There's nothing like a big round number to concentrate the mind. Investors, in particular, have a tendency to get excited about arbitrary price points with an abundance of zeroes. Think the 1999 best-seller 'Dow 36,000' (we're still waiting but not for long, I suspect).

Last week's big round number was 10,000 - the price in (US) dollars for a tonne of copper. It was the first time the metal, which is used in everything from kettles to electric vehicles and wind turbines, had fetched that price since the peak of the last industrial metals upswing in 2011.

When you consider that you could have bought a tonne of copper for US$4,300 a year ago, the recent rise is quite something. It is hardly surprising that talk of a commodities boom is picking up. And not just any old rally; what's getting investors excited is the prospect of a commodities supercycle.

Most industries are cyclical to an extent, but commodities are more so than most because the price of metals, crops and energy are closely tied to real day to day supply and demand. The price of a share can be sustained by hopes for future growth in earnings, but the cost of a tonne of copper reflects the balance of buyers and sellers today.

This means that commodities are always moving in mini bull and bear markets. Rising demand and constrained supply pushes prices higher and that, in turn, creates the oversupply that brings the market back into balance.

A supercycle is different. It is always driven by some kind of structural change in which demand is transformed over a period of many years, and usually all around the world at the same time. The mass production of motor cars in the early part of the last century, and then the growth of aviation, fundamentally changed the supply/demand dynamic for oil, for example.

Commodity supercycles are not that common, but when they kick in they last for years. There have probably only been four proper ones in the past 150 years. The first was triggered by American industrialisation and urbanisation, fuelled by the US's railway boom and accelerated by the First World War's demand for armaments.

The causes of the other three are well-known: the post-war recovery in Europe and Japan; the 1970s oil shock, boosted by Lyndon Johnson's Wars on Poverty and in Vietnam, and the space race; and China's rapid growth after it joined the World Trade Organisation in 2000.

So, the big question today is whether the recent price signals, from copper (which has doubled in a year), iron ore, nickel, zinc and other metals, indicate a temporary upswing as the world emerges from the Covid pandemic or the start of something more substantial. The answer to that question may well be one of the most important for investors today.

It's easy to make the case for a short-term bull market in commodities. The economic data around the world in recent weeks has surprised economists if not stock market investors who identified the possibility of a V-shaped recovery in activity a year ago. Coupled with short-term supply interruptions due to the pandemic, and longer-term constraints thanks to a decade of falling prices, it's no surprise that prices should have bolted in recent months.

What's more interesting, however, is the potential for that all-important multi-decade shift in demand. And for that you need look no further than the twin drivers of Joe Biden's transformational spending programme and the energy transition that has the potential to absorb however many trillions of dollars the world's big-spending governments want to print.

A third of Biden's so-called American Jobs Plan is earmarked for transport infrastructure and electric vehicles. China, too, has decided that electric vehicles will be the mainstream option within 15 years. Here in Europe, time has already been called on the internal combustion engine over the next decade or so. By 2040, Wood Mackenzie forecasts, there could be 300 million electric vehicles on the world's roads. In 2019 there were 5 million.

And that is just cars. Factor in green energy generation, let alone the once in a hundred years rebuilding of crumbling infrastructure on both sides of the Atlantic, and the demand for green metals like copper, nickel, aluminium and platinum is likely to soar. Glencore, the commodities trader and mining company, thinks demand for copper could double in 30 years.

Importantly, capital investment in new capacity is well below what is needed to meet that growth in demand. Of the more than 200 big copper deposits to have been found in the past three decades, only a handful have come in the last 10 years. Only 80 or so are now in production or have been closed. It takes years to develop a copper mine and in recent years shareholders have encouraged the payment of dividends over preparing for a future boom.

So, how might investors position themselves for the supercycle ahead? The simplest and cheapest way is via a commodities-focused exchange traded fund. There are plenty of different flavours but a broad-based exposure to metals and energy makes sense. To turbo-charge returns in the event of a prolonged upswing, investing directly in commodity producers is a better idea. With relatively fixed costs, miners' and oil companies' earnings will rise more quickly than the price of their underlying resources.

The other advantage of investing in commodity-related shares is that they can also deliver a high and sustainable dividend income. The combination of price gains and re-invested dividends over the duration of a typical supercycle might point you towards your own big round number.

By now most investors are tiring of their inboxes being filled by sell-side economists and strategists talking about reflation, how much more optimistic they are relative to consensus, and for how much longer the reflation trade will persist.

