What are the major factors impacting iron ore prices, what’s likely to happen next and what role should big miners play in a portfolio right now? Pendal’s Brenton Saunders explains

• Falling iron ore prices depressing the miners’ stock prices
• Outlook hinges on Beijing policies
• Strong dividends make sector hard to ignore

A dramatic fall in iron ore prices has delivered a swift turn in fortunes for the big mining companies that only months ago were enjoying posting record profits.

We asked What is the outlook impact for inevstors and

The price of the steel-making commodity has almost halved from its July record of nearly $220 a tonne to trade briefly below $100 in recent days as a change in China’s demand for the commodity drives lower prices.

The decline is raising questions about the prospects for the three big Australian iron producers, BHP, Rio Tinto and Fortescue Metals Group, which until recently have used their inflated margins to reward shareholders with all-time-high dividends.

“There are not many large businesses whose revenue can double and halve inside of 12 months — and these are some of them,” says Brenton Saunders, an analyst and portfolio manager at Pendal who follows the iron ore market.

Investors should take a step back to understand the recent history of the commodity and the ebbs and flows of steel production in China which make up half the global demand for iron ore, he says.

A change of gears

“Iron ore has been through an amazing change,” says Saunders, driven by Covid-related stimulus in China.

“We just absolutely changed gears,” says Saunders. “China implemented a range of fairly old-school stimulus measures that resulted in a further acceleration of housing and infrastructure investment.”

The result was that much of 2020 was characterised by enormous iron ore demand from China, compensating for pandemic-related shutdowns elsewhere in the world.

“Then by the third quarter of 2020, the rest of the world had also implemented a large amount of stimulus and was starting to recover from the first Covid wave.

“That created the perfect storm — China was taking all the iron ore the world could offer and the rest of world was starting to recover.

“There just wasn’t enough iron ore to go around.”

Then China changed its tune.

China moves to lower demand

The price of iron ore got so high it was starting to cause dislocations in the downstream products that steel is used for, and Beijing took a strategic decision to lower demand and bring prices back down.

One move was to target improved environmental outcomes and improved air quality by limiting steel production. The second was the tightening of controls around property developers’ leverage.

Both moves worked.

“They announced they were going to limit steel production to the same level as 2020,” says Saunders.

“That seemed an impossibility, but steel production in China has fallen so far that it looks like we will get pretty close to flat year on year, which means the decline in the second half of 2021 has been about -12% on 1H 21 and -17% from the peak in May.”

It was that decline that brought about the initial downdraft in the iron ore price, which was then compounded by a deterioration in sentiment in the property industry which accounts for around a third of steel demand in China.

“It created the perfect storm in the opposite direction,” says Saunders.

What it means for investors

The question is what happens next?

Saunders says he expects Chinese property construction to enter a sustained decline.

Land sales — a leading indicator and normally hotly contested — are seeing low clearance rates and lenders are less inclined to make credit available.

Environmental and air quality concerns will likely also see steel production capped, especially with Beijing hosting the Winter Olympics in February.

Chinese steel production will remain depressed until at least the end of February next year before a more fundamental rebound, Saunders says.

“But by that stage, the Chinese supply chain in steel is going to be fairly heavily depleted and will need to be restocked.

“There is the potential for a much better end of first quarter next year — but it could get worse before it gets better.”

Portfolio point of view

So, given that background and volatility, what role can iron ore stocks play in a portfolio right now?

Are they a must-hold or something investors can safely ignore?

“The volatility is intimidating at times,” says Saunders. “But the volatility can be offset by high, fully-franked yields.”

Fortescue Metals Group will pay a fully franked yield of more than 10 per cent over the next year for shareholders buying now. That yield may well be unsustainable, but it is a substantial fillip to a portfolio’s income.

BHP and Rio Tinto’s dividends will also be high, approaching 10 per cent and underpinned by the fact both businesses have significant non-iron ore operations.

BHP’s metallurgical coal operations are still enjoying strong price rises even as iron ore prices fall. Rio’s massive, vertically integrated aluminium operations produce one of the world’s fastest growing metals that is critical to the transition to net zero carbon emissions.

Saunders says the trick to making portfolio decisions on iron ore is to have a well-held view on the value of the big companies based on a “through-the-cycle”, long-term iron ore price derived from cost-curve analysis.

From there, a cyclical overlay tells you whether to buy or sell at any given point.

