Morningstar recently published its Basic Materials Outlook. Like most analysts, Daniel Rohr, director of basic materials research, is bullish on the overall commodities sector and cautions investors that the transitioning Chinese economy will continue to depress both prices and consumer spending.
"You are already seeing a knock on effect from the slowing fixed-asset investment environment and deflation of asset prices on households' willingness to spend," Rohr said. "That would more broadly fit the pattern that you observe when you look back through history at prior episodes of profound economic rebalancings. Japan, Taiwan, South Korea all had spectacular investment-led growth. Once that growth came to an end, a rebalancing wasn't accomplished by an acceleration in consumption and a deceleration in investment. In each and every case, consumption decelerated sharply as well."
Divestment as a Strategy
Morningstar expects Chinese household consumption growth to decelerate from the trailing 10-year average. Rohr said companies are responding to tectonic shifts in the macroeconomic environment by reorganizing their portfolios.
Miners coping with poor Chinese demand and weak commodity prices are looking to sell assets and shrink. Agricultural chemical companies have taken a different approach. Faltering crop prices have prompted many to seek mergers in a bid to cut overhead and grab synergies. "That's what we're seeing right now in China. As it pertains to commodities, it's a negative environment for ALL commodities, just somewhat less negative for the consumer-oriented ones," Rohr said.
Morningstar analysts remain relatively bullish, relative to the depressed market, on commodities oriented to the Chinese consumer but nonetheless expect Chinese household consumption growth to decelerate from the trailing 10-year average.
“The first thing we check off is limited exposure to Chinese fixed-asset investment,” Rohr said. “That’s one of the things we saw with Potash Corp. Agricultural demand, commodities that factor into the production of food, is something that’s not exposed in that way.”
Gold and The Fed
With gold, Rohr said Morningstar does not believe the recent Federal Reserve interest rate hikes are going to engender outflows from Gold exchange-traded funds.
Although Morningstar continues to be bearish on gold, the long-term picture of the metal, as a product, has a better outlook than its industrial and investment uses.
"To the extent that gold does offer an alternative to stocks we don't see that changing much, but, looking further out, we do see consumer demand for gold going up, meaning, mostly jewelry," Rohr said.
Morningstar also backed Allegheny Technologies, Inc. as a top basic materials pick, despite the very challenging environment in the steel sector. In a note, Morningstar said, "For Allegheny, near-term headwinds are significant. Its flat-rolled products segment has become unprofitable on an EBITDA basis, as the company is dealing with low stainless steel prices, weak demand from the energy end market, and an ongoing lockout of union employees. However, with the ramp-up of the new hot-rolling and processing facility, the eventual signing of a new contract with the United Steelworkers union that is likely to save costs for Allegheny relative to the expired agreement, and operational rightsizing, we expect the flat-rolled products segment to restore profitability in 2016."