What is really going on?
The poor market start this year reflects a dam-burst of emotion from a pent-up release of sombre economic facts, overlain on an over-valued market.
If the share-market (especially the US) had not been over-valued (i.e. trading on a P/E well above its long-term average) then any or all of the following would have had little impact:
- Rising US interest rates (less loose money sloshing around the rest of the world);
- A slowing industrial China (but burgeoning service sector); and
- More oil currently being produced than can be used (at almost any price).
For now, I wish to comment on how the latter two matters might affect client investments.
Resource prices, driven sharply lower by slowing industrial China, (actually the price of iron ore peaked in February 2011!) and the oil price (which most recently peaked 1.5 years ago) in particular have had a large impact on investor sentiment.
Does this mean, however, that these sectors are goners and destined to be so forever? Is this new news? Of course not.
It is natural for commodity prices to fall after a boom, there is now too much of most things being produced for what is currently required. This means that the high cost producers will face closure (like Mr Palmer’s nickel operations) and the markets will rebalance in time. The low cost producers will still be able to make money (or at least not lose much for long) and when the rebalancing has concluded the market will be much sounder.
We see this process as being well underway. Oil in particular will begin to see market volume declines later this year as virtually all of the US oil shale industry is now unprofitable at these prices. With no cheap money being lent to it, defaults will pick up and the market will re-balance.
For other commodities it will take more time, as the supply is substantial and demand may well fall for a number of years (for example for iron ore – given a declining industrial China). There will still be some producers who make money, but the windfall gains of the past 10 years are gone. Iron ore (and coal) will largely be a cost plus business now for those with low cost operations, for some time.