And right now?

“I’d have to say it’s a relatively easy and low-risk decision to buy the iron ore stocks at the moment,” says Saunders.

“The valuation overlay is attractive as the stocks have come back significantly, and the forecast yields are high.”

Think impact investing is only about solving problems in less-developed nations? You might be surprised to find opportunities in the developed world — such as water preservation. Regnan’s Tim Crockford explains in this fast podcast.

Listen to the podcast above or read the transcript below

Interview with Tim Crockford, head of Regnan’s impact investment team

Interviewer Sean Aylmer: Tim Crockford, explain exactly what impact investing is.

Tim Crockford, senior portfolio manager of Regnan Global Equity Impact Solutions Fund:
Impact investing is ultimately a form of investing where your investments are going towards companies that can solve problems relating to some of the major environmental or social challenges that we face globally

The idea behind the concept is if you can finance the companies that are trying to solve these challenges, ultimately these companies are able to come up with some pretty innovative and unique solutions for this set of problems, which of course is getting increasingly urgent to solve.

Interviewer: Why are we hearing so much more about impact investing now than say two years ago, let alone five years ago?

Tim Crockford: Good question. There are multiple catalysts, not least the Covid crisis we’ve all been facing over the last 18 months. That’s brought to light the effect of human activity and human economic activity. More generally we’ve got a number of underlying challenges which have been snowballing over the last five or 10 years. They are probably accelerating more recently since we’re getting to the stage that we can no longer procrastinate. We can no longer delay trying to address them.

Interviewer: What are the sectors or geographies where impact investing is most likely to play its greatest role?

Tim Crockford: It’s broad. It’s really across the board. The UN Sustainable Development Goals (SDGs) – when they were released back in 2015 – brought to light how some of the sustainability challenges that we face.

We tend to think of sustainability challenges as something for the more remote corners of the earth, in developing regions or frontier regions. But the interesting thing about the UN SDGs is they brought to light the extent to which some of these challenges are much closer to home to us.

You have issues like extreme poverty and improving social mobility which are typically challenges faced by some of the less-developed nations.

But if you look at challenges we face around waste and waste management and water, you’re talking about developing nations or indeed some of the most developed and mature countries.

So what’s increasingly changed over the last few years is this view that some of the major sustainability challenges are much closer to home.

Interviewer: In some ways that must make them more investable.

Tim Crockford: Yes, absolutely. We’ve been talking a lot this year about water as one of the major issues that needs to be addressed sooner rather than later. When it comes to water transmission and water infrastructure, the biggest problem is in the most developed of nations like the US, the UK and Australia, where you have water infrastructure, that’s aged so much and has been in the ground for so many years.

And it’s facing challenges, for example leaking. If you look at the US there is this massive problem where the US grid system loses the equivalent of 4 million Olympic-sized swimming pools worth of water every year, just through infrastructure leakage.

So one of the challenges there is just plugging the holes and stopping that massive loss of water – which would otherwise be potable and going to more productive uses.

So that is a good example of something that is a challenge being met by companies that are investable in places like the US.

Interviewer: So if I’m thinking about investing impact investing in terms of portfolio construction, it’s not really a discrete part of my portfolio. It’s more tied to the different asset classes that I want to invest in?

Tim Crockford: That’s what we think. We don’t see this as something that should be niche or the cherry on the cake in people’s portfolios.

The vast majority of our clients tend to not have a specific allocation for sustainable or impact equity. The vast majority will place us in their broader global equity allocations. Ultimately the fund we are running (Regnan Global Equity Impact Solutions Fund) is a global equity fund.

Given the differentiated collection of equities that they get with our portfolio, when they put our portfolio together with their other global equity managers they get access to a collection of companies and stocks which otherwise wouldn’t typically be in your average global equity fund.

So there’s a have-your-cake-and-eat-I approach taken by a lot of our investors. They’re seeing an opportunity to get exposure to some of these themes and to allocate more of their portfolios towards sustainable and impact.

On the other hand, from a portfolio construction point of view, they’re getting a nice diversified and differentiated collection of companies which they otherwise wouldn’t be investing in.

Interviewer: We’re five weeks away from the 26th United Nations Climate Change Conference in Glasgow at the beginning of November. What sort of difference does a conference like that make to investing?

