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After a raging bull market, where to next for the materials sector?

The ASX 200 materials sub-sector (OZMATR on ProRealTime charts) has been in a roaring uptrend since 4 February 2016, rallying a lazy 73% in 263 trading sessions to the highs seen on 16 February.

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Source: Bloomberg

Looking back and with the benefit of hindsight, on 16 February we can see a pronounced ‘gravestone’ doji at the trend high, which can often be a precursor to a change in the trend. One question is whether we look back in the coming six months and see this as the definitive high in what has been a rampant bull market. The question then is whether the sector has seen its best days. Are there greater downside risks ahead? Or has the pullback in the sector provided investors and traders with a more attractive entry point?

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Positive factors for the commodity space

To answer that, we can firstly look at global economics to give us a sense of the specific factor investors have been attracted to (for example growth, value or momentum). In my opinion, there are a number of clear indicators that show the global economy has been improving. In many developed markets we may even start seeing a stronger investment cycle and increased consumption. There are indicators that suggest global trade volumes could also pick up and these factors put upside risks to the 2017 global growth estimates of 3.2% and naturally this is bullish for growth sectors such as the materials sector.

China has detailed the fact they plan to target growth of ‘around 6.5%’, but the fact they will target a budget deficit of 3% and M2 money supply growth rate of 12% suggests growth is not going to fall far from 6.5%. To put perspective on this, this level of credit growth in 2017 is equal to over $3 trillion, which would be larger than Germany’s expected gross domestic product (GDP) in 2017. Again, this has to be supportive of commodity prices.

If Trump can actually pull off many of the tax reform proposals that have been widely talked about, with greater clarity on infrastructure spending and deregulation, then again this could be another positive kicker for the sector.

The contrarian in me, though, asks how much of these supportive factors have now actually been discounted into materials stocks. I would argue quite a bit.

Downside risk to bulk commodities in the months ahead

One area of the materials sector which gets a lot of focus from clients is steel and iron ore stocks and rightly so - the space has been red hot. Iron ore has been supported by capacity cuts in the steel and coal space, while demand for iron ore in 2H16 was extremely strong and largely reflected in inventory levels at China’s ports hitting a 10 year high, married with higher import volumes. We are seeing a deficit of around 10mt of iron ore and, subsequently, it’s no surprise to see iron ore prices above $90 per metric ton. Interestingly though, commodity analysts (such as HSBC) are expecting this deficit to turn into a surplus of 30mt in Q2 before widening to around 40mt in Q4 and that is a big headwind for iron ore from here.

Many feel current spot prices are simply unsustainable, with a view that the longer prices stay at current levels the more incentivised the likes of RIO, FMG and BHP will be to get the ore out of the ground. If I were in a long position in this space I would certainly be looking at steel and iron ore prices in earnest and assessing the placement of my stop loss.

Let’s not forget we are in a seasonally strong period for iron ore, but that changes soon where we can see that price has fallen in four of the last six months of May. In that month the average fall has been 8.43%, so this is also a consideration when holding long exposures through March and into April.

Other areas of the materials sector have come in and out of the limelight, and by way of example we saw good demand for the lithium space (names like LIT and ORE) throughout much of 2016 and again in the November period. Two names in this space getting focus and very much worth putting on the radar, but trade in the US are SQM and ALB. 

Cobalt explorers are also getting a strong focus with names like LRS and COB having a nice run of late, but there seems to be an air of caution and traders are generally positive, but concerned we could easily see a sharp drop in prices at any stage.

Trading these high risk, often illiquid stocks on leverage can offer high reward, but naturally we need to keep a firm eye on risk and money management to limit losses if the trade turns against you.

Optimistic but cautious

There are some clear catalyst for further appreciation in a sector that has run hard, but I can’t help but feel that the easy money in the sector has been made and it’s going to be harder for the bulls to push prices significantly higher from here. There are even risks that we see iron ore and steel prices start to trend lower too, given the calls for a return to deficit and that would certainly bring out far better shorting conditions in names like FMG and RIO. So traders will be keenly watching inventory levels, but for now I am optimistic, but turning far more cautious.

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