Basic Materials: China-Led Rally of 2016 Rests on a Shaky Foundation

• We view the basic materials sector as overvalued on the whole. On a market-capitalization-weighted basis, our coverage trades at a 25% premium to our fair value estimates.
• The valuation disconnect largely reflects our bearish long-term outlook for Chinese fixed-asset investment. Many materials sector stocks enjoyed a stellar run in 2016 thanks to Beijing's renewed stimulus efforts, which buoyed demand and prices for commodities ranging from coal to copper to iron ore. The market appears to be valuing commodity producers as if prevailing prices are sustainable. We expect gains to prove fleeting, as we doubt the sustainability of the credit-fueled, investment-led growth model.
• Amid the runup in metal prices, gold was an underperformer in 2016. We're more constructive on gold than industrial commodities in the long run, largely because of rising consumer demand from India and China. But the near term could prove challenging, as multiple rate hikes by the U.S. Federal Reserve in 2017 threaten investor demand for the yellow metal.
• Outside the mining space, we see value in materials stocks tied to U.S. residential construction. We expect housing starts will continue to build momentum in 2017, thanks to a combination of favorable demographics and improved household finances. North American lumber producers, which should enjoy strengthening demand and rising prices, look undervalued. Following a hearty post-election upswing, we're less enthusiastic about materials companies that serve U.S. infrastructure markets. Our U.S. cement and aggregates coverage looks fairly valued. We think U.S. steel producers, which would benefit from stronger infrastructure spending and stiffer trade barriers under Trump, are overvalued.

Mined commodities enjoyed a banner year in 2016. The coking coal price quadrupled, iron ore and thermal coal doubled, and copper rose about 35%. Mining company shares outperformed the market by a considerable margin, especially those struggling under the weight of heavy debt burdens.

We see tremendous risks to the downside following this rally. The market appears to be valuing mining stocks as if prevailing commodity prices are sustainable. We doubt that will be the case. For starters, current commodity prices are well above the marginal cost of production, particularly for metallurgical coal and copper. With most commodities suffering structural overcapacity, it shouldn't take too long for high prices to induce curtailed supply back to the market. The supply response should be especially quick in coal after Beijing scrapped its 276 working day rule for coal mines.

New supply from projects greenlit amid headier prices is also set to enter the market. China continues to add significant low-cost steel and aluminum capacity to replace less efficient facilities targeted for closure by the government's "supply-side reforms." In mining, while the market has largely passed the peak of supply additions, it must still absorb plenty of new production in the years to come.

Meanwhile, the stimulus-led demand uptick of 2016 is likely to prove fleeting. Future demand growth depends heavily on China's ability to sustain rising fixed-asset investment outlays for years to come. Faltering returns on investment and a swelling debt burden cast doubt on this prospect. The next time China's economy slows, Beijing may once again attempt to stimulate. Not only would this exacerbate China's underlying problems in the long run, but repeated stimulus efforts have diminished its efficacy in boosting short-term growth. China's total supply of credit increased 17% in 2016, but generated only a 2% increase in steel demand.

While the gold price ended 2016 higher than it began the year, the yellow metal was one of the weakest performers among major metals. Rising interest rates were the culprit. Heading into the fourth quarter, gold was trading above $1,300 per ounce. Following the Federal Reserve's 25-basis-point increase in December, gold had sunk below $1,150 per ounce. The U.S. central bank expects about three more interest rate hikes in 2017, increasing the opportunity cost of holding gold and threatening the case for gold as an investment. We see limited opportunities in gold miners, and caution that even undervalued companies are likely to face near-term headwinds as rising Chinese and Indian jewelry demand is slow to replace shrinking investment demand.

The U.S. housing market continued to build momentum in 2016, although starts were somewhat lower than we had expected, as a sustained contraction in vacancies absorbed much of the demand created by household formation. Headship rates, in free fall since the financial crisis, appear to have stabilized, which should mark a turning point in millennial household formation.

Accordingly, our decade-long outlook for housing remains bright. We expect housing demand from the millennial generation will drive strong construction activity through 2020. Through the third quarter of 2016, underlying housing demand, or completions and vacancy contraction, rose above a 1.4 million unit annual pace. Falling housing vacancies should drive house prices and rental rates higher, encouraging builders to ramp up activity during 2017 and beyond.

We believe lumber producers will prove the best way to play resurgent housing demand. Rising construction activity should boost profitability for producers like

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Following the election of Donald J. Trump as America's next president, U.S. aggregates and concrete companies rallied sharply. However, we're skeptical that the touted $1 trillion infrastructure spending plan will be executed in its proposed form. Furthermore, we think shares are now pricing in significant growth and therefore see little risk-adjusted upside at this time. What gets said on the campaign trail doesn't always come to fruition, presenting a meaningful risk to these construction names.

