Currency Wars Still Raging…

Perhaps things aren’t so bad for Australia after all. According to the Age:

Australia’s unemployment rate has fallen to 6.1 per cent in March, taking pressure off the Reserve Bank to cut interest rates next month.

The unemployment rate has now fallen for the last two months, from 6.3 in January, and 6.2 per cent in February, but it has remained above 6 per cent for the last ten months.

Don’t count on it.

Don’t let the lipstick disguise the fact that you’re still looking at a pig.

OK, that may be harsh, but it’s important that investors and commentators don’t fall into the trap of thinking that everything is fine with the Australian economy.

Even if we assume that the Australian Bureau of Statistics’ numbers are right, it’s as a result of one thing — record low interest rates.

The headline for the article is ‘Jobless rate falls in March, taking pressure off Reserve Bank to cut rates’.

Already you’re seeing the kind of reaction to positive news that the US has gone through over the past three years. Every time there is a sign of economic recovery, analysts, investors, and commentators start talking about the potential to raise interest rates.

‘After all,’ they claim, ‘this is a sure sign of a recovery.’

Except…it soon becomes obvious that, when interest rates go up and money printing stops, the economy falls back into its old ways.

A lost advantage

There’s another reason you can tell that this state of affairs won’t last long.

The Age article notes:

The news sent the Australian dollar soaring, the currency rising 1.3 per cent to US77.79c at 11:31am.

Don’t the Age journalists know that there’s a war going on…a currency war?

In the era of currency wars, the last thing any central bank or government wants is for their currency to rise.

All central banks and governments want to weaken their currencies as they see that as the best way to drive exports — the more exports, the more prosperous the country.

That’s the theory anyway. There are just a few problems with that stance.

The first is that in order for an economy to increase exports, it needs to produce the products or services that it can export.

For a long time, Australia’s comparative advantage has been the abundance of natural resources. As the resources sector boomed, Australia was right there, ready to ship iron ore, coal, and aluminium to anywhere that wanted it.

The huge increase in demand created the fear that supply may not be able to keep up. Prices soared.

However, that’s changed. No one is worried about supply problems today. The assumption is that there’s plenty of supply — look at this comment from Fortescue Metal Group’s [ASX:FMG] latest production report:

FY15 shipping guidance is increased to 160-165mt reflecting the strong operational performance for the year to date.

Despite the perceived problems facing higher cost producers, it’s pushing ahead with plans to increase production…which could drive iron ore prices down even lower.

The second problem is that companies that need to import goods and services to run their business here in Australia are disadvantaged by a lower Australian dollar.

With the Aussie dollar down 20% over the past year, assuming that all else remains equal, many companies will have seen some of their costs increase by 20% or more.

That’s not what any company wants in an already weak market.

That’s why folks shouldn’t get too excited about a lower unemployment rate. It looks great in the short term, but it’s worth remembering the context.

Have employers begun hiring again on the prospect of lower interest rates? If they have, then any pause by the Reserve Bank of Australia (RBA) could just as easily result in the unemployment number rising again in the not-too-distant future.

Lower dollar helps

Funnily enough, the lower Aussie dollar may be helping some local producers. All commodities are priced in US dollars. When producers sell their goods in US dollars and convert that into Aussie dollars, they should receive a benefit from the weaker dollar.

However, don’t get too excited. The oil price has halved, and the iron ore price has fallen around 70% from the high. And if a big percentage of their costs are in US dollars, then they won’t get the benefit either.

A small boost from the weaker Aussie dollar over the past year may have helped a little, but it’s not enough to make up for slumping commodity prices.

Don’t diversify

As I explained yesterday, the best time to get into any market is when investors absolutely hate it.

Right now, investors absolutely hate resources stocks. That creates an opportunity.

You just have to pick your opportunities carefully.

And if you decide you want to buy now, should it be the big diversified miners, or should it be the miners that have a concentration in one resource?

