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Industrial Metals Stock Outlook - March 2018

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Industrial metals such as iron, aluminum and copper are essential to regular technology and infrastructure. President Trump’s promise to go on an infrastructure binge naturally provided a boost to the price of industrial metals last year. Growth in U.S. GDP and continued improvement in end-use sectors like automotive, aerospace and construction acted as tailwinds for metals. Consequently, mining companies’ earnings improved significantly, leverage ratios have come down and improvement was witnessed in their capital allocation plans.

The momentum is likely to sustain in 2018 as well. The Chinese economy is expected to stimulate growth with further construction and infrastructure building projects. Prices have also gained on the back of China's drive to clean up its environment.

Though Trump’s recent imposition of tariffs on steel and aluminum imports is a welcome relief to domestic players, the fear of a global trade war is creating a cloud of uncertainty. Further, the Federal Reserve implemented its sixth rate hike rate since the financial crisis of 2008. The new benchmark short-term interest rate is now in the range of 1.50-1.75%. Higher rates normally translate into a stronger dollar which results in lower metal prices.

Let’s take a closer look at the price movement of a few important metals and what lies ahead.

Iron

Iron ore prices underwent volatile movements in 2017, ranging from a peak of $95 per ton in February 2017 to a low of $53 per ton in July. These movements were mainly due to Chinese restocking and destocking cycles. The demand for foreign iron ore was spurred by China's aggressive campaign to shut down polluting domestic steel mills. Higher-grade ore limits emissions and boosts productivity. Beijing mandated cuts of as much as 50% during the winter months which helped revive the domestic rebar price, bolstering iron ore prices in the process.

So far this year, iron ore prices have been trending higher and scaled a high of $78.3 per ton in February but remains below the important psychological mark of $80 per ton. Strong demand in China for imported ore is behind the recent uptick in prices.

Aluminum

Aluminum prices have gained in 2017 owing to improved supply-demand dynamics, Trump’s win, higher coal prices and China’s directive toward capacity cut.

This year, Trump imposed a 10% tariff on aluminum imports following the U.S. Department of Commerce’s investigations under Section 232 of the Trade Expansion Act of 1962. Per the report, aluminum imports had risen to 90% of total demand for primary aluminum and thus “threaten to impair the national security”. In the aluminum industry, employment fell by 58% in the 2013-2016 period with six smelters being shut down, and only two of the remaining five smelters operating at capacity.

The imposition of tariff on imports is anticipated to increase domestic aluminum production from its present capacity of 48% to approximately 80%, the minimum rate needed for the long-term viability of the industry.

LME (London Metals Exchange) aluminum prices achieved a high on Feb 19 of $2,265 per ton. However, since the release of Department of Commerce’s Section 232 findings, LME aluminum has fallen. A steep increase in Chinese aluminum exports as well as uncertainty regarding the impact of tariff has affected prices. Further, the fear of a global trade war negatively impacted metal prices.

Copper

Pick up in global manufacturing activity and hopes of Trump's $500 billion infrastructure splurge drove the red metal’s recovery last year. Renewed optimism about economic strength in the top consumer China aided prices. World mine production of copper declined 2% in 2017 due to lower output from Chile, the world’s biggest copper mine producing country which was negatively affected by the strike at the BHP Billiton Limited’s (BHP - Free Report) Escondida mine and lower output from Codelco mines. World refined copper balance for 2017 indicates a deficit of about 163,000 tons. Copper prices thus had a solid run in 2018, gaining about 28%.

Copper is currently near the $7,000 per metric ton level. The red metal’s prices have been weak this year. Demand from China which has been a major driver for copper prices, seem to have stabilized.

Furthermore, copper came under selling pressure after the U.S Department of Commerce released its Section 232 findings in mid-February. The risk of a global trade war seems to be weighing heavily on investors’ minds.

Industry Positioning — Mixed

The Zacks Industry Rank relies on the same estimate revisions methodology that drives the Zacks Rank for stocks. The way to look at the complete list of industries is that, we put our X industries (all 265 of them) into two groups: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

In the last 10 years, using a one week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank)

Within the Zacks Industry classification, the Mining-Iron and Mining-Non Ferrous industries (aluminum, copper, etc.) are grouped under the Basic Material sector (one of 16 Zacks sectors). The iron mining industry occupies space in the top 8% of the Zacks classified industries, with a Rank of #18. The non-ferrous mining industry, with a Zacks Industry Rank #247, occupies a position in the bottom 4%.

