UBS: Big miners can still perform even if China's economy slows

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UBS remains overweight in its exposure to Aussie mining stocks, despite a slowdown in China and lower commodity prices.

Analysts David Cassidy and Dean Dusanic argue that despite competing forces at play, the positive indicators for both mining and energy sub-sectors outweigh the negative.

The two analysts noted the changes under way in terms of demand from China. They referred to the period of Chinese growth since 2004 as the “China Age”, and said that the resulting strong demand had clearly supported commodity prices “particularly the steel making bulk commodities”.

However, growth since 2004 has also been accompanied by bigger swings in China’s demand cycle. That caused more volatility in commodities, which resource stocks have tended to track closely:

UBS

Cassidy and Dusanic said that if China continues its shift towards a slower and more stable rate of growth, volatility in commodity prices may subside.

In that environment, they cited data from 1991 to 2003 (before the boom in Chinese demand) to argue that resources stocks didn’t track commodity prices as closely when volatility was lower.

“On balance we think the commodity environment going forward could still be better than the 1992 to 2003 period, but it is a reasonable benchmark to compare and contrast with the more recent 2004 to 2017 period,” they said.

The two analysts said that lower volatility would bring different dynamics into play. Rather than just tracking commodities prices, analysts will place more emphasis on free cash-flow in determining fair value.

In view of that, “company-specific execution” will be more important. Diversified exposure with asset positions such as oil and copper will be beneficial, although Cassidy and Dusanic said they still expect the bigger, low-cost iron ore producers to perform well.

Against a backdrop of lower volatility, Cassidy and Dusanic said that UBS client views were mixed on the outlook for resources stocks.

On one hand, an argument can be made that resources stocks look quite cheap by a number of valuation metrics. They’re currently below the market average on both a price-to-earnings ratio and a price-to-book ratio:

UBS

“Valuation advocates generally rely on low price to book as the bedrock to their argument, as well as the generally moderate nature of commodity assumptions required for reasonably good cash-flow projections (particularly for the large cap low cost miners),” the two analysts said.

In addition, they cited the reflation argument whereby commodities stand to benefit from more government spending on infrastructure projects.

Off-setting that is a view among some clients that resource stocks won’t be able to escape the effects of China’s slowdown, and the resulting pressure on commodity prices.

On balance, UBS remains overweight resources in both mining stocks and the energy sub-sectors.

“This is based on relative value of these sectors versus the broader market (figures 11 and 12) and a reasonably constructive view of global growth relative to recent years (notwithstanding the likelihood of slower China demand growth),” they said.

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