boom over southern cross

Well it has happened again. The commodity boom is over. Seriously, this time it is really over according to commodity experts from the northern hemisphere. Of course these experts never called the beginning of the current bull market; however they feel confident to predict the end. No doubt the same experts have never visited a mine, or considered the impact of Chinese urbanisation, but feel suitably well qualified to price BHP ADR's from behind a Manhattan trading desk.

On our estimates, since the current bull market began in 2001, the end of the commodity boom has been predicted at least twice a year. That means the commodity boom has ended on over a dozen occasions, only to rise like a phoenix from the ashes of the non-believers. However we are hearing from reliable sources that this time, there is no doubt. It is finished. Kaput. It ends with the Olympics in Beijing.

Just two weeks ago the bears confidently predicted the sun was setting forever on the domestic bank sector. According to the doomsday predictions, the Australian bank sector was poised for a complete price meltdown after both ANZ and NAB increased provisioning by a miniscule 0.3% of risk-weighted assets totalling $270b. A clear example of short-termism at its very best.

As a result, a combination of this provisioning, and a SUN profit warning which really turned out to be an earnings upgrade for the bank division, precipitated a total capitulation of sentiment for the domestic bank sector. However a week later, miraculously all is forgiven and the banks are cheap and 20% off their lows. In fact we have recently witnessed panic buying. Strange days indeed.

It is just so easy to be bearish particularly when the world is ending. However as we have previously mentioned, if the world is really ending, you should be a buyer of equities because if you are right, you won't have to settle the trade the next day. One of my colleagues worked with a well-known and widely-regarded economist with a reputation for being constantly bearish. According to legend he is refuted to have called 6 out of the last 2 recessions. Now that is bearish.

We apologise for our "tongue in cheek" summary of recent Australian equity market themes, however if it was not so serious, it would be really funny. Sadly for genuine investors, it is not the slightest bit amusing. It only seems like a short time ago investors viewed the equity market as a vehicle for creating long term wealth. However it now appears that punters regard it as a casino for short term speculation. The current environment must be very frustrating for the majority of domestic institutional fund managers, private investors and listed corporates.

Survey says

In this context, it was very interesting to view a daily prime lending securities sheet from a global investment bank. It is basically a playbook for hedge fund long/short positions and trading activity. Unsurprisingly, financials represent over 50% of the current 15 most shorted US stocks.

However, more importantly, the short activity analysis of the top 15 new global short positions revealed that BHP is now the No 1 'new' most shorted stock globally. It is worth noting that an oil stock is in No 2 position, while steel companies occupy the 4th and 5th new short positions. Clearly the resource/materials sector represents the new hedge fund trading target and it appears the focus has changed from the mid-tier resources to the global majors.

Hedge funds; returns down, trading up

We just do not believe the unprecedented volatility and weekly switching of investment themes is representative of normal domestic institutional trading activity. We have no doubt that the unprecedented volatility is being driven by 'high velocity' hedge fund trading. In this regard it is worth highlighting some recent industry statistics from Hedge Fund Research. The figures reveal from a sample of 60 hedge funds that returns are expected to fall nearly 2.8% this month which would represent the worst performance since July 2002. This follows reports of major hedge fund losses of between 10-15%, and a significant increase in redemptions, for the year to June 30.

It appears obvious that faced with declining returns and possible redemptions, hedge funds have significantly increased trading activities in order to generate performance. The result is an unprecedented increase in equity market volatility. This is driving a new short term trading dynamic and it appears that any company or sector is a target and fair game for the speculators.

We simply do not believe that domestic fund managers have actively driven Asciano (AIO) down to $2.70 despite valuations at $4.50. The only logical sellers are the momentum based hedge funds. However, the selling in some equities like AIO and the mid-tier resource sector in particular has been like a "knife through hot butter." There has been absolutely no resistance.

We believe an adjustment in asset class weightings are a significant factor. It appears recent asset allocation decisions lowering equity weightings to approx 34%, from levels of over 40% a year ago, have left domestic institutions with lower cash inflows, and simply unable to take advantage of some extraordinary opportunities presented by the significant increase in volatility.

There is no doubt that the current hedge fund shorting attack on resources is well-timed considering the total domination and outperformance of the sector in the first half of C 08.On reflection, the long resources theme had become the "crowded" trade and the sector was due for a trading correction. Certainly the subsequent unwinding of long positions has exacerbated the recent "short" attack by the hedge funds.

However we believe the significant weakness in global resource stocks is being driven primarily by hedge fund selling supported by two short term factors which are blinding investors to the continuing strong long term fundamentals.