To be clear, there were very few people talking about a strong V-shaped recovery this time last year. Indeed, a scan of the forecasts of leading sell side economists in April 2020 shows consensus* forecasts of 3% for the CY21 for Australia and 3.8% for the USA.

Indeed, peak pessimism was not reached until September 2020, when economic growth downgrades ceased and modest upgrades commenced. Currently, consensus for CY21 has risen to 5.7% in the USA and 4.4% for Australia.

By contrast, our forecasts for the US in 2021 - which we published in mid-April 2020 - was 6.5% (represented by the cross in Chart 1). For Australia (Chart 2) we were even more optimistic, forecasting 7.0% economic growth. As we moved through 2020, it was clear the expected contraction in economic growth in 2020 was going to be less than expected and hence we reduced our forecast rebound in Australia's economic growth in 2021 to a still sizeable 6.0%.

Much of our more upbeat analysis was based on: (i) the nature of the shock being more akin to a natural disaster; (ii) the quantum of the fiscal packages; (iii) excess credit growth; (iv) the outlook for vaccine development; (v) and the prospect of pent up demand.

One year on, the clambering to upgrade growth estimates has only intensified. Over the past two months, consensus forecasts for Australian economic growth in 2021 have been upgraded a further 0.7%. In the USA the revision over the past 2 months is a remarkable 1.6%.

In other words, consensus economic growth forecasts are now more realistic, but the upward revisions are not yet complete and there is still scope for consensus to upgrade economic growth further in coming months to nearer our long held forecasts.

Indeed, when we compare our forecasts for economic growth to consensus there are now examples of economic growth forecasts for the US that exceed our forecast. The most notable is the Bank of Canada's recent upgrade of 2021 US economic growth from 5.0% to 7.0%. Given the US is Canada's largest trading partner, the Bank of Canada has a strong incentive to get its US outlook near the mark! The Bank of Canada also lifted its global growth forecast in 2021 to 6.8%, which is 1.25% higher than any global growth year since IMF data commenced (1980) and 0.8% above the IMF's April forecasts!

However, one of the largest gaps between consensus and our own 2021 forecasts is for Australia. We remain 1.5% above the consensus forecast and around 1% above the most optimistic forecaster. Given there remains an appreciable gap between our forecasts and other forecasters, it's reasonable to ask what supports our optimism?

1. Australia's data continues to consistently beat economic forecasters

Charts 3 and 4 show our calculation of economic data surprises for economic activity and inflation relative to consensus forecasts (US vs Australia). A positive reading represents economic data beating consensus expectations weighted by data importance and time decay. Clearly, Australia's economic activity data is not only continuing to beat increasingly upbeat economic forecasts, the positive data surprises are larger in Australia.

2. Real economic growth is expanding at pace

Secondly, our nowcasting techniques (Chart 5) for gauging in real-time how fast the economy is expanding already suggest that real economic growth is expanding at 4%yoy by the end of 1Q2021. That is, we are about to see a very solid 1Q GDP print for Australia that we expect will be the catalyst for a further upgrade of the consensus view.[1]

Clear trends and themes have emerged in investment markets as a result of the pandemic and its effect on discretionary and non-discretionary spending and where we live. Exploring these themes was the focus of Sage Capital's recent webinar, which delved into how these dynamics are playing out in Australia and around the world.

Bricks and mortar drives markets

The webinar provided perspectives on the nature of the current housing boom and how long it can continue. It explored a related theme of consumer spending and how it has shifted one year after the first COVID lockdowns.

The housing market cycle was the main theme during the session, given low interest rates the world-over have stimulated a boom in residential property markets. Detached dwellings in particular have benefitted, as people seek more space at home when they are prevented from travelling too far from their homes due to stay-at-home orders and border closures.

As a result, apartment prices have not experienced the same gains as stand-alone homes. Flagging demand for inner-city properties is also the result of many people embracing the opportunity to move out of the city given the widespread adoption of the work-from-home way of working.

Inner city apartments notwithstanding, the booming housing market isn't just good news for property, it also has flow-on effects to other sectors. The strong residential real estate market has translated to high demand for mortgages, which is good news for lenders and also service providers such as mortgage insurers.

It's worth noting the lending sector is strong for another reason. At the start of the pandemic, many lenders made very large bad debt provisions, assuming borrowers would be stretched as a result of the pandemic leading to shut downs in many areas of the economy. These provisions, at least in Australia, have proven to be too generous, largely due to government stimulus programs helping borrowers to meet their obligations and taking the pressure off lenders.

