A leading investment strategist has called the end of the commodity "super-cycle" that helped keep Australia out of recession during the global financial crisis.
"After an upturn lasting a decade, the commodity super-cycle's end is at hand," says the head of investment strategy for Australia at UBS, Mark Rider. Rider, who has worked for the Reserve Bank of Australia as the head of economic activity and forecasting, says the forces of supply and demand that contributed to a rapid and sustained rise in commodity prices over the past decade are now driving prices lower.
On the demand side, China is settling into a more moderate pace of economic growth and many of the largest developed economies are struggling with government debt. "Robust supply growth has also become increasingly evident, or is in prospect, for a wide range of commodities," Rider says. "Weaker demand and increased supply have restored the balance to commodities markets."
China's economic expansion, which has been running at an annual rate of more than 10 per cent over the past two decades, has slowed to about 7.5 per cent. "The peak in the current cycle for a range of major commodities is well behind us," Rider says. He says aluminum, nickel, zinc, natural gas, oil, iron ore, hard coking coal and thermal coal are well off their cyclical highs.
"Deeper mines, lower-grade minerals, more remote and challenging locations, and shortages of both labour and equipment, have pushed up costs," Rider says. Of course, it is not just China's economy that is behind falling commodity prices.
Investors are still nervous about the prospects for global economic growth, and the sovereign debt problems in the eurozone continue to weigh on investor sentiment. Then there is the fragile US economic recovery and concerns over the "fiscal cliff" where, if politicians cannot agree on the budget, automatic spending cuts and tax increases will push the country into recession.
That is not good news for small investors whose mainstay mining stocks include BHP Billiton and Rio Tinto. Both have underperformed the market by big margins. Since peaking at $49 in April 2011, BHP's share price is down more than 30 per cent to about $35. Rio Tinto's share price is down more than 30 per cent to about $60, from its February 2011 peak of $89.
Rider argues that while the prices of commodities are likely to remain below their record highs, that does not mean they will soon revert to their pre-2002 levels, when the super-cycle started. However, previous cycles suggest that the downswing in commodity prices could last two decades, he says.
The high Australian dollar is not helping our miners, as it makes commodities exports more expensive. Rider says with the exception of iron ore, our miners are no longer low-cost producers and overseas producers have lower costs. "The type of earnings that [our miners] can get is not going to be anywhere as strong as they were just a few years ago," Rider says. Miners will need to continue clamping down on costs, and a lower Australian dollar would help them, he says. "The [Australian] mining sector has been at the leading edge of the upturn, and now it is clearly starting to see its competitiveness undermined by the escalation of costs."
Clime Asset Management said in a note last month that it values BHP shares at $38 and Rio Tinto shares at $55. Clime says resources businesses are among the most challenging to value and investors should buy with a large margin of safety. Both companies rank highly on Clime's qualitative ratings system, which assesses a range of financial and solvency ratios.
Clime says that over the next decade BHP's earnings mix will tilt towards energy-related commodities such as oil, gas, uranium and potash, as energy consumption ramps up in the emerging economies. "BHP appears well positioned for this transition - better than Rio Tinto, which is much more focused on iron ore production," Clime says.
While China's growth is slowing, economists are not expecting its performance to fall into a hole. Rider says China still has a lot of investment to make, but the strongest phase is behind it. The chief economist at AMP Capital Investors, Shane Oliver, says there is still no sign of a hard landing and Chinese growth - at more than 7 per cent - is still very strong.
"China's catch-up potential remains immense," he says. "On a per-capita basis, roads, railways, airports, phone lines, living space and cars are well below US and Australian levels."
The movement of people from China's countryside to its cities has a long way to go and the drivers of growth remain in place. The stabilisation of Chinese growth should be positive for the Australian economy and resource stocks, Oliver says.
Why investors should look beyond the miners
Michael Heffernan, a senior client adviser and economist at Lonsec sharebrokers, says even with the big falls in the price of BHP Billiton and Rio Tinto shares, he would not be buying them now. He says the two miners are "not going broke, but investors could be doing something better with their money". He has been advising clients to sell some of their BHP and RIO shares and buy Telstra, the big banks, Woolworths and Wesfarmers — stocks that have done very well. As interest rates come down, these stocks, which are on dividend yields of 5 per cent to 7 per cent, fully franked, are going to be more in demand, he says. And they have the potential for higher share prices as well, he says. BHP and Rio have cash yields of about 3 per cent. Heffernan says commodity prices are not likely to be going higher over the next 12 months but once economic growth picks up in Europe and the US, investors could take a look at the big miners again.