Investors should be shifting out of cyclical sectors and into natural resources and energy stocks that have lagged behind the market in the past couple of years, according to Charles Tan, investment companies analyst at Cantor Fitzgerald.
Tan says the rally in cyclicals that has dominated the past two years is nearing its conclusion and past economic cycles suggest commodities are about to rally hard next.
Closed-ended funds sitting on large discounts are an excellent high-beta, high-yielding way to play this new trend, he explains.
“Financials, technology and consumer-related sectors led global equity markets higher in 2013 as an improving economic outlook lifted investor sentiment,” he said.
“However, mining and energy stocks remained out of favour as they have done since the onset of the recent financial crisis.”
“Over the past five years, we have observed investor interest shift from defensives and income-generating assets (2008 to 2011) to cyclicals and other growth-oriented sectors (2011 to 2013).”
“In our view, we are nearing another inflexion point in the investment cycle and the next step is likely to be a rotation into commodities as the recovery matures, inflation picks up and central banks begin to raise interest rates.”
“If history is any guide, we should next find ourselves in an environment of excess liquidity over the coming years, which has tended to be beneficial for commodity prices and, by extension, the producers of said commodities,” he added.
Data from FE Analytics
shows that the consumer services and industrials sectors have significantly outperformed the FTSE All Share over the last two years, while the mining sector has struggled, losing 20 per cent.
Performance of sectors over 2yrs
Source: FE Analytics
The analyst says that in past cycles, excess liquidity has tended to pour into those sectors that have lagged.
In the cycle that ran from 1990 to 1999, the excess cash found its way into technology stocks instead, as the mania for internet stocks took hold, while in the 2000 to 2007 cycle it was commodities that soared in the 2005 to 2007 concluding period.
Commodities, energy and mining look likely to be the sectors that prosper this time around, Tan said.
He admits that his argument is essentially technical, but says that there are also fundamental reasons to believe that the prices of commodity and energy stocks could be about to recover.
The analyst says that the scaling back of capital expenditure by miners and oil and gas companies in recent years should tighten global supply and raise prices, thereby boosting earnings for companies and encouraging them to pay dividends and buy back shares.
However, analysts disagree on how far this trend has run and when it will feed through into prices.
Esty Dwek, investment strategist at HSBC Private Bank, said: “Demand for commodities has not picked up meaningfully, in part because Chinese demand has not sharply rebounded.”
“At the same time, the supply side has remained rather ample, limiting any price appreciation potential.”
“In our view, this trend is likely to continue for some time yet as the global recovery is likely to develop only gradually and supply is likely to outpace demand growth.”
Tan says that while capex has remained high in absolute terms, companies are being more strategic in their expenditure.
“It’s more about managing opportunities that they have committed to rather than ramping up new investment,” he said.
“We are never going to see the supply glut that everybody has been fearful of, but if economies pick up a bit you are going to see demand surge.”
Many investors worry, like Dwek, that a pick-up in Chinese demand is necessary to see a rebound in the commodities sector, but Tan says this is not necessarily the case.
“Vehicle sales in Europe are at their lowest point ever and the average car is eight or nine years old, so you can certainly argue that there is a capital replacement cycle due,” he said.
“If you start to see Europe pick up even half as well as America, there could be a significant demand boost for commodities.”
“We all tend to forget that the EU economy as a whole is bigger than the US.”
A number of high-profile managers have been buying into Rio Tinto in particular, as FE Trustnet
recently reported, with equity income managers chief among them.
Asa Bridle, mining sector analyst at Cantor Fitzgerald, says that while the sector’s capex remains high, it is being channelled into more strategically important areas and companies are listening to shareholder demands to return cash.
“The sector has been under pressure to return cash to shareholders,” he said. “They need to find a way to offset the risks of mining and attract investors, and a dividend is a suitable way to do it.”
Tan points out that the yields on investment trusts that buy into these sectors are attractive, with New City Energy
yielding 5.5 per cent, BlackRock World Mining
4.7 per cent and City Natural Resources
4.3 per cent. BlackRock Commodities Income
yields 5.7 per cent.
“There are only a handful of resource-focused investment trusts of investable size and with a track record long enough for meaningful analysis,” Tan said.
“However, it is clear from their NAV performance numbers that they are, in essence, a higher-beta way of gaining exposure to the commodities investment theme, and have outperformed the broader materials sector substantially over time.”
In the last period of excess liquidity Tan identifies, it was BlackRock World Mining that produced the best numbers, returning 220.7 per cent in NAV terms between 2005 and 2007.
City Natural Resources returned 192.8 per cent and BlackRock Commodities Income 78.9 per cent. The basic materials sector made 49.8 per cent in that time and the mining subsector 95.4 per cent.
“We would expect these funds to be among the best-performing in a rising market driven by excess liquidity and commodity-led inflation,” Tan said.