While this has been good news for financial institutions and also the housing market, concerns are emerging about whether the market is running too hot. Governments and regulators are also worried about housing affordability. As a result, some countries are taking action to moderate house price growth.

As examples, New Zealand has taken steps to cool its housing market and Canada has recently tapered its bond-buying program. The Reserve Bank of Australia has not given any indication it's going to steer away from its lower for longer approach to interest rates. But that does not mean investors should not be informed by actions in other jurisdictions. It's a trend of which our portfolio managers should be aware, as these same trends could play out in other markets.

What's happening at the checkout?

Turning to consumer spending patterns, one of the fundamentals we're always curious about is the connection between housing market movements and consumer spending, and how this may play out across the investments in our portfolios.

Retail spending is highly correlated with house prices. So when house prices are strong, we're much more likely to buy a new car, renovate and buy furniture and appliances. But this trend often reverses as interest rates and home loan repayments rise, and people are less inclined to spend money on non-discretionary items.

We are also closely watching shifts in consumer spending as a result of the pandemic, investigating whether and when these shifts normalise and who the winners are in the short- medium- and long-term.

When it comes to discretionary and non-discretionary spending, consumers will look for alternate ways to spend their money if recreational travel remains off the table. Which is why Sage Capital has been scouring the market for retailers with a real digital capability that may have been so far largely overlooked by investors.

Retailers that are strong omni-channel marketers that have a demonstrated ability to do online fulfilment are well placed, especially those with strong national store networks, so they can easily deliver orders on the same day they are placed.

This is a real advantage over online competitors that rely on big fulfilment centres for retail distribution. Achieving same day delivery is going to be very difficult for these operators and require significant capital expenditure to maintain their competitive position.

Our ability to add value

At Sage Capital, we understand these trends and aim to position the portfolio accordingly. These insights help us form a view on when to rotate in and out of stocks exposed to the housing market and the retail sector.

As for the future, there are still many unknowns. These include the COVID-19 vaccination rollout in Australia and around the world and how that may affect international border openings and the future of international travel. The way these themes play out has implications for any investments exposed to the movement of people and goods across borders.

These are just some of the themes we have been investigating at Sage Capital and that inform our approach to portfolio management. We look forward to sharing further insights form our webinars in the future.

As a long short manager, the investment team is able to use its shorting powers to benefit from a falling market. At the same time, it can go long stocks when markets rise. This investment style, and the diversified nature of the portfolio, helps mitigate risks and provides protection when markets correct.

Sage Capital is an Australian long-short equities manager with two investment strategies, the CC Sage Capital Equity Plus Fund and the CC Sage Capital Absolute Return Fund. Long-short strategies are often popular with investors when traditional asset classes are challenged. It's a strategy that aims to provide consistent returns through market cycles.

Both Funds have performed well for investors over the one year to 31 March 2021. The CC Sage Capital Equity Plus Fund delivered a net return of 43.59%* and the CC Sage Capital Absolute Return Fund delivered a net return of 9.98%*, outperforming their respective benchmarks for the same period by 6.12% and 9.89%.

*Past performance is not indicative of future performance.

This information is for Wholesale and Professional Investors only and is provided by the Investment Manager, Sage Capital Pty Ltd ACN 632 839 877 AR No. 001276472 ('Sage Capital'). Channel Investment Management Limited ACN 163 234 240 AFSL 439007 ('CIML') is the responsible entity and issuer of units in the CC Sage Capital Equity Plus Fund ARSN 634 148 913 and the CC Sage Capital Absolute Return Fund ARSN 634 149 287 (collectively 'the Funds'). Channel Capital Pty Ltd ACN 162 591 568 AR No. 001274413 ('Channel') provides investment infrastructure services for Sage Capital and is the holding company of CIML. This information is supplied on the following conditions which are expressly accepted and agreed to by each interested party ('Recipient'). This information does not purport to contain all of the information that may be required to evaluate Sage Capital or the Funds and the Recipient should conduct their own independent review, investigations and analysis of Sage Capital and of the information contained or referred to in this document. This email (including attachments) is subject to copyright, is only intended for the addressee/s, and may contain confidential information. Unauthorised use, copying, or distribution of any part of this email is prohibited. Any use by unintended recipients is expressly prohibited. To the extent permitted, all liability is disclaimed for any loss or damage incurred by any person relying on the information in this email. This communication has been prepared for the purposes of providing general advice, without taking into account your particular investment objectives, financial situation or needs. Past performance is not indicative of future performance. All investments contain risk. An investor should, before making any investment decisions, consider the appropriateness of the information in this communication, and seek professional advice having regard to these matters, any relevant offer document and in particular, you should seek independent financial advice. For further information and before investing, please read the Product Disclosure Statement available from www.sagecap.com.au and www.channelcapital.com.au.

