US Treasury spreads are at their lowest level in more than a decade and an inverted US yield curve is typically a precursor of a recession. Given the mining sector’s sensitivity to economic growth prospects, this could be seen as a harbinger of underperformance. Tal Lomnitzer, Senior Investment Manager in the Janus Henderson Global Natural Resources Team, explains why they are not concerned.
An inverted US yield curve has successfully predicted every US recession in the last 60 years. No wonder we have been fielding questions about what a flattening, or inverted, yield curve means for the mining sector. A recession should be bad news for a sector so inextricably tied to economic development but the data suggest that a flat or inverted curve can actually be a positive environment for mining stocks. This makes sense to us given constrained commodity supply, ongoing capital discipline, strong cash flows, returns to shareholders and attractive valuations. So do we fear an inverted yield curve? Not at all.
Flatter and flatter…
The US yield curve has been flattening since 2011, fuelling concerns of slower growth and recession on the horizon.
Flattening US yield curve
Source: Bloomberg, monthly data from April 2009 to April 2019.
Past performance is not a guide to future performance.
The yield spread between US 10-year Treasuries and US 2-year Treasuries is the lowest it has been since 2007, at around 20 basis points. This has been driven by tightening US monetary policy as the US Federal Reserve (Fed) has worked to unwind the unprecedented stimulus put in place to avert financial ‘Armageddon’ during the global financial crisis. The market fears that yield curve flattening will turn to inversion where short-end rates go higher than long-end rates. Unlike equity markets, the yield curve is a very good predictor of impending recession, though typically with a seven-to-ten quarter lag.
Given the sensitivity of underlying commodity prices to changes in economic growth (GDP), one might think that a flattening or inverted yield curve would presage underperformance; the analysis from Jefferies below looking at 30 years of data suggests that the opposite is true. Mining stocks have tended to do well in flattening yield curve environments and significantly outperformed when the US 2-10 year Treasury curve inverted in 1998, 2000 and 2006/7. Similar analysis from Credit Suisse finds that basic materials outperform 97% of the time in the 12 months after yield curve inversion.
12-month price performance in different yield curve scenarios
Source: Chris LaFemina & Timothy Ward, Jefferies Research, 19 June 2018, data from December 1985 to May 2018, in local currency terms. Mining stocks are FTSE 350 Mining Index, metals prices are Bloomberg Industrial Metals Subindex (USD).
Past performance is not a guide to future performance.
It’s all about the dollar and emerging markets
This counterintuitive result is because emerging markets (EM) have become the ‘tail that wags the commodity dog’. A flattening yield curve, driven by the Fed raising short-end rates, usually reflects the late-cycle part of an expansion when growth slows and inflation rises. The US dollar tends to strengthen with higher short-end rates, which plays havoc with EM balance sheets and currencies. Last year saw several mini EM currency ‘crises’ as this sequence played out.
Late cycle environments tend to favour real (physical) assets and higher near-term inflation expectations have historically meant that commodity-linked assets outperform. When the Fed signals that it will stop raising rates, the dollar tends to weaken, typically leading to an EM recovery, driving demand for commodities. In an ironic twist, cyclical mining shares can show defensive characteristics. Should economic growth falter, we anticipate that mining equity performance would be supported by returns to shareholders via dividend payments and buybacks.
2019 has seen a strong rebound, driven by the Fed ratcheting back guidance for interest rate increases and constructive commentary on the China/US trade discussions. Improving Chinese economic data, as a result of government stimulus, is encouraging for future commodity demand. Buyers of mining shares have been attracted by strong free cash-flow yields and undemanding valuations. Traditionally, the valuations of big companies move first and are closely followed by mid-cap companies but this has not yet happened, suggesting that the upturn may have further to run. In recent weeks, we have seen a positive reversal of the China Economic Surprise Index confirmed by a recovery in the Chinese 10-year bond yield, which base metals such as copper tend to track closely.
Energy and metal commodity prices are supported by ongoing supply side capital discipline and moderate demand growth. Commodity prices are lower than 2011 highs, yet margins are very healthy and balance sheets strong. Cost inflation is likely to provide commodity price support while the inventories of metals on both the London Metal and Shanghai exchanges are low, making for a constructive price environment.
Valuations and returns suggest that the mining sector is trading around mid-cycle. Return on capital employed (ROCE) has improved to 12.5% versus an historical average of 14.5%.
Mining industry average ROCE
Source: Paul Gait, Bernstein Research, data from January 1985 to March 2019.
We believe that returns are too low relative to market tightness, leading already thin inventories to decline further. We need to see higher prices and returns for a sustained period to incentivise investment in sorely needed new resources production.
Resources investment is best approached as a broad canvas. We need to consider what is required to meet mankind’s need for shelter, sustenance, mobility and social connectivity, and how this can be done in a sustainable manner. The answer is: with difficulty. Companies across the energy, minerals and agricultural spectrum will need to be fast adaptors. Consumer needs are changing quickly, whether in food choices (sustainable), energy choices (renewable) or in the type of metals required to drive an increasingly electric-based economy (copper, aluminium, nickel, lithium). Gas also has interesting appeal as a transitional fuel.
Whatever the resource, we continue to invest in companies with world class assets, low costs, growth, strong balance sheets, good or improving environmental, social and governance profiles and strong management teams.
Inverted yield curve: A yield curve is a graph that plots the yields of similar quality bonds against their time to maturity and can signal market expectations about a country’s economic direction. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields because investors want a higher level of return for their longer-term commitment. An inverted yield curve environment is when yields on bonds with a short maturity are higher than the yields on bonds with a longer maturity (of the same credit quality), a scenario which is considered by some market commentators to be a predictor of economic recession.
Free cash-flow yield: Free cash flow is cash that a company generates after allowing for day-to-day running expenses and capital expenditure. It can then use the cash to make purchases, pay dividends or reduce debt. Free cash-flow yield is a financial ratio that standardises the free cash flow per share a company is expected to earn against its market value per share. It is calculated by taking the free cash flow per share divided by the share price.