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Mining risks reduced, but not gone
The mining sector has significantly lagged the general equity market in recent years. However, as 2014 moves into top gear, a number of the downside risks have reduced (albeit not disappeared), writes Evy Hambro, Fund Manager of BlackRock’s BGF World Mining Fund.
The industry has made good progress in refocusing its strategy; operating costs have been aggressively targeted and investment in projects reassessed. Many commodities are trading close to or below their marginal cost of production, implying that price downside should be limited, in the absence of a collapse in demand.
The global economic backdrop is showing signs of synchronous growth and this has typically been supportive of commodity prices. The sector is trading on an undemanding valuation, as well as being at a dividend yield premium to the broader equity market, and with capital expenditure rolling off, management are guiding investors towards rising free cashflows.
In our view there are three sources of potential upside for the mining sector in 2014:
- Higher than expected commodity demand
- Lower than expected commodity supply
- Better than expected company performance
On the demand side, stronger than expected economic data from China or global synchronous growth could lead to commodity demand which is higher than current estimates. This could push prices up and thus improve company profitability. On the supply side, existing mines underperforming due to weather, industrial relations’ issues or government interventions could result in reduced supply and higher commodity prices. This could also be echoed by new projects missing current production estimates.
Should commodity prices rise and company margins improve, we could then see earnings’ upgrades. The market continues to remain sceptical of management’s ability to deliver on the promises of capital discipline and cost cutting. To date the companies have delivered on message with continued and improved cost control as well as capital discipline. A continuation of these actions in 2014 could result in upgrades across the sector.
Signs of these factors could prompt a significant rotation of capital away from areas of the equity market that performed very strongly in 2013.
Gold in 2014
In the near term a strengthening US economy and the withdrawal of quantitative easing could act as headwinds to the gold price. However, we expect much of this has already been factored into markets and the gold price should find some stability over coming months. From this point we believe there is the potential for the gold price to trend higher as strong retail demand, ongoing central bank demand and the consequences of significant levels of monetary easing across the globe contribute to inflationary pressures, which make real assets such as gold attractive to investors.
In 2013 while we saw strong physical demand from Asia, notably China, the gold price came under significant downward pressure from Exchange Traded Fund selling based on expectations for quantitative easing to be withdrawn and the US dollar to strengthen. If this selling continues through 2014, gold is unlikely to gain positive momentum, however if it stops or we see buying emerge from the investment community, an upward trajectory would be expected.
Looking back on the mining sector in 2013
Last year really proved to be a year of two halves. During the first six months, commodity prices continued their downward trend and mining equities lurched lower as ample commodity supply, concerns over the trajectory of Chinese economic growth, and widespread asset write downs weighed on the sector. A number of mining commodities fell by double digit percentages and the Euromoney Global Mining Index declined 33 percent. Gold bullion sank 30 percent as the market began to price in an end to quantitative easing and gold equities showed leverage to this fall: the FTSE Gold Mines Index declined 48 percent.”
Towards the end of the year, confidence showed tentative signs of improvement. Economic indicators from the US continued their gradual ascent, the Chinese economy experienced pockets of acceleration and the beleaguered Eurozone surprised on the upside with PMIs moving into expansionary territory. The sector therefore ended the year on a slightly firmer footing, helped too by material progress from the industry in addressing investor concerns over capital discipline.