In our Investment Strategy Note we discuss how even the best long-term performing fund managers always have shorter term periods of underperformance - it's not a bug, it's a feature of the best.

Summary:

• The goal of equity fund investors is generally to be with the top performing managers over the long term (5-10+ years).
• Data shows that virtually all long-term top performing managers have shorter term periods (1-3 years) where they underperform their benchmark.
• Ditching long term top performing managers at the first sign of underperformance is likely to be a suboptimal strategy.
• To be with long term top performing managers you should expect you will have to endure short term periods of underperformance.

The financial media love to laud or lament short-term investment performance, both good and bad. As an investor, it's easy to get drawn in, as you mentally extrapolate out recent trends across your portfolio.

But to capture superior long-term results, which is what most of us ultimately aim for, we must first be willing to tolerate periods of short-term pain.

These short-term swings can be difficult to stomach and will often tempt investors to bail out of the market. However, without being able to accept periods of underperformance, investors may miss out on the market's inevitable rebound and fail to harvest the long-term superior returns of equities.

If investors can develop a deeper understanding of how top funds perform over time, they will more confidently weather the inevitable periods of short-term volatility in performance, and be more likely to reach their long-term investment goals.

Don't be alarmed

The evidence is clear: virtually every top-performing fund has instances where it underperforms its benchmark and its peers, particularly over time periods of three years or less.

A study by independent US investment bank, Baird, looked at a group of more than 1,500 funds with 10-year track records. They then narrowed the list to 600 funds that outperformed their respective benchmarks by one percentage point or more, on an annualized basis, over the 10-year period. The list was further narrowed to include only those funds that both outperformed and exhibited less volatility than the market benchmark.

Despite their impressive long-term performance, 85% of these top managers had at least one three-year period in which they underperformed their benchmark by one percentage point or more. About half of them lagged their benchmarks by three percentage points, and one-quarter of them fell five or more percentage points below the benchmark for at least one three-year period.

Depending on which of the three-year periods investors looked at, they could have been highly alarmed by these periods of underperformance. Yet in the long-run investors profited: all these managers were top performers over the full 10-year time span.

It pays to be patient

When looking at shorter periods, the results were even more telling. All the top managers dropped below their benchmark at least once. Moreover, one-quarter of them went through at least one 12-month period where they underperformed their benchmark by 15 percentage points or more.

By these measures, it looks as though all fund managers, including even the best ones, will go through periods of underperformance. For investors, it can be particularly challenging knowing what to do when your fund is in the midst of one of these tough periods.

The evidence suggests that rather than leaving a top-performing manager during difficult times, it pays to be patient through periods of underperformance. Indeed, the longer an investor can wait, the better their funds' chances of beating its benchmark become.

Time diversification

One of the major factors affecting fund performance is the cyclical relationship between asset prices and the business cycle. In the short term, investments can fluctuate in value for a number of reasons, including changes in the economy, volatility, political uncertainty, business failures, interest rate changes, fluctuations in currency values, and company earnings. In an economic downturn, GDP growth slows, and business earnings decline, which leads to less optimistic outlooks for companies and lower stock prices. In an economic expansion, the reverse tends to happen.

But time is an investor's best ally.

As investor holding periods lengthen, short-term risks tend to become less relevant, partly because many short-term price movements tend to offset each other over a complete business cycle. This means that, as an investment's holding period increases (e.g., 20 years vs. 5 years), investment risk due to market volatility (i.e., ups and downs of prices) will decrease.  Because of this relationship, both the frequency and magnitude of underperformance become less dramatic over more extended periods.

