By Chris Berry (@cberry1)
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In 2012, Nate Silver, a well known statistician and writer, penned the book “The Signal and The Noise” which discusses using statistics and probabilities to determine real-world outcomes. With volatility in the financial markets on the rise led by a collapsing oil price and plunging emerging market currencies, determining and differentiating the signals from the noise has profound implications for navigating the metals and mining markets as we forge ahead into 2015.
With the price of a barrel of oil (WTI) currently at US $56.05 and widely believed to be headed lower and other commodities including iron ore, silver, copper, and corn under similar relentless pressure, these trends are clear signals and the “noise” they generate is the damage done to investor portfolios.
Other signals include the state of the global economy with China slowing and readjusting its growth paradigm, the Euro Zone and Japan struggling to generate growth, and the US economy viewed as the “cleanest dirty shirt”. The recent PMI numbers released in China this week fell below 50 indicating a shrinking manufacturing sector. The PMI data in Europe is struggling to stay above 50 and in the US the Markit number is well above 50, but has recently fallen from 54.8 to 53.7. The trend here bodes ill for bulk metals and those widely used in various manufacturing businesses.
The US Dollar has strengthened by 8.7% in 2014 and many, myself included, expect this to continue into 2015 as Japan, the Euro Zone, and other economies around the world, many of which are dependent on commodity exports for growth, struggle to reflate their economies by weakening their currencies or other monetary policy quick fixes. Currency movements are yet another signal contributing to the overall noise in the markets. Case in point is the Russian Ruble, currently unable to halt a historic and breathtaking collapse.
Finally, one cannot ignore the performance of the sovereign debt markets and the downward spiral in yields. The trend is clear with the US 10 year bond yield struggling to stay above 2% and government bond yields on the short end of the curve in various Euro Zone countries negative in real terms. When the bond market speaks, it pays to stop and listen. The signal coming from the credit markets vis-à-vis commodities is that we are either in or entering a disinflationary period which is not indicative of any near-term turn higher in the commodity markets.
I’m not one to resort to hyperbole, but it does appear that while some parts of the world are in full-blown crisis mode (OPEC, Russia, commodity exporters), contagion from this volatility could easily spread to other parts of the global economy. With respect to metals, the data paints a troubling picture for investors and companies. Even some of the market darlings like nickel are under pressure as many now believe Russia may need to sell some of its nickel stockpile to stem the decline in its currency.
That said, every crisis does indeed offer opportunities and therefore avoiding all metals is a mistake. A mistake that I think equates to “throwing the baby out with the bathwater”. If you were to just focus on the collapse in the oil price or the gloomy forecast for gold trumpeted by financial media types, you’d think the entire commodity space was to be avoided. This couldn’t be further from the truth. Some metals are in real trouble, but there are those that look quite healthy in the near and longer-term including lithium and cobalt. Both metals have a demand profile growing well above global GDP and are essential in many new technology trends like vehicle electrification. Failing to at least consider these metals and the opportunities they provide means walking away from potential gains in an overly hated sector. It’s times like these that separate the true contrarians from the fakers. Which one are you?
One of the key questions going forward is how do you utilize these signals to mitigate the inherent risks specific to metals and minerals investing? I don’t claim to have the magic formula (you should run away – fast – from anyone who does), but I do think it’s clear that focusing on the sustainability of the mining companies is crucial. Given that the mining industry is structurally, more than cyclically, challenged right now, I think this mandates looking at companies somewhat differently than during the previous 10 years when most mining companies’ share prices went nowhere but up.
To survive and thrive going forward, a mining company, regardless of market cap, needs to have more than strong management or a bulletproof balance sheet. The idea of sustainability is rooted in achieving the lowest cost of production in your respective industry. With excess capacity of a host of metals and minerals and GDP growth rates stumbling, those opportunities with a disruptive advantage that allow for massive cost reductions must be considered. The mining industry has been traditionally slow to embrace change, but with the complexities to global supply chains only increasing and supply gluts of numerous commodities essentially guaranteeing flat to down commodity prices going forward, if a company you’re looking at can’t economically produce a commodity in the lowest decile, you may want to think twice.
In other market environments a “better mousetrap” ranks low on the list of investor must haves, but we’re not in an up market, and numerous signals in the financial markets shout this loud and clear. We’ve written extensively about this theme in the past and will continue to do so into 2015. The winds of deflation are blowing stronger each day and I think we’re headed for more next year. This, along with structural challenges to be reckoned with in the commodities markets, makes plain the need to separate the signals from the noise in mining investment.
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