Spot commodity prices signal robust outlook for top miners

Spot commodity prices imply that consensus earnings forecasts for the miners could increase by more than 50pc.

Spot commodity pricing would put Rio Tinto on a forward PE ratio of seven times. Picture: Bloomberg

Deutsche Bank strategists Tim Baker and Joseph Kim have five reasons to stay “dug into miners”.

First, the miners are still in an earnings upgrade cycle. Spot commodity prices imply that the consensus earnings forecasts for the miners could be increased by more than 50 per cent. And many of Australian miners would be trading on single-digit price-to-earnings ratios if spot prices were incorporated into analyst forecasts.

Spot commodity pricing would put BHP Billiton on a forward PE ratio of 12 times and Rio Tinto on seven times. South32 would be on nine, Fortescue Metals on four and Whitehaven Coal on six. Interesting on that score on Thursday were Australia’s international trade data showing that the combined trade surplus for November and December was more than 70 per cent higher than economists expected, mostly because of higher commodity export volumes and prices.

At the same time, high commodity prices and restrained capital expenditure should see record cash flow for miners. That could drive a wave of capital management initiatives that may include bigger dividends, special dividends and share buybacks. It’s a fair assumption since miners are unlikely to ramp up investment again after the biggest mining capex boom of all time. Deutsche Bank says the miners’ free cash flow should peak at a record $27 billion in fiscal 2017 before easing to still-robust levels around $15bn in the next two years.

Recent share price strength in the mining companies may be partly driven by expectations of capital management, and if they surge before the results there could be some profit-taking afterwards. But if commodity prices stay firm, miners should remain supported on dips. Of course, much depends on China’s regulatory landscape, changes in which boosted its demand for coal last year.

Chinese demand for raw materials could also be affected by any trade war caused by Donald Trump’s protectionist policies, although the view seems to be that the US President will be pragmatic when it comes to China. Slapping massive tariffs on China would certainly drive up prices in the US.

As for China’s economy, economists are expecting a pro-growth stance to dominate before the National People’s Congress in October.

Also, investors may still be underweight the miners, according to Deutsche Bank. While domestic superannuation funds have been steadily increasing their holdings of Australian equities ex-banks and REITS, foreign investors have been net sellers since mid-2015. It’s consistent with Deutsche Bank’s view that foreigners are underweight Australian miners.

That said, the short positions on Fortescue, South32 and Whitehaven Coal are unusually low, so watch out if the hedge funds get any reason to sell.

But China’s cyclical upturn looks to have momentum, amid a doubling of nominal GDP and positive lead indicators, the Deutsche Bank strategists say. The SpaceKnow Satellite Manufacturing Index — which uses an algorithm to compare satellite images of more than 6000 industrial sites across China and assigns values for visual changes over time that indicate economic activity — confirms the bottoming in China’s manufacturing PMI data over the past year. The SpaceKnow index hit a 5.5-year high last month after a five-year low 12 months ago.

Finally, the Deutsche Bank strategists say the “China overinvestment story” seems exaggerated. Sure, China’s capex-to-GDP ratio is at a record 45 per cent, but the capex data is not readily comparable. Data on steel use per person tells a different story — China uses 20 per cent less steel than Japan and the US did in the 1960-80 period.