Deutsche Bank thinks there are better buys out there than mining stocks

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It’s been a wild start to the year for Australian mining stocks, mirroring broader sentiment towards the outlook for the Chinese economy.

Earlier in the year they were smashed, weighed down by the combination of weaker commodity prices and heightened fears that the Chinese economy was beginning to unravel.

Then, seemingly in the blink of an eye, everything was good again.

The US dollar weakened on the back of lower US rate hike expectations, boosting commodity prices, just as Chinese economic activity accelerated on the back of a wave of credit-fueled construction spending.

Mining stocks soared higher in response, recording some eye-watering gains in recent months. From late January, shares in BHP Billiton are up 45%, outpacing a 39% increase for those in Rio Tinto. Making those gains look tiny, shares in Fortescue Metals have surged by a near-unbelievable 129%.

Commodities have rebounded, and mining stocks have followed suit. The question are now pondering is how long the upswing can last.

While others may disagree, Tim Baker and Joseph Kim, equity analysts at Deutsche Bank Australia, think there are better opportunities out there besides the miners, suggesting that while strength in commodities implies very large earnings upgrades, this is largely factored into share prices.

They also cast doubt on some of the factors that have driven the resurgence in commodity markets — tight supply and Chinese fiscal spending.

“We don’t expect spot commodity prices to persist anyway. For iron ore, Australian supply growth has been flattish in recent months, but is set to pick up from here,” they note.

“On the demand side, the upturn in Chinese property is certainly supportive. But this has required large amounts of stimulus, and Deutsche Bank economists expect policy settings to go back to neutral around mid-year. This suggests a slowing in second-half growth.”

A lot of stimulus indeed, as shown in this excellent, and to some terrifying, chart showing China’s ballooning debt-to-GDP ratio below.

The surge in credit growth in the first three months of the year — the largest quarterly increase on record — has certainly helped the nation’s property market, and as a consequence commodity prices.

However, how long this can last with the enormous levels of unsold housing inventory that litter smaller Chinese cities —estimated to be four years worth according to analysts at ANZ — remains debatable.

Instead of banking on a long-lasting, stimulus-driven infrastructure boom to drive Chinese economic growth, Baker and Kim believe that investors should instead look at stocks that will benefit from an upswing in Australian economic conditions.

“The missing piece of the domestic recovery has been business capex. Outside of resources it’s been flattish, and recent building approvals data give no hint of a pick-up. But there are green shoots elsewhere,” they note.

“Capacity utilization has risen to a five-year high, which should lead to more capex. And motor vehicle sales to business are growing at a 10% clip. We’d also note that very low inflation provides scope for RBA rate cuts to support the domestic recovery if needed.”

As a result of this view, Deutsche are “overweight stocks that benefit from the firming domestic cycle”.

“We note that Harvey Norman and Qantas have underperformed in the past month, and like the value on offer here.”

“We remain underweight mining. Our model portfolio has an underweight position in BHP, a minor overweight in Rio, and nothing else.”

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