Tim Crockford: At the margin it’s another catalyst bringing to light the huge financing gap that needs to be plugged.  A lot of this is about raising awareness of just how much funding is required to solve some of these environmental, as well as social challenges.
But we are more likely around that time to be making a bit of noise, not just about the problem aspect, but about the solutions. Because from an investment point of view, the flip side of the coin is that this is a massive investment opportunity for those investors who are willing to get ahead of the curve.

This is a massive investment opportunity for investors who can see that this gap in financing exists and those early players – those investors that are early to the party – are going to be well-rewarded.

So it is an opportunity on one hand to bring the challenge and the problems to light, but for us it will be making noise about some of the solutions that exist and the opportunity side of things.

Interviewer: Tim, thank you for talking to Pendal newsletter The Point. That was Tim Crockford, lead of the Regnan Equity Impact Solutions team.

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About Tim Crockford

Tim Crockford leads Regnan’s Equity Impact Solutions team and is senior fund manager of Regnan Global Equity Impact Solutions Fund. Tim previously managed the Hermes Impact Opportunities Equity Fund after co-founding the Hermes impact team in 2016.

Here are the main factors driving Australian equities this week according to our head of equities Crispin Murray. Reported by quantitative analyst Lee Ma

GLOBAL markets rebound marginally last week. The S&P500 gained 0.5% while the S&P/ASX 300 index finished in the red (-0.8%).

The market is clearly weighing up negatives around central banks removing stimulus earlier than expected versus the positives of a strengthening global economy.

Our view is that the taper is now largely priced in by the market. The incremental news is that the global economy is re-accelerating after the Delta-driven slowdown and an easing of some supply chain bottlenecks.

This should lead to an equity market rally into the year’s end.

The main news last week was the ongoing Evergrande story amid Chinese property concerns; and the Fed’s slightly more hawkish messaging, with the pace of tapering now slightly faster than the market expected.

Covid and vaccinations

Global trends have continued to improve, notably in the US. After school re-openings led to a rise in cases, US infection rates are now falling along with hospitalisations in some states.

Emerging markets are also improving as they ramp up vaccination. This is important since supply bottlenecks stemmed from factory closures in a number of EM countries such as Vietnam.

US data continues to show most hospitalisations and deaths are among the unvaccinated. This shaped the US Food and Drug Administration’s view on booster doses — which are approved only for over-65s.

The view is that the role of the vaccine is to stop people getting too sick, rather than completely stop the virus. The FDA did not see a need to approve an extra dose for the broader population given a lack of data on long-term effects.

This will give time for a variant-specific booster to be trialled (which is now underway).

At home, NSW is going better than expected and Victoria is in line with forecasts.

First-dose vaccination rates in NSW are averaging 42k per day v 46k last week. This has taken NSW to 88% first dose and potentially 90% this coming week. Second-dose vaccinations are more in line with expectations at 70k per day v 61k last week. The run rate is expected to pick up to 72k this week.

NSW is on track to reach 70% on October 5 and 80% by October 15.

Hospitalisations in NSW appear to have peaked at 1268 and are now down to 1146. ICU cases peaked at 234 and are now 222. Both figures are well below forecasts from the start of September.

We remain of the view that we will see a sharp recovery in activity on the east coast coming into November.

We are positive on domestic stocks leveraged to this.

Economics and policy

Updates from the US Federal Reserve last week were broadly in line with market expectations — with a slightly more bearish tilt.

The taper is due to start in November and finish by mid-year — two-to-three months earlier than consensus.

This implies a reduction of $15 billion per quarter rather than per meeting as the market previously thought (or $18 billion per meeting v $15 billion expected).

The dot plots were in line with an even split for the first hike in 2022 versus 2023. The logic for the faster taper is to give the central bank some flexibility if inflation stays higher next year.

The market has 25bp priced in by the end of 2022.

On the data front, median expectation for inflation has risen 20bp to 2.3%, implying the 30bp average increase in rate levels by the end 2022 in the dots.

The 2022 median GDP growth rate forecast has also risen by 50bps to 3.8%. Unemployment is now expected to fall to 3.8% by the end of 2022.

Fed chair Jerome Powell’s language has become more cautious on inflation, with the “transitory” period now lasting into 2023 and even 2024.

Overall, the underlying message was that inflationary pressures have been more resilient, particularly given supply chain bottlenecks.

This extended period of higher average inflation means the Fed will need more flexibility to respond, potentially before the end of 2022.

