Iron ore coming up roses

Anyone who looks deeper into the current problems with collateralised debt obligations, or CDOs, in the United States, draws the conclusion that things are looking pretty scary in North America. (Yesterday, US share traders got spooked about the debt markets again, this time after a reported loss from America's biggest home-building company).

However, apart from one or two hedge funds here and there, and lots of scary statistics and foretelling by market commentators, the problem seems to have remained contained thus far.

Meanwhile, equity markets seem to have recaptured their former strength with shares of resources companies powering ahead as spot prices remain at higher-than-expected levels. This time, however, securities analysts are joining the party as well as one after the other decides to increase price forecasts.

This week alone (Monday and Tuesday) saw JP Morgan, WilsonHTM and UBS increase their price forecasts across the base materials spectrum – and in large percentages. New estimates foresee another bumper price increase for iron ore at the upcoming annual price negotiations (plus 25%), the spot price of uranium averaging nearly US$200/lb in 2008, and copper remaining north of US$3/lb for at least the next two years.

It's good news for big Australian miners, especially Rio (currently trading at around $102), which is enjoying a string of market forecast upgrades including an ambitious price target of $129. (See today's breakout panel).

What a difference a few months can make. The question that has to be asked though is whether equity investors are not digging a large hole for themselves to fall into later this year.

The answer is: probably not. Those in favour of the current equity markets surge state that while the news flow from the US CDO market will undoubtedly remain negative, a clear positive is that the problems seem to reveal themselves in little bits and pieces, more than all at once. (CDOs are 'collateralised' or combined funds which package a range of bonds into high-yielding/high-risk packages).

Assuming this gradual process of CDO control remains in place, this allows investors to focus on the main pillar underneath the current resources boom, and that is a stronger-than-expected global economy. While securities analysts are lifting their price forecasts for base materials (including oil), economists are increasing their GDP growth forecasts for Japan and the US, while keeping an upward bias towards China.

So far, economists see no reason why economic growth would disappoint in the second half of this year. Most will acknowledge that price inflation will make a comeback, and soon, too, but the fact that it has unexpectedly subsided over the past few months in places such as the US and Australia will now give central bankers in these countries more time to act gently. As this will keep bond yields contained, the general view is the way forward for equity markets continues to look positive.

If anything, more bad news stemming from the forced devaluation of CDOs may well keep the Federal Reserve Bank on the sidelines for the remainder of this year. Again, assuming the US consumer doesn't freeze in light of more shock announcements (which are on the way, there's little doubt about that), the US economy should do just fine, as will the rest of the world.

Market strategists at global research group GaveKal have discovered another reason why the CDO problem in the US could have a beneficial impact on global equities. US pension funds (and other institutions) have been taking up large amounts of so-called 'structured products’ over the past few years.

Now consider the following: Each dollar of these structured products in essence consisted of 80 cents in a 10-year zero-coupon bond and 20 cents in CDOs, or similar financial products. With this arrangement, the pension funds were offered a 'high yield’ (represented by the CDOs in the products) and 'capital guarantee’ (provided by the US Treasury).

The large take-up of these structured products has created a big demand for 10-year zero bonds and CDOs, says GaveKal who goes as far as stating that this is part of the explanation of why US bond yields have remained so low for so long. (Add China's large appetite for US Treasuries and we probably have the full explanation).

Now that the CDO part of the arrangement seems to be falling apart, these fund managers are likely to seek compensation elsewhere. The most logical thing to do would be to redirect some of their funds towards riskier/higher-return assets, such as share markets.

More money flowing into equity markets that are already basking in abundant liquidity can only be a positive for these markets, GaveKal concludes – and who would disagree with this view?

The problem is, of course, that the current boom for prices of oil, copper and lead, and ongoing stretched labour markets, will eventually lead to resurgent price inflation. And that's why most economists are still pencilling in US rate hikes for 2008 (a similar shift seems to be happening in Australia). On top of this will come more scary events from the CDO markets and the underlying sub-prime home loans.

The combination of all these factors may contribute to a completely different environment later this year, or into next year, but that's something to worry about then. Right now, the outlook for economic growth, global liquidity, inflation and company profits seems positive and that is bound to translate into higher share prices – even though a careful selection of which stocks to own seems more important than ever at this stage of the bull cycle.