Improved Price Performance

Over the past year, the Mining-Iron and Mining-Non Ferrous industries have recorded a rise of 34.1% and 31.2%, respectively. The industries have outperformed both the Basic Material sector’s increase of 12.7% and the S&P 500’s growth of 10.6%.

Valuation Signals More Upside

Valuation looks attractive for both the industries going by the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) multiple, a preferred valuation metric for cyclical industries like iron and non-ferrous industries. The mining-iron industry has a trailing 12-month EV/EBITDA multiple of 5.1 and the mining-ferrous industry has a trailing 12-month EV/EBITDA multiple of 8.7. Both these compare favorably with the broader Basic Materials Sector’s EV/EBITDA multiple of 11.1 and S&P 500 EV/EBITDA multiple of 12.1. Both the industries’ favorable positioning compared with the overall market certainly signals more upside.

Q4 Earnings Scorecard, Projections

The basic materials sector logged a 45.2% increase in fourth-quarter earnings. The sector has been witnessing the highest percentage positive revisions for earnings lately. Earnings growth is projected at 42% for first-quarter 2018, 34% for second quarter and 14% in third. Overall, the sector’s earnings will grow a robust 34% in 2018. (Read more: Handicapping the Q1 Earnings Season)

What’s in Store?

Iron: World crude steel production improved 5.3% year over year in 2017. The trend is expected to sustain in 2018 as well. Increase in global steel demand particularly in China supported by infrastructure investment growth will boost demand for the steelmaking ingredient , iron ore. Also, the pollution control measures in China are leading to demand for higher-grade, imported ore. Conservative supply forecasts from the four major iron ore producers — Vale S.A. (VALE - Free Report) , BHP Billiton, Rio Tinto plc (RIO - Free Report) and Fortescue Metals Group Ltd. (FSUGY - Free Report) will aid prices.

Aluminum: Global aluminum markets are expected to be in a deficit in 2018. China’s demand, which accounts for about half of total demand, is likely to be sustained by the building and construction sector as well as the automotive and railway sectors. With the country deciding to cut capacity, supply will also be checked.

Moreover, demand should remain robust in North America, driven by the building and construction, automotive, packaging and airline industries. India appears promising given its current low levels of aluminum consumption and high urban population growth.

The imposition of the 10% tariff will be a relief for domestic players who had long been reeling under the onslaught of cheap imports and suffered significant reduction in production and employment. However, concerns of an impending global trade war loom large on the industry.

Copper: Per the International Copper Study Group (“ICSG”), copper is headed for a deficit in 2018. Labor negotiations at Escondida and at the many other mines with expiring contracts might lead to price disruption this year. Copper prices are likely to be influenced by demand from China, India and emerging markets, as well as economic activity in the United States and other industrialized countries.

Also, global copper production is set to spike in the long run as rising prices and increasing demand from the electric vehicles sector encourage project development. Output will rise as number of major projects come online, particularly in Peru and Australia. Production in Chile, the world’s top miner of the industrial metal, will return to growth in 2018, following a 4% contraction in 2017 due to strikes and operational disruptions.
 
How to Play the Industry


For investors keen on playing these industries, we recommend VALE which sports a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

In the last 30 days, earnings estimates for VALE have gone up 125% for the first quarter of 2018 and up 20% for 2018. The company has an average positive earnings surprise of 12.60% in the trailing four quarters.

However, we suggest staying away from or getting rid of stocks such Coeur Mining, Inc. (CDE - Free Report) and Nevsun Resources Ltd. (NSU - Free Report) . Coeur Mining has a Zacks Rank #5 (Strong Sell) and a negative average earnings surprise of 169% in the trailing four quarters. Its first quarter 2018 estimates have declined to a loss per share of 3 cents from the prior estimate of earnings of 7 cents, over the last 60 days. The earnings estimate for 2018 has plunged 68% over the last 60 days.

Nevsun Resources has a Zacks Rank #4 (Sell). The earnings estimate for 2018 has gone down 17% over the last 60 days.

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