Anticipating another leg-down in commodities (and mining stocks) before sufficient stress emerges in markets to force a decisive policy response - which will create an attractive buying opportunity - UBS joins our ranks of the anti-reflexive NEW QE front-running 'small-crowd'. Laying out five clear signals that keep them cautious: Equity valuations remain well above the October 2011 lows; Positioning is short in base metals and less long in oil and gold – improving this contrarian signal; China’s policy stance is not sufficiently stimulative to trigger restocking, and we see structural declines in commodity intensity there; and, Europe and emerging markets are in the early stages of destocking, with no stocking due in the US; UBS believes that investors will buy gold and gold equities early this cycle - correctly suggesting that it is right to move just ahead of the broader investor community, and buy gold and gold equities now. Clearly, buying gold early into a downturn carries greater risks and will be volatile – consequently, they advise investors wishing to go long gold and gold equities to hold a short or underweight copper and copper equity position against it. Interestingly within industrial commodities, they also like being long oil and short copper on a 3-year view.
UBS Commodities: Signalling Caution
Our five signals (see chart above) for commodities and miners keep us cautious on the sector. We anticipate another leg-down in commodities and mining stocks before sufficient stress emerges in markets to force a decisive policy response and create an attractive buying opportunity. Our key points are set out below:
- Valuation – Amber: We use the valuation range for BHP Plc to guide us as to when there is a compelling margin of safety to buy the sector as a whole, and for when the sector as a whole looks excessively rich. At present BHP Plc is trading around the middle of its trading range. We see a compelling margin of safety to buy the mining sector as a whole when BHP Plc is trading towards the bottom of its valuation range over the past three years, at a 40% discount to NPV. We see a 40% discount as an attractive buying opportunity for BHP and for the sector (£14.60 on the BHP plc line).
- Positioning – Amber plus: Positioning has moved to net short of base metals, and less long oil and gold. Our proprietary flow data suggests flows out of miners over three months, implying that investors are small underweight.
- China policy stance/inventory cycle – Amber: We have nuanced this signal. We are no longer looking at whether policy is stimulative (it is) but whether it is stimulative enough to trigger China restocking (it isn’t, in our view). China’s policy makers look set to respond to the current slow patch, and we now anticipate further boosts to infrastructure and local authority funding. But, for the first time in a decade, we see China’s policy makers pursuing only conservative stimulus, due to concerns about rebalancing, and we see the impact of stimulus as more muted than before, due to corporates’ need to destock over the coming months. Policy stimulus is not yet sufficient to trigger restocking, in our view.
- Rest of world inventory cycle – Amber minus: The US restock is over, while the emerging markets and Europe have just started to destock.
- Capital flows – Red: The Fed is not printing, neither is the ECB; the US banks are just lending at home, while the European banks are deleveraging. In this environment, capital is set to continue to flow out of emerging markets. This signal remains the most important driver for the sector.
Our key call is to buy gold/sell copper on a 3-6 month view.
We believe that investors will buy gold and gold equities early this cycle. In our view it is right to move just ahead of the broader investor community, and buy gold and gold equities now. Clearly, buying gold early into a downturn carries greater risks and will be volatile – consequently, we advise investors wishing to go long gold and gold equities to hold a short or underweight copper and copper equity position against it. We anticipate positive absolute returns from both sides of the trade in the coming months, but we also expect the copper position to dampen the volatility, and raise the sharp ratio of the position.
Gold/Copper seems ready to break one way or another...
Within industrial commodities we buy oil/sell copper on 3-year view. Oil is already on its cost curve, and we anticipate supply discipline from OPEC. We expect copper to return to its cost curve, 20% lower, as the market moves into surplus in 2014. We are buyers of gold equities, which we would express through a basket of high quality names.