Basic Materials: China Slowdown Weighs on Commodities (With One Exception)

• The basic materials sector is trading close to our aggregate fair values at a median price/fair value of 0.97 compared with a market price/fair value of 0.99.
• Mined commodity prices tied to China's sun setting infrastructure and housing boom are unlikely to recover, but we see uranium as an exception to this story as China builds out its fleet of nuclear reactors.
• While we expect China's housing market to eventually falter, the outlook for U.S. residential construction is better than most think, with implications for lumber and coatings companies.
• In the prevailing low price environment for steelmaking commodities, we are closely monitoring steel trade regulation. With one case already filed in early June, we expect more to come.

As China's economy rebalances, we think a slowdown in the country's investment growth rate is inevitable. This outlook does not paint a pretty picture for many industrial commodities for which China has been the main growth engine over the past decade, with recent data showing evidence of weakening Chinese demand. Global steel production fell year on year in both April and May because of lower Chinese output. Chinese steel consumption fell for the first time in over a decade in 2014, and we project it will continue its decline through 2015 and 2016.

We expect the shift in China's GDP composition to weigh on metals prices. Our long-term forecast for iron ore is $60 per metric ton compared with a trailing five-year average of $128. We project metallurgical coal prices of $110 per metric ton versus its trailing five-year average of $191 per metric ton. Since it is used later in the construction process, copper leverage to Chinese real estate is somewhat lagged. That said, copper prices have fallen with other metals, and we expect prices of $2.46 per pound compared with the trailing five-year average of $3.44 per pound. China's slowing electricity demand growth and shift away from polluting coal-fired plants leads us to expect thermal coal prices of $67 per metric ton versus the trailing five-year average of $91 per metric ton.

However, uranium remains a notable exception in the industrial commodities space. While China accounts for around half of global demand for coal, copper, and iron ore, it accounts for less than 10% of global uranium demand. We think China will quadruple its uranium demand over the next decade as the country builds out a fleet of nuclear reactors to supplement coal's baseload power generation. Uranium supply will struggle to keep pace, and we expect prices to need to increase from $50 per pound today to $75 per pound over the next few years to incentivize enough projects to plug the shortfall.

Although Chinese housing showed some signs of life in the recent quarter with the latest price data painting a picture of improving demand, we're still bearish on the long-term outlook for Chinese housing construction. Interest rate cuts and the lifting of restrictions on second-home buying seemed to help buoy near-term prices, but these are temporary measures that will do little to solve the long-term issues facing Chinese housing construction.

Whereas we expect weak Chinese housing construction to weigh on global industrial commodity demand, we are far more bullish on U.S. residential construction. Demographic conditions are ripe, as millennials, the largest generation in U.S. history, form households and buy their first homes. In addition, we expect financial constraints that have forestalled a full housing recovery to fade, as labor markets tighten and mortgage eligibility standards loosen. Consensus forecasts housing starts rising to 1.4 million-1.5 million over the next several years, up from current starts of roughly 1.0 million and in line with the trailing 50-year average. We forecast starts rising to 1.9 million by 2019, and the best decade for new residential construction since the 1970s. Industries with the highest exposure include timber and coatings.

In the prevailing low-price environment for steelmaking commodities, we are closely monitoring trade regulation. U.S. steelmakers, in particular, have been vocal about the need for increased protectionism on the trade front. In the first five months of 2015, imports accounted for 32% of finished steel consumption, up from 26% over the first five months of 2014. Elevated import volumes have weighed on steel prices, which have finally begun to stabilize after consistent declines over the trailing 12 months.

U.S. steelmakers filed a trade case on the import of corrosion-resistant steel in early June, and we anticipate additional trade case filings over the second half of the year. If these cases are filed and the Department of Commerce issues favorable rulings, shipment volumes and capacity utilization for U.S. steelmakers would exhibit a noticeable uptick.

Peabody Energy

BTU

Peabody Energy mines thermal coal in the U.S. primarily in the Powder River Basin and Illinois Basin, or ILB, and thermal and metallurgical coal in Australia. Peabody's domestic coal operations have struggled as low natural gas prices have driven significant coal-to-gas switching. With gas prices lingering between $2.50 and $3 per thousand cubic feet, coal's cost competitiveness continues to remain under threat. However, as natural gas prices rise to our energy team's forecast of $4 per thousand cubic feet, PRB and ILB coal will regain cost competitiveness. In addition, ILB coal should continue to gain share at the expense of the secular decline of Central Appalachian coal due to continually escalating costs. For its Australian operations, seaborne prices have continued to plunge as high-cost global supply has been slow to shutter amid weakening demand. However, as oversupply is rationalized, Peabody's Australian operations will benefit from higher seaborne prices.

Cloud Peak Energy

CLD

Cloud Peak Energy mines thermal coal out of the Powder River Basin (PRB) at low production costs. While rail issues that plagued deliveries over the last year have largely dissipated, prolonged weak natural gas prices have driven significant coal-to-gas switching. Combined with a relatively mild winter, utilities were able to build up depleted coal inventories organically through scheduled shipments. With gas prices lingering between $2.50 and $3 per thousand cubic feet, coal's cost competitiveness continues to remain under threat. However, as natural gas prices rise to our energy team's forecast of $4 per thousand cubic feet, PRB coal will regain its cost competitiveness, driving improved results for Cloud Peak.

Arrium

(

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Arrium is involved in iron ore mining, steelmaking and the supply of mining consumables such as grinding balls used in the processing of copper and gold. Arrium is undervalued, reflecting negative sentiment toward the relatively high-cost iron ore business, which we agree has limited value. The lower Australian dollar should help steel margins and offshore mining consumables earnings on translation. The mining consumables business provides a much-needed base of stable earnings. We think it's likely earnings and the share price will improve from current depressed levels, but investment is only for those with a high risk tolerance.

More Quarter-End Insights

• Stock Market Outlook: Pick Your Spots Carefully
• Economic Outlook: Stuck in Neutral as We Cling to Cash
• Credit Markets: Investment Grade Struggles, While High Yield Outperforms
• Consumer Cyclical: Assessing Disruptions in Restaurant, Retail, and Travel
• Consumer Defensive: Top-Shelf Picks for a Cautious Spending Environment
• Energy: No Rapid Rebound for Oil Prices
• Financial Services: A Favorable Outlook for Insurance
• Health Care: A Few Stocks Still Offer Upside
• Industrials: Stronger U.S. Dollar, Weaker Energy Activity Weigh
• Real Estate: Rising Interest Rates Wreak Havoc on REITs
• Tech & Telecom: M&A Heats Up, and the Cloud Changes the Landscape
• Utilities: Starting to Look Attractive After a Woeful 2015 Start