Basic Materials: Fates Tied to Faltering China

• Despite significant share price declines in recent months, the materials sector is not a land of investment opportunity. The average stock under our coverage trades at a 6% premium to our assessment of intrinsic value. However, the mean masks significant dispersion of valuation assessments.
• We continue to forecast weak Chinese fixed asset investment and commensurately tepid demand growth for related commodities such as copper and iron ore.
• We remain relatively bullish on commodities oriented to the Chinese consumer but nonetheless expect Chinese household consumption growth to decelerate from the trailing 10-year average.
• Companies are responding to tectonic shifts in the macroeconomic environment by reorganizing their portfolios. Miners coping with poor Chinese demand and weak commodity prices are looking to sell assets and shrink. Agricultural chemical companies have taken a different approach. Faltering crop prices have prompted many to seek mergers in a bid to cut overhead and grab synergies.

We remain negative on the outlook for Chinese fixed asset investment, a view we've held since 2011. Overcapacity abounds across the Chinese economy, from real estate to manufacturing to infrastructure. Excess investment has manifest in a worryingly high debt-to-GDP at the macroeconomic level and struggling manufacturers at the company level. The recent slowdown in FAI is therefore more of a structural than a cyclical phenomenon. We expect, at best, 1.5% growth in Chinese FAI in the next five to 10 years.

This will have profound implications for most mined commodities, since China's investment-led growth model underwrote nearly all demand growth in the last decade. For example, we believe China's copper demand has peaked and should shrink as real estate activity fades to a level more commensurate with underlying urbanization trends and power infrastructure spending pivots from copper-hungry distribution outlays to copper-light transmission outlays. We expect copper prices to slip below $2 per pound in 2017 and, in contrast to most forecasters, do not expect a sustained recovery to the $2.50-$3.00 range in subsequent years.

We remain relatively more bullish on commodities oriented to the Chinese consumer, as well as the stocks of companies that produce those commodities. Although we expect Chinese household consumption growth to decelerate, it should nonetheless perform much more strongly than the investment side of the economy. Our positive long-term gold outlook reflects this thesis. Although we expect gold prices to slip below $1,000 per ounce in 2016 as faltering investor interest in the yellow metal weighs on total demand, we believe sustained jewelry demand growth in China and India will lead gold prices on a sustained recovery thereafter, touching $1,300 per ounce by 2020.

Consolidation activity in the chemicals space has picked up, highlighted by the mega-deal between

Interestingly, and contrary to the broader trend in the materials space over the last decade, the Dow and DuPont plan is to eventually split the merged company into three separate publicly traded companies focusing on agriculture, material science, and specialty products. Although this reduces the ability to generate corporate cost synergies, we like the fact that it gives investors more choice. Prospective cost synergies will likely be the big selling point for any additional consolidation in the space. We wouldn't be surprised to see

Allegheny Technologies

ATI

Allegheny Technologies supplies specialty metals to a variety of end markets, including aerospace, energy, medical, and automotive. Some of the firm's major products include titanium and nickel-based alloys. Additionally, Allegheny manufactures flat-rolled stainless steel products. The company's product lines are frequently used in applications that require stress tolerance as well as corrosion and heat resistance.

Misplaced concern about the impact of lower oil prices provides investors with an opportunity to purchase Allegheny at an attractive price. Allegheny has a high degree of exposure to the production of next-generation commercial aircraft, which underpins attractive long-term growth prospects. Lower share prices since mid-2014 reflect the expectation that low oil prices will diminish commercial aircraft deliveries as well as sales to customers in the oil and gas space. We assert that the impact of these headwinds is overstated.

PotashCorp

POT

PotashCorp is the world's largest fertilizer company measured by capacity. The company's main focus is potash, where it is the global leader in installed capacity with a roughly 20% share. PotashCorp is also a player in the nitrogen and phosphate industries. The company is focused on growing its potash business, and brownfield expansions coming on line over the next couple of years will increase capacity.

We think the market is missing PotashCorp's long-term production potential and ability to grow free cash flow as it eventually fills its already-completed expansions. The market seems concerned about the long-term supply/demand outlook for potash, competitive dynamics, and recent price pressure. Our long-term view of the potash market gives us confidence that near-term headwinds will fade and strong fundamentals will eventually take hold. Following a temporary step back in demand in 2015, we expect normal growth to return in years to come. Capacity is expected to grow at a faster clip, but we're not expecting enormous pressure on prices, as current producers add supply judiciously.

Goldcorp

GG

Goldcorp is a large gold-mining company with operations in Canada, the United States, Mexico, and Latin America. It produced roughly 2.9 million ounces of gold in 2014. Goldcorp has historically focused on stable mining jurisdictions in North and South America while targeting rapid production growth through internal development and acquisitions. As of Dec. 31, 2014, Goldcorp had 50 million ounces of gold reserves.

Gold prices have fallen 10% year to date (as of Dec. 16), with shares of miner Goldcorp falling 36%. Fears of rising U.S. interest rates and operational challenges at Goldcorp's new mines have created an attractive opportunity to buy the growing low-cost gold miner at a discount. The market is concerned that higher interest rates will greatly diminish investment demand for gold. We agree and think near-term gold prices will weaken because of it. But we think the market is overlooking still-growing jewelry demand from China and India.

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