China

China remained in the limelight last week. Property giant Evergrande appears to have missed interest payments due on bank loans and offshore bond issues due last week. A grace period is likely to involve negotiating some form of restructure.

Cash flow appears to be directed into funding projects, which is politically sensible. We may see unfinished units sold at a discount to other developers, potentially those backed by the state.

Our view remains that this will not be a systemic issue. There will be some attempt to put a floor under the economy given the importance of the property market.

Market moves suggest this is the case — the Chinese currency, credit spreads and equity market did not move much despite the headlines.

Against this backdrop we think the case for a policy shift in China is high, which will support cyclicals.

There is a lot of sensitivity about an overly sharp slowdown next year as president Xi Jinping locks in his third term. The need for economic growth remains important.

Meanwhile the UK is experiencing some chaos from rising electricity prices, gas shortages and labour shortages (notably truck drivers).

This is leading to some food and fuel shortages. The issue reinforces the need for more inventories of strategic commodities, higher wages and more investment. This probably contributed to a more hawkish Bank of England meeting last week. A rate hike is now becoming likely by May.

A positive outlook

Overall we are becoming more positive as falling global Covid cases allow economies to re-open.

We can see the Fed GDP numbers start to tick better, having weakened sharply over the last two months.

The bond market also continues to signal that the economy is faring better. US bond yields are following their European counterparts in breaking out of their recent trading range.

The economic surprise index also looks to be bottoming. And a significant inventory re-build is required in a number of industries as soon as supply chain blockages are resolved.

All in all, this should be supportive of cyclicals and financials v defensives. Cyclical growth will continue to do well, but more defensive growth, such as healthcare may underperform.

Markets

Bond yields went up last week in the US and Australia. Commodities generally recorded gains.

Iron ore had a wash-out last week, bottoming in the US$90s, before sharply bouncing off these lows. In the $90s, the cost curve will start to move.

We have already seen a lot of marginal suppliers for iron ore — such as Ukraine and India — redirect stocks back into their own markets as prices fall. This will make China more reliant on Australian ore.

While we don’t expect a big bounce in iron ore, we do believe the falling prices have come to an end for this year.

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About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Find out more about Pendal Focus Australian Share Fund here.  

Contact a Pendal key account manager here.

As Melbourne construction workers protest mandatory vaccinations, investors may want to consider how a ban on unvaccinated workers could impact the economy, says Pendal’s Tim Hext

THIS WEEK has been relatively quiet for bond markets, despite an attempt at excitement around China.

I learnt long ago that little happens by accident in China.

The government has the ability and the smarts to control what is going on. Letting Evergrande wobble is more about sending a message than a misguided step that will send the economy into freefall.

Of course the usual chorus line of doomsdayers have lined up to predict just that.

I am not one of them.

Maybe eventually they do stumble, but you’ll go broke betting on it long before then.

The impact of banning unvaccinated workers

Our attention is more focused on what is happening domestically — in particular the how and when of re-opening in NSW and Victoria.

The area of concern for us is how unvaccinated workers are treated.

The concern is less ethical — I will leave readers to their own views — but what it means for the workforce.

If one in ten workers end up unvaccinated, whether for health or personal reasons, their potential exclusion will have a significant impact on the supply side of the economy.

Most employers are currently awaiting government guidance, but until rapid testing is widely available it seems many will be banned from working.

The demand side of the economy is likely to return quicker than the supply side.

We are increasingly confident that 2022 will see higher — not lower — inflation and the RBA will be tested on its benign view.

Wages should also pick up faster.

Future inflation as measured by markets remains stuck around 2%, which to us provides an opportunity.

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

CFA, GAICD

Anthony joined Pendal Group as Distribution Director in October 2018 and is a member of the Australian Executive team. Anthony is responsible for leading the Distribution, Marketing and Client Service functions, drawing upon his extensive experience in retail and institutional funds management.

Anthony joined Pendal following his tenure of fifteen years in senior leadership roles at Morningstar. Most recently Anthony was Managing Director, Research Strategy Australasia where he was responsible for the development of research and commentary on investment themes and trends within the Asia-Pacific region, in addition to representing Morningstar’s manager, equity and credit research capabilities. Anthony’s remit also extended to the development of retirement research, public policy initiatives, and engagement with regulatory authorities. Prior to this role, Anthony was also CEO, Australia and New Zealand from 2010-2014 and Managing Director of Morningstar Investment Management from 2009-2010. Anthony’s prior experience includes senior appointments ASSIRT Research and AMP Consulting.

