A big commodity call

PORTFOLIO POINT: UBS sees an improved outlook for coal, iron ore and gold, and lists two Australian miners in its global top 10.

After being negative on commodities all year, investment bank UBS recently revised its view and confirmed it was serious in multiple documents and strategy advisories sent to its clientele across the world. The move brings UBS in line with its peers, including Goldman Sachs and Macquarie.

What makes the switch even more remarkable is that "economic growth" inside or outside China does not feature prominently as motivating the change. So what does?

One of the key factors is an unwinding of the short US dollar / long commodity carry trade, which caused so many headaches for investors in August.

It was always UBS's view that such a cathartic event was hanging in front of the sector, but now that we've gone through the inevitable clean-out in excessive market positioning, the analysts believe the market is set for a new upswing. Mind you, the unwinding of these market positions is probably going to take a few more months to complete, but that's enough improvement for UBS to start preparing for a change in direction.

Other factors that have been taken into account are cheap valuations, overall market positioning, China's policies, the inventory cycle in the Western economies and dollar fund flows. Let's examine all these factors.

Shares in energy companies and miners have sold off quickly and relentlessly in the past months. The consensus is that many of these equities are now trading at significant discounts to net present value or on earnings and cash flow multiples not seen for many years. Many observers also believe that as long as general risk appetite remains low on the back of slowing economies into 2012, this situation may not change anytime soon.

On the other hand, the gap between defensive stocks in the sharemarket and commodities has now grown so wide that some experts believe a short-term bounce for commodities stocks has become almost inevitable, if only for pure technical reasons. This may well be the bounce we are witnessing this week and last.

Interestingly, banks had started underperforming about three months earlier than resources stocks this year, but they recently outperformed ahead of the local banks reporting season. This has left miners and energy stocks behind as the laggards, as shown on the chart below, which compares shares in Westpac and BHP Billiton on a relative comparison since October last year.

Note that UBS is not predicting an immediate recovery rally for commodities stocks is in the making. Instead, the analysts argue the outlook overall is improving and they continue to see further improvement, so that the balance will gradually tip in favour of such a recovery rally. The only factor that is currently firmly on "green" (in traffic lights terms) is the fact that overall valuations now look decidedly cheap. Other factors such as market positioning, China policies and the inventory cycle are improving, but not flashing "green" as yet.

UBS suggests we will be much closer to an all green lights situation by December or early next year.

As part of the excessive market positioning, dubbed the "mother of all carry trades", UBS analysts refer to the significant reduction in speculative market positions in commodity markets since May this year, as well as the net outflows of capital in emerging markets and the reduction in speculative long positions in commodity currencies such as the Australian dollar.

In May, the analysts say, investors had built up the largest-ever net short positioning in US dollars and – surprise – this was matched with the largest-ever net long positioning in commodities. Both positionings have been significantly rebalanced since.

More worrisome, perhaps, is that Chinese banks seem to grow increasingly cautious and more conservative in their lending. This acts as a dampener on economic activity and further feeds into the popularity of the shadow lending system and other alternative sources for funding. Macquarie does acknowledge the banks' reluctance can disappear instantly on the central government's command, but thus far a general policy of "targeted tightening" remains in place.

Combining all of the above, it seems the best investors can hope for is for further deterioration in economic growth and inflation. The combination of the two might convince authorities in Beijing sooner rather than later it's time to loosen up a bit and start stimulating overall activity again. It certainly puts the "disappointing" third-quarter GDP growth of 9.1% in a different perspective.

UBS's favourite commodities are thermal coal, iron ore and gold. Its list of most preferred stocks globally is a direct reflection of these preferences. Two Australian-listed companies made it onto the global top 10: Rio Tinto (RIO) and Fortescue Metals Group (FMG) – though that's not necessarily a view unique to UBS (understatement). Where UBS differs from (some) other experts is in its choice of least-preferred commodities: aluminium and nickel. Many experts would probably agree with the first choice, not necessarily with the second.

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service. This is an edited version of an article sent to FNArena clients.