Market news and an update on our view on commodities.
Market News
US equity markets bounced last night – S&P 500 (+0.7%); Nasdaq (+1.6%) – driven by technology stocks, with Nvidia up 8% due to investor confidence ahead of results. The improved mood continued this morning in Asia: Nikkei 225 (+0.9%); Hang Seng (+1.0%); Shanghai Composite (+0.9%). The FTSE 100 is currently trading 0.2% higher at 7,272. The yield on Japan’s 10-year bond surged to a nine-year high while Treasuries steadied – the 10-year yields 4.34%. Gold moved back up to $1,900 an ounce. Brent Crude slipped to $84 a barrel, while European gas hit a two-month high on the threat of possible industrial action in Australia.
China is ramping up the fight with yuan bears on two fronts to stop the selloff from spiralling. The PBOC once again set a stronger-than-expected reference rate at its daily fixing. Earlier, authorities pushed up funding costs in the offshore market, sending the yuan’s one-month Hibor to the highest since 2018.
The dominant role of China’s economy in setting the tone for wider emerging markets is starting to fade according to Goldman. EPS revisions by Chinese firms had a big impact on other EMs between 2010-2018, but that gave way to little or no correlation after 2019. It suggests there’s “a slow divorce occurring,” Goldman analysts wrote — something that may comfort investors given current concerns about China.
S&P followed Moody’s in downgrading and cutting the outlook for a slew of US banks. It lowered KeyCorp, Comerica and others, saying a decline in deposits had squeezed liquidity while the value of many lenders’ securities has fallen.
UK government borrowing came in below forecasts in the first four months of the fiscal year, providing room for Jeremy Hunt to cut taxes. The budget deficit was £56.6bn. Sterling currently traded at $1.2791 and €1.1705.
Source: Bloomberg
Commodity Update
At Patronus, we believe commodity assets will be very valuable in the future. We view the recent run-up in real yields to be something that won’t endure and that client portfolios should have an allocation to commodities-related assets to achieve a better long-term outcome.
After a decade in the doldrums culminating in negative oil prices in April 2020, commodity prices exploded into life. Catalysts for the move include a strong rebound in global growth, the acceleration of the energy transition, the Russian invasion of Ukraine, and a growing list of supply side problems.
In recent, months commodities have stabilised despite the growing concerns about China. Although we agree there is potential for a disappointment in growth in the coming year due to fiscal retrenchment and tighter monetary policy, we believe that the structural underpinnings of a bull market in commodities remain in place.
Many of the recent supply issues were directly related to the pandemic and have largely abated, only to be replaced by problems relating to the Russian invasion. However, there are other, more structural factors that are more enduring and more important. Firstly, a decade-long commodity bear market has seen a collapse of investment in bringing new supply onstream. New discoveries of key resources like oil and copper have been anaemic by historical standards in recent years. Addressing this will take years or even decades at best and may be impossible where structural shortages exist. Secondly, increased geopolitical tensions drive competition for critically important resources.
Commodities prices remain historically depressed relative to financial assets. Investor sponsorship remains tiny relative to the traditional asset classes and, within equity indices, energy and materials represent only a small fraction of the market. For example, the combined size of the two sectors represents only 7% of the S&P 500. There are certain environments (inflationary or periods of financial repression) where resource stocks can dramatically outperform headline indices. Diversification benefits alone demand a non-trivial allocation.
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This morning, BHP Group released results for the financial year to 30 June 2023 which highlighted the negative impact of lower commodity prices and inflationary pressures. The results were slightly below market expectations and the shares are currently down 1% in early trading this morning.
BHP is a diversified resources company with exposure to iron ore, metallurgical coal, copper, nickel, and potash. Assets are high quality and largely located in lower-risk jurisdictions, with strong development potential. The group’s capital allocation framework provides flexibility at the bottom of the cycle and discipline at the top, and has seen a shift in focus to low-cost, high-return projects. BHP has positioned itself to benefit from the unfolding mega-trends of decarbonisation, electrification, population growth, and the drive for higher living standards in the developing world, which it sees becoming key drivers of commodity demand.
During the latest financial year, underlying attributable profit from continuing operations fell by 37% to $13.4bn, slightly below the market forecast of $13.9bn. The decline was driven by significantly lower prices in key commodities including copper (-12%), metallurgical coal (-22%), and iron ore (-18%). Nickel prices remained stable (+3%).
The group achieved its full-year production guidance for copper, iron ore, and metallurgical coal. Nickel achieved revised guidance and finished in line with the lower end of original guidance. In Canada, the group’s investment in potash is progressing at pace with first production at Jansen on track for the latter half of 2026, and the company is creating a new copper province in South Australia following the acquisition of OZ Minerals.
The group experienced an effective inflation rate of c.10% in the financial year and expects the lagged impact of inflation to continue into FY24, particularly in labour costs. As a result, unit costs were 9% higher across the group’s major assets, although Western Australian Iron Ore (WAIO) extended its lead as the lowest cost major iron ore producer globally.
The group generated a 54% margin from continuing operations (down from 65%) and its underlying return on capital employed moved from 48% to 29%.
BHP continues to exercise capital discipline, with capital and exploration expenditure of $7.1bn, up 16%. The group increased its exposure to future-facing commodities and 70% of medium-term capital spend is expected to be focused on these commodities. During the year, free cash flow fell by 77% to $5.6bn due to lower profitability. Net debt moved up from $0.3bn to $11.2bn (18.7% gearing), due in part to the $5.9bn acquisition of OZ Minerals in May. Borrowing remains in the target range of $5bn-$15bn and is expected to remain towards the upper end in the near term.
BHP’s dividend policy provides for a minimum 50% payout of underlying attributable profit at every reporting period. Today, the group has announced a final dividend of $0.80 (or $4.1bn), which includes an additional amount of $0.64bn above the minimum 50% payout. In total for FY2023, the group is paying $1.70 (vs. $3.25 last year) equating to a 64% payout ratio and a yield of 6%.
Looking forward, the group highlights that commodity demand has remained relatively robust in China and India even as developed world economies have slowed substantially. In the near term, China's trajectory is contingent on the effectiveness of recent policy measures. The company expects buoyant growth in India with strong construction activity underpinning an expansion in steelmaking capacity. More broadly, there is increased recognition of the importance of critical minerals and strategies across the globe to incentivise investment in supply and demand, which provides opportunities and challenges.
The company also makes the point that the overall cost of mining production is now estimated to be higher than it was prior to the pandemic. This implies that price support is also expected to be higher than in previous cycles and low-cost operators stand to capture potentially higher relative margins in certain commodities.
Source: Bloomberg