Anthony is a director and immediate past president of the CFA Society of Sydney and a member of the National Advocacy Council. He is a Graduate Member of the Australian Institute of Company Directors, a CFA charterholder, holds a graduate diploma in Applied Finance and Investments from FINSIA, and a bachelor’s degree in Business from the University of Technology, Sydney.

Higher interest rates will eventually work, but they’re not working just now, argues Pendal’s OLIVER GE. That could mean bonds become even better value next year

• Inelastic demand and supply mean rates work differently
• In likely scenario, bonds a good place to invest
• Find out about Pendal fixed interest capabilities

WHAT if higher interest rates worked against cutting inflation?

Or at least had little effect on demand — making rate hikes ineffective in the fight against inflation?

“I want to talk about the idea that in an environment where demand is still reasonably strong, interest rate hikes effectively do nothing,” says Oliver Ge, an assistant portfolio manager with Pendal’s income and fixed interest team.

“Rather than cooling things down, they might be pushing them back up,” Oliver says.

The idea comes down to the notion of elasticity of demand – a measure of the change in the demand for a product in relation to the change in its price.

Elastic demand means there’s a big change in quantity demanded when there’s a change in price.

Inelastic demand is the opposite – little change in demand no matter what the change in price.

“When households are in decent shape, as they are today – when you have wages growth at decade highs and unemployment at near record lows, and savings are still plentiful – you end up with an environment where people are much less sensitive to price changes,” Ge says.

Covid lowered our price sensitivity

“During lockdowns, people were happy to pay for a whole range of goods like laptops, gardening tools, toilet paper,” notes Ge. “Consumer demand collectively channelled its momentum into household items.

“Suppliers jacked up prices but there was still plenty of demand.

“While we have moved on from Covid, we haven’t moved on from this sort of low-price sensitivity environment.

“The money has only moved on from chasing goods to instead chasing services.

“The bottom line is that the elasticity of demand is very, very low. It’s basically inelastic.”

Services are labour intensive – hospitals, hotels, cafes, restaurants, airlines employ hundreds of thousands of people, Ge says.

“Even though we’ve added a million people to the workforce since 2020, businesses are still experiencing labour shortages.

“It’s a Covid hangover. People want to go out. They don’t want to be the people serving everyone else.”

“As a central banker you see inflation rising and your natural instinct is to raise rates. But the usual transmission mechanism is broken,” he says.

Transmission breakdown

Previously lifting interest rates would trigger tighter lending and refinancing, and companies would cut back on costs, including staff, says Ge. That would lead to higher unemployment and that would dampen inflation.

“But today, businesses aren’t really cutting back on staff. They’ve struggled to find and retain the right people, and thus don’t’ now want to lose them,” Oliver explains.

“Instead what they’ve chosen to do is compromise in other areas – say reduce the quality of ingredients if they are a restaurant.

“Or they are just passing the cost through to the consumer. And people are happy, at present, to pay the higher prices. Until they’re not.”

This process demonstrates an inelasticity of supply, as well as demand.

“So you have this relationship where higher rates are hurting businesses and to cope, they’re lifting prices, which consumers are paying.

“There’s a breakdown in the transmission of monetary policy to the employment market. In a very counterintuitive way, hikes are making things worse, not better.”

What it means for fixed interest investors

Higher interest rates will eventually work, but they’re not working just now, argues Ge.

“It will be the straw that breaks the camel’s back. It’s hard to see the stresses today but when it comes, it will come suddenly.

“I think there will be a fairly aggressive breaking point around the middle of next year. The Reserve Bank could realise too late, and then desperately try to reverse the rate rises.

“At which point bonds could become very good value. They are already good value, but that’s when the have the potential to become even better value.”

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About Oliver Ge and Pendal’s Income and Fixed Interest boutique

Oliver Ge is an assistant portfolio manager with Pendal’s Income and Fixed Interest (IFI) team.

Oliver works on developing and running key quantitative investment models, and acting as trading support for the team. Oliver received his Bachelor of Commerce (Finance) from the University of Sydney and is also a CFA Charterholder.

Pendal’s IFI boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.

The invests across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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About Pendal Group

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager