One of the most interesting observations of the recent market pullback (notwithstanding the spectacular collapse of volatility ETPs) is that some of the sectors we would have expected to outperform did poorly, and vice versa (see below). In a down market, we would have expected Materials, Industrials and Consumer Discretionary to be amongst the underperforming sectors; Utilities, Telecom and Healthcare to be outperforming. Even though some of the sector performances can be explained by specific reasoning (ex: expected rise in interest rates depressed Utilities), the pullback seems to actually broadly favor cyclicals. In hindsight, this could make sense as economies globally seem to be gaining steam, and the latest macroeconomic data suggest they are not slowing down anytime soon.
Specifically, looking at the Materials sector, it was very interesting to see that commodity metals prices barely moved, and in some cases, rallied through the market sell-off. Below is a chart of a basket of bulk/commodity metals (white line; indexed to 2015; includes iron ore, copper, aluminum, etc.) and the MSCI World Index (blue line). In aggregate, metals prices were flat relative to a market decline of -7%.
For a longer-term perspective of metal prices, the chart below extends back to 2013 and captures the deep downturn in commodity prices that occurred in 2014/15.
While one could argue all day about whether or not commodity prices are fundamentally too expensive at current levels, it appears (at least thus far) that we have seen the trough, and that perhaps, we are now in a more “normalized” environment.
So what could this mean?
Mining companies that have restrained spending (CAPEX) over the past few years have increased spending in 2017 by 5% and are likely to increase spending again by 10% through 2020 just to keep production flat and by 50% to keep production up with nominal level of demand growth. CAPEX should act as tailwind to the global economy. In fact, looking at historical spending levels, those growth levels could in fact be conservative.
Specifically, these tailwinds help construction machinery companies like Caterpillar (CAT) and Komatsu (6301 JT), to name just a few. Indeed, on its most recent earnings call, Caterpillar CEO was bullish across all of its end markets. Shipments of its large mining trucks troughed in 2016 and are expected to grow +180% in 2017, double-digit growth again in 2018, and likely another 30%-50% to reach replacement demand levels. While both Caterpillar and Komatsu stocks have climbed more than 50% since the beginning of 2017, there are interesting opportunities across the supply chain where shares have yet to reflect the potential growth in spending (and demand) levels for its products and services.
As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF LUIS AHN
Luis Ahn is a Partner and Analyst at R Squared Capital Management.
Prior to joining R Squared, Luis was a Senior Analyst at Bloom Tree Partners.
Luis received an MBA from The Wharton School and Bachelor of Science in Quantitative Economics and Computer Science from Tufts University.
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