China; business as usual

It appears the major factor supporting the emerging view of an end to the commodity bull market is the recent slowing in Chinese GDP growth and the prospect of further weakness after the Olympics. While Chinese growth has slowed from 11.4% last year, to 10.4% for the 6 months to June, the magnitude of the fall hardly represents Armageddon for commodity demand. In addition it is worth highlighting a few other important issues.

The easing of economic growth confirms the Government's success, through monetary and fiscal policy, in slowing the economy to dampen inflationary expectations. We believe an easing in the white-hot growth from last year, and a fall in the recent rampant inflation, will support the sustainability of stronger, long term economic growth. In addition, despite the fall in Chinese headline growth, the commodity-intensive drivers of the economy remain strong. We believe the continued strength in Industrial production (+16%) and fixed asset investment (+26%), supports our view that internal demand is driving 80% of China's economic growth.

At this time it is worth making a very important point. The recent Government policy initiatives have been solely implemented to lower inflationary expectations. Make no mistake; the Government is pursuing a policy of strong economic growth. In this regard, recent comments from President Hu Jintao and Premier Wen Jiabao confirmed that the Government's commitment to both strong growth, and the urbanisation process, remains in the national interest. More importantly, we believe the Government realises that strong economic growth remains in the Party's best interest to maintain its grip on power. The Chinese Government is committed to strong economic growth and urbanisation because their tenure is dependent on its continuance. We believe this important dynamic underwrites the long term demand for commodities.

In this regard, the central bank recently announced a relaxation of controls on lending to small and medium sized companies, and additionally the Government has since adopted more expansionary macro-economic policies. We believe the recent comments by the President and the Premier represent a shift in emphasis towards policies promoting internal growth. Importantly, such a policy change is not without precedent.

In 1997-8 when the Asian crisis slowed Chinese export growth from 30% to minus 11%, Government growth initiatives ensured GDP growth slowed by just 1.5%. Similarly, after the dotcom collapse and the global recession in 2000-01, China's export growth fell from 40% to virtually zero. However increased Government spending ensured that GDP growth slowed by just 0.1 of a percentage point. We believe the Government is again actively supporting a strong growth policy and as a result the decoupling story remains firmly intact.

Domestic demand

However over the last 7 years the contribution of exports has decreased significantly as a proportion of total Chinese economic growth. As a result internal demand, as represented by consumption and investment, now accounts for 80% of Chinese GDP growth. In this regard the major part of Chinese commodity demand is domestic. The prime example is residential construction which accounts for nearly 70% of Chinese domestic steel consumption. In addition a similar percentage of copper is used internally considering the growth in electricity generating capacity. We expect internal demand to support strong GDP growth.

There is little doubt the recent economic slowdowns in Europe and Japan has undermined the synchronised world growth theme. Although we expect Chinese GDP growth to weaken to between 9.5% to 10% pa before resuming a stronger growth path, BRIC growth remains robust. However we believe current share prices reflect a global recession.

In this regard, it is worth noting that China has accounted for between 60% to 90% of global commodity demand growth over the last 7 years. In addition, it is widely regarded, and we agree, that internal demand accounts for approx 80% Chinese GDP growth. Further, Beijing's economy accounts for less than 1 percentage point of Chinese 10.4% GDP growth. Finally China remains in the early stages of a multi-decade commodity-intensive industrialisation cycle. As a result we expect the strong growth outlook for China will underpin long term commodity demand.

The US dollar

We believe another factor driving the opportunistic view of an end to the commodity bull market is the recent strength in the US currency, and the subsequent unwinding of the short US dollar/long commodity trade. Our negative view on the structural weakness of the US economy due to the twin trade and budget deficits, and our expectation that US dollar remains in a long term bear market, are widely known. In fact we think this view has been significantly reinforced by the subprime crisis.

However, despite a 30%+ fall in the US dollar index since 2001, history also reveals sharp rallies occur in bear markets. We believe the current US dollar rally to a five-month high against the Euro represents just such a rally. In addition, we believe the current rebound is being underpinned by a belief that the Fed will raise interest rates considering Bernanke's recent jawboning on remaining vigilant on inflation. However he completely contradicted this stance by acknowledging the continuing weakness in the economy. We believe the fragile nature of the US economy and the banking system completely negates any chance of a rate hike anytime soon. In addition, strong US export growth driven by the low US dollar is the only factor preventing a US recession. As a result the Fed simply can't afford to raise interest rates.

