While all stocks are affected by economic trends to some degree, few are as sensitive to global growth as industrial mining stocks.
In the case of mining stocks such as Vale (VALE), BHP Billiton (BHP), Rio Tinto (RIO) and Freeport McMoRan (FCX), the most important driver of performance is the outlook for economic growth in general, and China’s economy in particular. That’s why investors in these stocks need to pay close attention to the growing chorus of concerns about credit conditions in China — and the possibility of a negative surprise from the country at some point in the coming year.
These worries were on display in the first installment of the Barron’s Roundtable, which is available here with a subscription. The issue of China’s credit bubble and its possible impact on growth came up frequently, but the key quote was provided by hedge fund manager Felix Zulauf:
“I have great respect for China’s achievements, but its credit and investment boom, which started 10 years ago, is overdone. Many have predicted its demise through the years, but they were early. Now it is more obvious that it’s in a terminal stage… In the past five years, total credit outstanding more than doubled, growing by $14 trillion, to $24 trillion. That growth is equivalent to the size of the U.S. commercial-banking sector. The balance sheet of China’s central bank has expanded more than any other since 2000. This is the biggest monetary expansion and credit boom in modern history.
The classic signs of an end are now visible. They include an acceleration and expansion of credit not matched by GDP growth; the aggressive expansion of a shadow-banking system, in China’s case, via wealth-management products; massive investments in property, and weak risk management at financial institutions.”
If this “hard landing” scenario in fact occurs, industrial mining stocks don’t stand a chance.
This is particularly important now, with mining stocks having rallied far off their 2013 lows. At their Jan. 17 closing prices, FCX stock was up 35% since the end of June, while Rio Tinto, BHP, and Vale had tacked on 36%, 18% and 8%, respectively.
These moves certainly aren’t without justification. Twelve-month forward earnings estimates have been ticking up in the past three months amid the signs of improving global growth, as can be seen in the table below.
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At the same time, mining stocks’ valuations remain extremely cheap — especially in relation to the broader market. Rio Tinto and Vale can both be had for single-digit P/Es based on forward earnings (9.7 and 6.3, respectively) while BHP sits at 13.0 and FCX stock at 11.3 (prior to the slight dropoff FCX is telegraphing for Wednesday morning after its latest earnings report).
And, with the exception of Vale, all offer dividend yields higher than that of the broader U.S. market.
Based on these measures, the mining stocks look attractive. But don’t be fooled.
All four stocks are tightly correlated with China’s stock market, as gauged by the iShares China Large-Cap ETF (FXI). In fact, these mining stocks have correlations with FXI that are about 2.5 to three times those of the broader U.S. stock market.
This means that mining stocks essentially have the same risk-reward profile as the Chinese stock market, and by extension, the Chinese economy. With credit conditions in the country deteriorating — and its real-estate market largely regarded as being in a bubble — the potential for shocks clearly outweighs the odds of positive surprises. Even if China avoids a hard landing, the picture still might be challenging: Goldman Sachs just called for lower copper and iron ore prices in the years ahead due to declining steel intensity of the Chinese economy.
This isn’t a recommendation to sell these mining stocks short right now — the valuations argue against it, and it’s impossible to say how long a hard-landing scenario might take to play out. Instead, caution is the order of the day. Don’t try to play catchup when the miners rally, protect your positions if you have them, and don’t be too quick to buy the dips.
Mining stocks have performed well in the past six months, but the final lows might not yet be in.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.