriented to the Chinese consumer, as well as the stocks of companies that produce those commodities. Although we expect Chinese household consumption growth to decelerate, it should nonetheless perform much more strongly than the investment side of the economy.
What About Gold?
Our positive long-term gold outlook reflects this thesis. Although we expect gold prices to slip below $1,000 per ounce in 2016 as faltering investor interest in the yellow metals weighs on total demand, we believe sustained jewellery demand growth in China and India will lead gold prices on a sustained recovery thereafter, touching $1,300 per ounce by 2020. Consolidation activity in the chemicals space has picked up, highlighted by the mega-deal between Dow Chemical DOW and DuPont DD. With crop prices under pressure and agricultural chemical profits somewhat lagging, companies have been looking to cut costs to weather the storm.
Add in activist pressure and management shakeups at a number of big industry players and you get an environment ripe for M&A activity centered around cost synergies. We think the Dow and DuPont merger of equals will be value accretive for shareholders of both companies. Interestingly, and contrary to the broader trend in the materials space over the last decade, the Dow and DuPont plan is to eventually split the merged company into three separate publicly traded companies focusing on agriculture, material science, and specialty products.
Although this reduces the ability to generate corporate costs synergies, we like the fact that it gives investors more choice. Prospective cost synergies will likely be the big selling point for any additional consolidation in the space. We wouldn’t be surprised to see Monsanto MON take another run at Syngenta SYT, after being rebuffed in 2015.
