As China Slows Australian Miners valuation at 10-yr lows vs BanksVW Staff
Matthew Ross of Goldman Sachs is out with an interesting new report on Australian Miners. As we noted in a previous article, the Australian dollar is now the hottest short among hedge funds. Many are worried that the country which has not experienced a recession in 21 years could be headed for one as China slows. Australian miners have also been impacted lately, but Goldman notes that now could be a time to find value in the sector. Below is the full report from today.
Australian Miners valuations at 10-yr lows vs Banks: Having underperformed Banks by 90% from late 2010 (third largest gap in 50 years), momentum has started to reverse. If sector earnings fall to 10- year averages (i.e. 30% fall in Australian Miners EPS, 10% in Banks), Banks would still be 40% more expensive.
Falling A$, rising bond yields and global growth support Australian Miners vs. Banks
Our global forecasts call for a return to above 4% global growth and above 8% China growth in 2014. Early indicators of global and China industrial cycles have turned more supportive. Meanwhile, Australian banks have been a key beneficiary of the search for yield, which is now becoming exhausted in the Australian market. Our forecast rise in bond yields as the Fed tapers and rising risk of a domestic recession in 1H14 suggest that Australian banks will underperform. Miners are also highly leveraged to our forecast of A$/US$0.90 in 12 months’ time, while the impact to the banks is more lagged.
Both face structural risks, but Banks are near highs while Australian Miners languish While structural factors will lower growth rates (Banks: weak mortgage growth, Australian Miners: falling China demand), we think the valuation gap is excessive. Both have healthy balance sheets, but we view the banks as more constrained. Miners can do more on cost-out and would benefit more from a change in government, in our view. We prefer Australian Miners with diverse commodity portfolios and low-cost operations. Moving Overweight Miners (Buy BHP Billiton Limited (NYSE:BHP)), Underweight Banks (Sell WBC) Australian Miners: We expect BHP’s diverse asset base and low-cost operation to continue to deliver strong returns as Chinese commodity demand weakens.
Banks: Sell WBC, our least preferred bank, driven by valuation and its larger exposure to a structural decline in mortgage credit growth. ‘Best of’ Bank Puts lower the cost of downside exposure by 40% and should outperform in the event of a broad-based fall across the four majors.
Banks: Recent earnings announcements have highlighted their weak headline growth environment. While short-term earnings risks are low (helped by lower bad debts), we expect structural challenges will drive medium-term EPS growth of c.5% vs their 10% 20- year average. A number of factors support this view. While mortgage credit growth averaged 2x nominal GDP over the past 15 years, we expect it will be below nominal GDP over the next decade given: (1) the ageing of the population, (2) little room for banks to further narrow the gap between mortgage rates and the RBA cash rate and (3) regulation will reduce banks’ appetite for wholesale funding, restricting their ability to grow balance sheets.
When business lending recovers we expect Banks share to be impacted by firms increasingly accessing bond markets. Furthermore, their under investment in payments infrastructure and the innovation in mobile payments could threaten the banks’ incumbent position given the entry of new competitors (e.g. PayPal, Amazon.com, Inc. (NASDAQ:AMZN)). Lastly, while mining exposures only represent c. 2% of bank assets, if the bearish commodity prices implied by Australia Miners valuations were realized they would flow through the economy to ultimately impact bank profitability and asset quality.
Australian Miners: Following a 40% cut in earnings over the past 18 months, the downgrade cycle appears to have found a base being unchanged over the past 6 months. While we expect lower commodity demand from China and an increase in iron ore supply will lower sector profitability, we feel that current prices imply an overly bearish outlook. For example, our valuation stress-tests suggest >10% upside to BHP Billiton Limited (NYSE:BHP)’s share price assuming our bearish long-term commodity prices from now into perpetuity (i.e. an iron ore price of $88, c.40% below current spot levels). Against this backdrop, we expect large divergence of growth rates within the sector and have a strong preference for firms with diversified exposures and low-cost operations. The large Australian miners are among the lowest cost producers globally and will continue to earn strong margins as global supply comes on (particularly in a world where the A$ falls in-line with our forecast). We expect BHP Billiton Limited (NYSE:BHP)’s diversified portfolio to deliver more sustainable EPS growth and to relatively benefit from the industry consolidation that would follow from structurally lower commodity prices. Aggressive costout programs remain an upside case to our earnings forecasts.