A more wholistic view

Investors who buy into an equity fund based solely on a few quarters of strong returns are quite likely to reverse course and sell out of the fund when returns fall short. In our opinion, this churn benefits no one, and hence at Ophir we seek investors who agree with our investment philosophy and appreciate our process. We expect our portfolios to have negative years or underperform their benchmarks on occasions and understand that investors can start feeling nervous and uncomfortable through these periods. As seen below, our Ophir Opportunities Fund, which has the longest track record of any Ophir fund at nearly 9 years, has had two periods of 1-year underperformance and one period of 3-year underperformance (albeit briefly), yet is ranked no.1* over the long term, generating 24.6% p.a. (net) since its inception in August 2012.

We strongly believe investors should remain focused on their long-term financial plan and avoid knee-jerk reactions during times of negative absolute or relative performance. All equity fund managers have short term periods of underperformance. A more wholistic view of managers needs to be taken. This includes factors such as long-term track record (if it exists), people, investment process, levels of alignment and adherence to capacity constraints, amongst others. In this way, investors who take a more wholistic view are more likely to set themselves up for long-term success.

Source: Ophir Asset Management. *FE fundinfo data, Australian Small/Mid Caps, Aug 2012- March 2021

One year on from the 'fastest bear market in history' we can see the benefits in keeping calm and staying invested in the Australian stock market.

Prime Value Emerging Opportunities Fund portfolio manager, Richard Ivers, shares his views below on where the market is currently at. But first, let's rewind 12 months:

During February and March 2020 markets plummeted. In the USA, the S&P 500 fell 30 per cent in just 22 trading days after reaching a record high on 19 February 2020 - the fastest drop of its magnitude ever.

Likewise, the ASX 200 entered its fastest bear market, shedding 20.5% in just 14 days.

As economies globally shut down, the question seemed to be how far could markets fall?

What happened next surprised many investing experts and emphasised the virtues of the words: DON'T PANIC.

The fastest bear market in history turned out to be the shortest bear market. One year on, the recovery has been remarkable.

Prime Value Asset Management's Australian equities funds show the benefits in keeping a steady hand.

Looking through the market

As Prime Value fund managers Richard Ivers and ST Wong often say, their job is to "look through" short-term market fluctuations when making investment decisions.

When markets were spiralling one year ago, Richard and ST sought to turn crisis into opportunity.

The savage sell-off meant many good quality companies were suddenly available at better value, in line with Prime Value's 'Growth at a Reasonable Price' approach.

For the Prime Value Emerging Opportunities Fund, the volatility among small cap stocks has provided many opportunities during the shutdowns and on through the recovery.

Investing during this uncertainty - always with an eye on 'protecting the downside' - allowed the Prime Value Emerging Opportunities Fund to be the best performing Australian small caps fund for the year to 30 June 2020, the second best performing Australian equities fund in any category for the calendar year to 31 December 2020 (Morningstar), and currently the best among funds who blend value and growth styles for the year to 31 March 2021 (Morningstar).

Current state of play

Richard Ivers, portfolio manager for the fund, says the market continues to create opportunities. "The small caps market is still choppy, there is more takeover activity, and there are some good buying opportunities at present.

"The volatility has created the opportunity to buy some quality companies relatively cheaply."

He says looking through the COVID-19 market recovery continues to be key. "We see some big fluctuations in stocks which may be perceived as winners or losers from the recovery. By looking through the short-term issues and analysing the strength of the business we can find some real gems.

"But the economy is changing, and investors need to look through the market swings. A key current question is how will the COVID winners and losers from last year fare during 2021

"Many people are trying to trade the re-opening, but it always has to come back to growth at a reasonable price.

"For example, some of the travel stocks are now over-priced. But there are other ways to benefit from economies re-opening which are less obvious, via really good businesses."

Right here right now - the biggest themes driving markets are electrification and decarbonisation - which are really 2 sides of the same coin.  And with the global resolve now clearly past the inflection point, these 2 themes are likely to be the dominant drivers for most of this decade.

So far, in an effort to gain exposure, Aussie investors have stumbled from graphite to cobalt to lithium to nickel and then back to lithium again.   However, there is an emerging viewpoint that copper could be the surest way to gain exposure to the enormous electrification opportunity.  For example, Goldman Sachs recently released a piece of research titled: Green Metals: Copper is the New Oil.

Given that the Australian market is renowned as one of 2 global resources hubs, it would be reasonable to assume that there would be a host of copper producers listed on the ASX    However that is not the case. If we exclude BHP and RIO - whose main earnings come from iron ore - there are only 4 ASX listed copper producers. Over the past decade, a combination of corporate activity, low copper price, increased fiscal discipline and depleted ore bodies has left us with just FOUR ASX listed copper producers. This is extraordinary for the most widely used base metal on our planet.

