Is It Time to Have a Punt on Iron Ore Producers?

Over the past few weeks, the Aussie market has corrected sharply. While there are genuine economic reasons for that — emerging market issues and trade war worries — the state of our political scene isn’t helping.

On 24 August, we found ourselves with a Prime Minister we didn’t elect. The market declined for a few days leading into the change, then rallied briefly to new highs. But from there it’s been all downhill, as you can see in the chart of the ASX 200 below.

MoneyMorning 17-09-18

Source: BigCharts
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Is it because the market now sees a strong possibility of Bill Shorten winning the next election? The government must call it before May next year, which means there really isn’t much time for Morrison and the Libs to convince the electorate they deserve a crack.

And frankly, the people have simply had enough of the farcical state of politics. Despite Shorten’s personal unpopularity, a swing towards Labor looks likely.

This is what the market is worried about. Shorten is well left of the centre and if he gets voted in, I feel that over time the economy’s cost base is likely to rise. He’s opposed to tax cuts and wants to move heavily towards renewable energy generation, which would require higher taxes to pay for it, either directly or via higher energy bills.

This is coming at a time when the housing market is falling and global stock markets look like they are turning down after a solid two year bull run, and a more prolonged, 10-year secular bull market.

Having said that, US stock markets (in contrast to the rest of the developed world) are still trading around all-time highs. US stocks don’t look like turning down yet. While ever that is the case, I don’t see a lot of downside risks for our market.

(To be fair to the Aussie market, it’s still looking reasonably strong, despite the recent pullback. You’d need to see more falls before becoming nervous about a more prolonged and deeper correction playing out.)

However, events could change pretty quickly. Next week, the US Federal Reserve meets and is likely to raise rates again. The accompanying outlook statement and economic forecasts could move the market significantly, especially if the Fed signals a faster pace of rate rises for 2019.

Given the strength of the US economy, this remains a key risk. Higher US interest rates means a strong US dollar. This in turn puts pressure on emerging markets and commodities.

This combination is not great for Australia.

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Should we start investing in Iron Ore producers?

Iron ore miner Fortescue Metals Group Ltd [ASX:FMG] is a good proxy stock for Chinese economic growth. As you can see in the chart below, over the past few years, FMG’s share price has been in decline.

This suggests that China’s steel intensive, infrastructure-led growth has been slowing for some time now. Over the past month, FMG’s share price sell-off has gathered pace.

MoneyMorning 17-09-18

Source: BigCharts
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While it’s due for a rally, the overall trend is a concern.

Fortescue is a good barometer because its product is marginally inferior to, say, Rio Tinto’s iron ore. When demand is strong, FMG will get a good price for its iron ore. But when demand weakens, the discount to the benchmark price widens.

More recently, Rio Tinto’s share price has come under pressure too. As you can see in the chart below, it peaked in May this year. It then broke down sharply in August, and in early September fell to its lowest price since December last year.

MoneyMorning 17-09-18

Source: BigCharts
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It is in the process of rallying nicely from the lows, but as with FMG, RIO is in a decent downtrend.

This is not to suggest that China’s economy is in imminent danger. It simply represents a slowdown in its infrastructure-led growth (which consumes lots of iron ore) and a transition to more consumer spending.

And it’s not to suggest that it’s dark days ahead for Australia’s iron ore producers. The iron ore price, as you can see in the chart below, is at or nearing an important juncture.

As you can see, since peaking in early 2017, iron ore prices have been volatile. The chart has formed what is known as a consolidation pattern. This is often what happens after a large price movement, which is what occurred with iron ore throughout 2016.

MoneyMorning 17-09-18

Source: Optuma
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The big question for FMG and RIO (and BHP) is why might prices break?

The chart shows that we’re getting to the pointy end of that question. It looks like prices want to move higher. But with FMG and RIO both in share price downtrends, it raises the question of what is it that shareholders of these companies see?

Regardless, if iron ore prices do break higher out of the consolidation pattern, investors are likely to turn their attention to iron ore producers in the short-term. But if the iron ore price turns south instead, it will be a sign of a continuing slowdown in China. In that case, they’d be wise to steer well clear of the iron ore producers.


Greg Canavan,
Editor, Crisis & Opportunity

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Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

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