Can you be a world dominating company when there’s inherently cyclicality and volatility in the underlying price of the commodity you produce? Or even more simply can commodity stocks be world dominators?
We take up the same question we tackled in yesterday’s Daily Reckoning. If you accept the premise that you’re investing in a great transitional period in history where, generally speaking, standards of living are falling in the West and rising in the East, what Australian companies (if any) are in the best spot to dominate (or at least profit) from this trend?
It might not be as easy to profit as it sounds. Take volatility. According to Emma Connors in today’s Australian Financial Review, “A sharp increase in volatility in the always fast-moving commodities markets has underlined the difficulty inherent in forecasting prices.”
Despite this difficulty, the government is basing its budget forecasts on record high commodity prices and a record high terms of trade. It’s the huge gains in coal and iron ore prices that will contribute to a nominal 9.25% rise in GDP next year according to the Treasury forecasts. Remember, though, that you can subtract 6% from that rate, the undeclared rate of inflation.
In recent weekly updates to Australian Wealth Gameplan we’ve reported that Chinese steel prices and iron ore imports (along with ore prices in the spot market) have both been trending down. But in Bloomberg today we read that Chinese steel prices were up 4.7% last week, the most in eleven months. What gives?
We reckon this volatility is introduced by the $1.4 trillion in Chinese stimulus measures from last year. That spending coincided with a boom in fixed asset investment. Now, the question is how much of the demand and spending was driven by stimulus, and how much is sustainable?
“Chinese banks may struggle to recoup about 23 per cent of the $1.3 trillion they’ve lent to finance local government infrastructure projects, according to a person with knowledge of data collected by the nation’s regulator,” reports Andrea Papuc, also in Bloomberg. “About half of all loans needed to be serviced by secondary sources including guarantors because the ventures couldn’t generate revenues, the source said, declining to be identified because the information is confidential.”
Hmm. You mean Chinese banks went on a lending boom to finance projects that are not generating a return and the loans might damage bank capital? Sounds familiar, doesn’t it?
“The government has been grappling with how to rein in the credit fuelled stimulus before it leads to overheating, according to a July 14 report by Fitch Ratings analyst Charlene Chu. Lending hasn’t slowed as much as official data suggests because Chinese banks are shifting loans off balance sheets by repackaging them into investment products sold to investors, the report show.”
Hey, that doesn’t sound anything like the securitisation of subprime mortgages AT ALL, does it?
But rather than make allusions to the last credit bubble in which cheap money was fuelled into an asset class that was sold to investors but failed to generate a big return, we should just say that if the earnings growth of Aussie resource stocks depends on regular, predictable, steady Chinese demand, earnings growth is going to be really volatile.
That’s not to say that the iron ore and coal companies taking advantage of record export prices can’t be world dominators. They can be, if only based on their ownership of easily accessible, high quality ore bodies. But the underlying assumptions about the prices for those commodities may be overly stable, given the violent nature of bursting bubbles.
But hey, laissez le bon temps rouler, as they say in New Orleans. Let the good times roll. Tomorrow, how not to get rolled over.
for The Daily Reckoning Australia