Of the 4 producers, OZL and C6C are both trading on PERs in the mid20's.  SFR would appear superficially cheap, however the DeGrussa mine is scheduled to be depleted sometime during 2022. 

This leaves Aeris, which our funds have been steadily accumulating on a PER of <3x.

Aeries recently came to life on the well-timed and equally well priced purchase of the Cracow gold mine from Evolution in 2020.   In fact so well timed and priced was the acquisition, that in the space of 12 months they have been able to completely pay off their debt and are now generating strong surplus cashflow. But it is the Tritton Copper mine near Cobar in western NSW that has piqued our interest. 

The Tritton min has been producing copper since 2005.   During this time it has produced over 320,000 tonnes of contained metal.   Over the past decade, it has produced between 23,000 and 30,000 tonnes every year.   It is forecast to produce around that amount - ~23,000t - this current financial year, at an AISC of $3.75 per lb.   Yet despite this long term record, the stock is trading on a consensus average PER of 3x over 2021FY to 2023FY.  

Clearly the market has concerns.  From our analysis, there are 2 major investor issues: mine life and hedging

Mine Life

The last stated reserve of 86t contained metal equates to a little under 4 years.  So on the surface this would appear an issue.   However, there are important factors that make it highly likely that the mine will be operating for many years to come.

The first of these is highlighted by existing resources (as opposed to reserves).  At 250,000 tonnes of contained copper, this is equates to more than 10 years at the current production rate.   At the current high copper price, we would expect a solid and ongoing conversion of resources into reserves    But there is an even more important point.   Reserve definition drilling requires a much higher level of saturation.   Most mines of this nature drill the ore body to sustain mine plans (only) several years out.  As the mine goes deeper, infill drilling of known resources will continue to add to reserves.   The best demonstration of this is to review past reserve statements.   In 2013, total cu reserves were 126,000 tonnes.  Since then the Tritton mine has produced nearly 190,000 tonnes and counting.

The second factor that adds to our confidence is that Aeris has reported strong exploration success over the past 12 months.  In the coming years we are likely to see additional tonnes from 3 sources:

• Life of mine extensions via mineralisation at depth, South Wing, Budgerygar and the corridor between Tritton and Budgerygar
• Brownfields exploration at Murrawombie, where >5 metre intersections as high as 4% have been recorded
• Greenfields exploration via the Constellation target where the first drill hole spectacularly intersected 20m at 2.4% Cu.

It's important to recognise that for much of the past decade, Aeris has been struggling with low Cu and gold prices and hence has not had the dollars to spend on exploration.  This has changed in the past 12 months, and we would expect a steady stream of positive drill results.

Hedging

Like a lot of companies, when the Cu price rallied hard, Aeris prudently put in place some hedging in the event that the move faulted.   Clearly in hindsight this has capped their short term benefit.  

However the hedging currently in place is modest.   Aeris has locked in 78% for the current quarter (which has only 7 weeks to run) and 26% for the September quarter, both at an average of $4.57 per pound. 

This will still see a strong cash build, whilst also allowing the company to sell part production into the decade high price.    Beyond the September quarter, Aeris is unhedged and will be able to sell 100% of its production at spot, which at the time of writing had pushed through $6.30 per pound.  

Strong Risk-Return Proposition

If prices hold anywhere near the current level, this will see Aeris generate 'super profits'.   If the emerging consensus view is correct, then a combination of 'super profits and limited cu producers may see investors clamour for stock. 

On past earnings, a PER of 9x would equate to a share price north of 30c.   If we flow through the current spot price for copper, then the 'theoretical' valuation is multiples thereof.   .   If the market is being overly cautious, then this is a rare opportunity in a sector that has the strongest of tailwinds.

Recently I attended a UBS hosted virtual China Commodity Tour. In light of the observations that I had made back in a research note to you all in December 2020, I thought it would be useful to provide an update to those views given recent positive trends.

