Morgan Stanley iron ore forecast a risk for shares

It will be hard to avoid a shares pullback by year’s end if Morgan Stanley’s iron ore forecasts are right.

Even with record-low interest rates still propping up the sharemarket, it will be hard to avoid a decent pullback before the end of the year if Morgan Stanley’s iron ore forecasts are right.

The broker reiterated its call for Australia’s biggest commodity export to tumble to $US40 a tonne in the second half and a record low of $US35 in the fourth quarter.

While global sharemarkets, monetary policy and oil prices had also driven the sharemarket in the past 12 months, Australia’s S&P/ASX 200 share index has had a fairly strong positive correlation with the iron ore price. Shares and commodities bore the brunt of concern about China’s faltering economy before policy stimulus in China finally gained traction and other central banks came to the party, boosting risk assets across the board.

But when iron ore was trading around $US40 a tonne at the end of last year, Australia’s sharemarket was hovering around 5000, versus 5532 points at yesterday’s close. Crude oil was trading around $US35 a barrel at that time versus $US45 now and its recovery has certainly helped the local sharemarket, as has lower-for-longer interest rates and the US sharemarket’s rise to record highs.

But if iron ore were to average $US35 in the fourth quarter, as Morgan Stanley expects, the sticker-shock of a new low for the spot pricing era would be a major blow to the Australian sharemarket since it had benefited from a recovery in resources stocks this year.

BHP was cautious as usual but perhaps understated the risks to the global economy in its earnings outlook statements yesterday. While China’s economy appears to have stabilised, BHP said it expected global growth in the second half to “remain modest” and it saw “downside risks”.

With China’s iron ore port inventory recently hitting a 19-month high of 106 million tonnes — near the record high of 114 million tonnes it hit two years ago — it’s not hard to imagine the price peeling off once the frenetic August construction period is out of the way.

According to Morgan Stanley, China’s steel-intensive infrastructure programs have needed a higher-than-expected steel output rate from its industry, underpinning iron ore demand and giving upside risk to 2016 ore price expectations, the consensus for which is $US47 a tonne.

But the broker is sticking to its call for a seasonal pullback as China’s steel demand and production rate abate ahead of winter, undermining ore demand and prices.

“While the enforcement of steel production capacity cuts and higher credit liquidity for steel-intensive projects may mitigate seasonal flows, offering short-term support for trade flows and steel and ore prices, winter constraints on Asia’s trade and deployment of steel are profound, invariably retarding second-half relative price performances,” the broker says.

And beyond the seasonal pullback, ore prices should also become increasingly capped in the second half by ongoing supply growth as the world’s major producers continue to ramp up production.

Rio Tinto has just approved its Silvergrass development, firming up expectations that it will be producing a massive 340 million tonnes per annum in the years ahead, BHP Billiton is due produce 270Mtpa this fiscal year, Vale’s 26Mpta S11D project development is on schedule and nearing start-up, Roy Hill appears set to reach 40-50Mtpa by year-end, and Fortescue has guided towards 165- 170Mt for fiscal 2017, which is 25-30Mt above Morgan Stanley’s own forecast.