I follow the S&P/ASX 300 Metals & Mining index. It’s down 48.8% since the recent peak in 2011.

The major resource stocks haven’t done much better. Over the same timeframe, BHP Billiton [ASX:BHP] is down 36.8%, and Rio Tinto [ASX:RIO] is down 34.2%.

Gold miner, Newcrest Ltd [ASX:NCM] has fallen even further. It’s down 64.5%.

During bear markets, the non-diversified resources stocks fair worse. That’s because as soon as bad news affecting that commodity hits the market, investors sell off in a panic.

At the same time, because miners such as BHP and Rio are diversified across many commodities, the bad news doesn’t affect them as much.

That means, when you’re looking at a turnaround in the resources market, if you want the biggest proverbial ‘bang for your buck’, the best way to get that is by focussing on the commodities and the stocks that could bag you the biggest returns during a rally.

Newcrest is another good example of this. Since the start of the year, the share prices of BHP and Rio have barely moved, meanwhile, as the gold price has rallied, Newcrest has piled on a 30% gain.

In short, if you want to get the best returns as the resources market rebounds, don’t invest in big diversified mining stocks. Invest in those with a heavy concentration in one commodity.

And if you’re thinking that iron ore is one commodity worth looking at, resources analyst Jason Stevenson thinks differently. As he told Money Morning readers yesterday:

The graph below shows the iron ore supply expansion projects for all the major miners — BHP Billiton, Rio Tinto, Roy Hill, Vale, and many more. The vertical axis shows the tonnes, in millions, each project is set to bring online during that given year. The horizontal axis shows the year.

Source: RBC

Click to enlarge

Now this is just new supply from new projects. As you can see, the iron ore expansion is only one-third completed by the entire industry. Yet, the iron ore price stands at US$49.70 per tonne and will almost certainly dive lower. That said, an expected pullback in the US dollar may provide some breathing room…seeing a short term jump in the price.

Assuming Chinese steel demand stabilises at 800 million tonnes per year for the next 10 years (a 30% increase in total steel consumption), the price will continue to fall lower towards US$35 dollars per tonne this year. This is because demand will remain constant whilst supply expands rapidly.

In fact, there’s a risk that the iron ore price could decline below US$35 per tonne. There’s no doubt the future of many ASX iron ore juniors is in jeopardy. This includes Fortescue Metals Group [ASX:FMG].

The industry desperately needs India to come to the table. The new government already has huge infrastructure plans in place for the next five years. Indian Prime Minister Modi has pledged to develop multiple super highways, high-speed trains and construct 100 new cities focussed on specialised economic domains and “equipped with world class amenities”.

India is without a doubt the next China.

Adding to this, Modi wants to transform the country into a globally competitive manufacturing hub.

After decades of corruption and red tape, the country does have a long way to go. But certainly, Modi could be the man for this job. He’s already in the process of abolishing India’s planning commission — a useless and corrupt organisation that has led to a massive backlog of undeveloped projects.

The issues don’t stop here. Financing is another. Indian banks are sitting on US$22billion of infrastructure, construction, and iron and steel project loans — nearly 20% of these loans are non-performing.

Based on India’s business history and financial system, it’s going to be difficult for Modi to find the funds for development. Until this time, iron ore will continue to be in the doghouse.

Iron ore is one sector that won’t enjoy a return to the bull market in 2016 with many other commodities.

It’s simple. If you want to buy into the resources sector, don’t buy iron ore. And I’ll also add, don’t buy a diversified miner either, especially if you want to profit from a commodities rebound.

So, which commodities make sense right now?

Jason will share all the details with you tomorrow. Keep an eye on your inbox!

Kris Sayce,
Editor, Tactical Wealth

Editor’s Note: This article originally appeared in Port Phillip Insider, the daily insider’s guide to Port Phillip Publishing’s latest research and analysis. It comes free with subscription to any Port Phillip Publishing investment advisory.

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Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Markets and Money e-newsletter in 2005. He is the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service, Markets & Money.

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