China is not only the world's second largest economy, it is also Australia's and New Zealand's largest trading partner (c. 30-40% of both countries' exports) and its economic performance influences investor sentiment in both economies. In recent times navigating a more assertive China under President Xi Jinping has been a key factor to monitor for investors in Australasian equities. China in particular has proven itself to be very effective at managing COVID-19, which allowed a strong recovery to develop. More recently the pace of vaccinations in China has picked up reaching 200 million shots with the government targeting 40% of the population by July. In terms of macro developments, Q1 2021 GDP growth jumped 18.3% (relative to a year earlier) whilst sequential growth slowed, as expected, to about 2% (quarter-on-quarter). UBS expect this to stay at around 6% for the balance of the year, resulting in a full-year GDP growth forecast of 9%. This mirrors a strong growth recovery in the US being driven by policy stimulus and progress towards a normalization of activity- Goldman Sachs is forecasting over 7% US GDP growth for 2021. Other growth metrics in China remain robust; Fixed Asset Investment rebounded 25.6% in the first quarter, Industrial Production grew by 28% and Retail Sales rebounded 34% (8.5% higher than the first quarter of 2019). Similar trends were evident in property with sales up 64% from where we were this time last year. With Chinese stimulus beginning to recede, growth rates will moderate but real consumption growth should remain robust in the period ahead.  

Key presenters in the UBS tour highlighted a broadly positive demand backdrop but one where the authorities are focused on moderating any excesses. The government is tightening credit availability to property developers to avoid overheating with forecasts of lower housing starts in 2021, although Infrastructure is expected to grow by 6.5-7%. This combination suggests positive steel demand this year (a recent CLSA survey estimated more than 3% growth). Policy makers in China are increasingly focused on restricting steel exports and limiting production due to pollution in a number of key regions, in particular Tangshan. During the past week China removed steel export tax rebates for 146 types of steel products and will increase the export tax on certain steel products from 15% to 20%. With steel exports in China currently annualizing over 60 million tonnes, the government is now clearly signaling a new direction in this area. China produced 271 million tonnes of crude steel in the first quarter of 2021, up 15.6% year-on-year. On an annualised basis this equates to 1.08 billion tonnes. If China maintained this level of steel output for the rest of the year, expectations were that annual production would therefore increase by around 4%. However, following the tour and recent news flow around the removal of export rebates, our base case has now been revised lower and assumes that China will reduce their exports through the balance of this year resulting in steel output growth of only 1.5%.

On the face of it this is a negative for iron ore demand in China with over 80% of output being produced from blast furnaces (a process that requires iron ore at a ratio of 1.7 tonnes of ore to produce a tonne of steel). However, with China withdrawing tonnage from the steel export market we expect other regions to increase blast furnace capacity utilization to make up the difference. Principally this will be evident in Japan, South Korea, Taiwan and to a lesser extent Europe. This shift in productive locations will help offset the lost tonnage of iron ore demand from China. In addition, it is worth noting that China's focus on pollution is resulting in a higher demand for the best quality iron ore (lump and pellets). This works in favour of the large Australian miners, BHP and Rio Tinto.

The iron ore supply side remains relatively constrained but production from Brazil is gradually improving, as their COVID challenges improve. We forecast that major producer Vale will increase volumes by 30 million tonnes this year from their mines in Brazil. India remains a major uncertainty with rampant COVID infections potentially reducing last year's level of exports. Overall the market still appears tight this year but particularly in the first-half of 2021.

Despite the iron ore demand / supply backdrop continuing in a state of flux, in late April its price hit a new record high of close to US$200/t. This ultimately demonstrated that with the world progressing through its recovery phase, and with massive amounts of development occurring in property and infrastructure, the scales are tilted in this commodity's favour. 

As we look forward there remains uncertainty across market commentators as to where the iron ore price will move to. Our central view is that the spot price will weaken over the course of this year to average US$165/t in 2021 and US$120/t in 2022. This appears to be a negative forecast, but such a price would still result in material earnings upside for the mining sector relative to consensus expectations and would also support substantial capital return opportunities. On the basis of the current iron ore price the sector is generating a free-cashflow yield of almost 20%. On our base case of a declining price, the free cashflow yield ranges from 10-19% in FY21 and 10-13% in FY22.  Our top pick in the sector is Rio Tinto - we estimate Rio can return 35% of its market capitalization over the next three years and remain debt free. If it were to raise even a small amount of debt the potential size of a capital return increases materially. Both BHP and Rio Tinto are more diversified commodity exposures than Fortescue and with better quality iron ore, so this is our least preferred exposure in the sector.

Our core insight from the UBS-hosted event was that while the overall backdrop remains supportive for iron ore, there are a myriad of factors which need to be carefully navigated at an individual country and stock level. We believe this backdrop remains supportive for our active investment approach.