Morning Note - Commodities in Focus

by James Gerrish 07 October 2010

**07/10/10  -  7.11am  -  by James Gerrish** 

The market had a tight range of consolidation overnight with US stocks pushing slightly higher by the close. The DOW JONES added +22 points or +0.21% to 10967. In London the FTSE 100 rose +45 points or +0.81% to 5681. Locally, SPI FUTURES are indicating a marginally positive open or +6 points. 

Commodities have been in focus in recent months with a strong run in Gold and other base metals prompting heated debate on whether its a sustainable rise or spike based on USD weakness. Access Economics came out last week to say that over supply in key commodities such as Iron Ore in the coming years will put pressure on prices and send the Governments predicted surplas back into the red. This went against Treasury estimates and we now see a report released by the International Monetary Fund (IMF) overnight that supports the outlook for higher commodity prices over the medium term. 

While I believe that the current buying in commodities is USD related, I'm also conscious of the underlying demand fundamentals that will be supportive of prices over the coming years. In the IMF's biannual World Economic Outlook report, its states that there are "few convincing signs" that key metal supplies are catching up with demand. The report goes onto to say that the commodity boom that began earlier this decade is only about halfway through the average growth period of 20 years."If demand continues to grow at the rates experienced over the past decade, the current era of higher scarcity, rising metal price trends, and a balance of risks tilted towards the upside, may continue for some time," the report says.  
 
The emerging market story (that we've been harping on about for some time now) is well under way. The Asian region is growing at 7.9% this year with expectations for growth of 6.7% next year. In Australia, 3% growth this year is expected to rise to 3.5% next year. 

I read an interesting report from Charlie Aiken from Southern Cross Equities yesterday referring to the HIICS (Highly Indebted Industrialised Countries) v's the widely used BRICs (Brazil, Russia, India, China - which refers to the new world economies. The new world economies is where we're seeing growth and this is being led by the significant rise in populations and the emergence of the middle class. 

I was asked on Sky Business this week why the story of emerging markets as an investment theme has legs this time around given that emerging market investments were savaged the same way investments in the US, Europe and Japan were. The main reason here is a growing level of domestic consumption particularly China. I know that China is still an export economy and America is its biggest market, however this theme is starting to change with the growth of domestic consumer spending.

As Charlie made reference to in his report (and I certainly agree), we feel that there will be rotation from the old world economies to the new world economies as capital tends to find its way to where it can make the highest risk adjusted return. Thats a large reason we're seeing the Australian Dollar rise so sharply. (and fall so sharply after the proposed mining tax was introduced). We wrote about the concept of risk adjusted returns in the morning note on Tuesday 28th Sep. 

Overnight, UBS has just raised its forecast for the Aussie Dollar. See below

3 month: 1.00 (was 0.88)
6 month: 1.03 (0.88)
12 month: 1.05 (0.86)

For FY11 (June YE) this results in the average currency moving from ~ 0.87 to ~ 0.99 (+14%).

From an equity market perspective we expect the increase in the AUD to reduce the overall earnings growth for the Industrials in FY11 by ~ 150 bp (from +12% to +10.5%) reflecting only ~ 8% of FY11 Industrial EBIT is US based and another 4% is from Asia. Changes to the other key cross rates (Euro, Sterling) have been modest.
The potential change in the Resources is more significant (from ~+50% to ~ +15%) however this has historically been offset by increasing commodity prices.

Industrial stocks (ASX200) most sensitive to the stronger AUD are:

Negative (potential downgrades > 10%): PPX, IPL, JHX, CSR, RMD, ANN, ALL, BLY, BKN, NWS, CSL, BXB, FGL, COH, AXA.

Positive (potential upgrades > 10%): QAN, VBA, PBG, BLD, CCL.

Disclaimer

James Gerrish is an Authorised Representative (Rep No. 352904) of Shaw Stockbroking Limited ("Shaw Stockbroking"). Shaw Stockbroking is a holder of Australian Financial Services Licence No 236048. Shaw Stockbroking, its directors, officers, associates and employees each declare that they, from time to time, may hold interests in financial products and/or earn brokerage, commission, fees or other benefits from financial products mentioned in this e-mail or attached documents. Unless specifically stated within this page or an attached document, any information communicated by this e-mail constitutes unsolicited general financial product advice which has been compiled without regard to any investor's individual objectives, financial situation or needs. It is not specific advice for any particular investor. Before making any decision about the information provided, you need to consider the appropriateness of this information having regard to your individual objectives, financial situation and needs and consult your adviser. Any indicative information and assumptions used here are summarised and also may change without notice to you, particularly if based on past performance or relate to a future matter.
 

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