We believe nothing has changed to alter our bearish view on the US dollar. In fact we believe the outlook has actually weakened. In addition, we think there is good chance that the US economy will fall into a lost decade of growth similar to the Japanese economy. Consequently we believe the recent strength of the US dollar represents a 3-6 month rally in a long term bear market. In the meantime we believe the commodity bears are using the USD rally as a cover to promote a short term trading sell on resources.

Vale

It appears positive comments by the management of Vale and Xstrata, support our view that the recent weakness in resource share prices has been driven by speculative selling, which is masking the continuing strong long term outlook for commodities.

After a record 2/4 08 result, Vale management commented that despite sharp recent declines in share prices sparked by the U.S. credit crunch, demand for its commodities remained strong. The CEO Roger Agnelli added, "In spite of the current risks, we believe that the fundamentals of the mineral and metals markets have not changed, remaining very robust."

In addition, Vale is confirming its positive view on the long term fundamentals for the commodity cycle by announcing cap-ex of $US59b out to 2012 to increase iron-ore capacity by 40% as well as doubling nickel and copper production. Hardly the actions of a company negative on the cycle.

Xstrata

In an outlook statement released last week by Xstrata, the CEO Mick Davis states, "The Olympic Games and further weakness from the export sector is expected to have a temporary impact on economic growth in the ¾ due to enforced slowdowns or suspensions of manufacturing and heavy industries surrounding Beijing."

In addition he added, "the Chinese Government's apparent readiness to take a pragmatic approach to monetary and fiscal policy in order to promote growth and employment and urbanisation, leads me to expect demand for metals and energy commodities to remain strong over the next few years, albeit with a slower rate of demand growth until the global economy recovers towards the end of 2009 or early 2010.

Consolidation

In the future we expect 3 or 4 "super majors" will account for 75% of global base metal supply. In this context we expect global resource consolidation to accelerate quickly considering the unprecedented falls in share prices. In the outlook statement Xstrata confirmed, "acquisitions remain an integral element of Xstrata's growth strategy...aimed at adding scale and diversity to our portfolio." Similarly at the 2/4 result, Vale CEO Roger Agnelli said "we have to grow or risk being swallowed up."

Xstrata has just made a $US10b for platinum producer Lonmin, at a 43% premium to the last sale after the stock had just reached a 52 week low. Consequently the hedge fund "shorts" were buried at the bottom which prompted a huge short covering rally. We believe the overseas predators are coming to Australia and we hope, like BHP Chairman Don Argus, that the Australian resource landscape will not be "hollowed out" like the once dominant Canadian resource industry. Lonmin is a clear example. We urge investors not to be bearish at the bottom. M&A will underpin the sector at these low levels. There is a huge arbitrage between what the top down shorters believe and the company commentary.

$US13b reasons to be bullish

According to a recent comment by Graham Birch, the manager of the $13 billion Blackrock BGF-World Mining Fund,' Mining shares are discounting a very, very sharp slowdown in world economic growth. It's completely absurd. BHP Billiton is very attractive.''

OK, Graham Birch is a dedicated mining fund manager and he is paid to be bullish. However he makes a very important point. We believe the significant fall in some resource share prices, particularly the 50%+ falls in the mid-tier resource stocks such as Oz Minerals (OZL) and Kagara (KZL), have already discounted a sharp slowing of Chinese growth and a global recession. Interestingly, in the outlook statement, Xstrata commented that the zinc and nickel prices have reached the marginal costs of production and currently the prices of both metals are bottoming.

The global corporates are confirming that commodity demand is strong and the positive long term fundamentals remain intact. We are more inclined to believe the corporates than the Manhattan desk view of resources. You can guarantee underperformance by selling resource stocks after a 30-50% share price correction. Consequently we urge investors to use this unprecedented weakness as a genuine investment opportunity.

Corporates are bullish

We firmly believe genuine investors are being seduced by hedge fund selling and short termism. Listen to the global corporates. The major resource companies are the insiders. They remain at the coalface of commodity demand and they remain universally bullish.

We believe current resource share prices are already discounting a global recession and a severe slowdown in the Chinese economy. However the major global resource companies are all confirming that current commodity demand remains strong across the broad commodity spectrum, and future demand is expected to under-pinned by Chinese urbanisation. While global growth has become disparate, the BRIC economies remain the real drivers of commodity demand.

We expect the BHP Billiton result (US$15.5B) on Aug 18th will result in earnings and dividend upgrades and confirm the positive fundamentals for the sector at a time when the hedge funds are very short. Investors have just one week before BHP triggers the short covering rally. Our view remains that adding to high quality resource sector exposures as these discounted (shorted) entry points is a very low real risk proposition. We remain strongly of the view the commodity cycle won't end with a sporting event.