During his campaign, Trump proposed to spend $1 trillion over a 10-year period to repair roads, bridges, and other infrastructure, which could potentially translate to a 55% increase in annual spending. However, we think this is unlikely. First, it's unclear whether the $100 billion would be incremental or part of existing spending levels. Additionally, political bipartisanship remains a likely barrier. Second, Trump's proposed plan requires an unprecedented level of public-private partnerships and infrastructure privatization. The questionable efficacy of past privatization of public assets will likely fuel challenges to the proposed plan. Third, increasing infrastructure spending tends to be a very slow process from announcement of a plan to a newly paved road.

Shares of U.S. steelmakers moved sharply higher in the fourth quarter. The rally was driven by optimism that a Trump presidency will lead to materially higher nonresidential construction activity and more stringent trade policies that will benefit U.S. producers. Higher steel prices and the perception of improved supply discipline in China have added fuel to the fire. However, we contend that recent price performance has been driven mostly by speculation rather than concrete evidence that industry fundamentals will improve. Instead, we forecast ongoing weak global steel demand as Chinese fixed-asset investment remains soft. Additionally, we remain skeptical that China will achieve its lofty targets for capacity cuts through the end of the decade. Therefore, although U.S. steelmakers will enjoy healthy near-term profits, we see considerable downside over the long term. Based on our outlook, every U.S. steelmaker we cover is trading above fair value.

Top Picks

Albemarle

ALB

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $120

Fair Value Uncertainty: High

Five-Star Price: $72

Narrow-moat Albemarle is a chemical company with operations in lithium (used in batteries), bromine (used in flame retardants), and oil-refining catalysts. The stock is one of the best ways to play higher electric and hybrid vehicle penetration. As the largest and one of the lowest-cost suppliers of lithium globally, Albemarle is well positioned to benefit from higher lithium demand and prices through its significant expansions in the coming years, with cash flows set to double by 2020. We believe shares are undervalued, trading at roughly a 30% discount to our $120 fair value estimate.

Cameco

CCJ

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $18.00

Fair Value Uncertainty: High

Five-Star Price: $10.80

Narrow-moat Cameco produced 27.2 million pounds of uranium in 2015, making it one of the world's largest uranium producers. The flagship McArthur River mine in Saskatchewan accounted for 50% of output. Cameco intends to increase annual uranium production substantially over the next several years. In addition to its large uranium mining business, Cameco owns a uranium marketing business and operates uranium conversion and fabrication facilities.

We think the market is mispricing Cameco. Uranium offers a rare growth opportunity in metals and mining. China's structural slowdown portends the end of a decade-long boom for most commodities--but not for uranium. China's modest nuclear reactor fleet uses little uranium today. That's set to change in a major way. Beijing is pivoting to nuclear in order to reduce the country's heavy reliance on coal. We believe the market overemphasizes the current supply glut caused by delayed Japanese reactor restarts. This situation won't last much longer. We expect global uranium demand to grow 40% over the next 10 years, a staggering amount for a commodity that saw next to zero demand growth in the past 10 years. Supply will struggle to keep pace. We believe uranium prices will rise from about $20 a pound currently to $65 a pound (constant dollars), as higher prices are required to spur new mine investment. Early contracting by utilities means we see significant price increases by 2017. As one of the largest and lowest-cost producers globally with expansion potential, Cameco should benefit meaningfully from higher uranium prices.

Canfor

(

)

Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: CAD 27.00

Fair Value Uncertainty: High

Five-Star Price: CAD 16.20

Canfor is a softwood lumber company that also owns around half of Canfor Pulp. It is active throughout North America, with lumber mills in British Columbia, Alberta, and the southeastern United States.

We like Canfor for its leverage to U.S. housing. Rising housing starts should lead lumber demand higher, driving up industry capacity utilization, and with it, prices. Our bullish housing outlook is predicated on the notion that tighter labor markets and improved mortgage availability will unleash enormous pent-up demand from the extended housing bust. Canfor is particularly attractive in light of recent poor share price performance, which has disconnected from fundamentals amid fears surrounding trade negotiations. As of Dec. 15, shares are down 40% from June 2015. Meanwhile, framing lumber prices are up 7% from the year-ago period. As momentum continues to build for U.S. housing, we see nearly 75% upside in the stock.

More Quarter-End Insights

Market Outlook: New Expectations Set the Tone for 2017

Economic Outlook: More of the Same Anemic Growth

Credit Insights: Global Rates on the Rise

Consumer Cyclical: Poised (and Priced) for a Strong 2017

Consumer Defensive: Cooking Up a Bit More Value

Energy: OPEC Adds a Plot Twist, but Ending in Unchanged

Financials: What Will Really Drive Interest Rates?

Healthcare: What Does a Trump Administration Mean for Healthcare Stocks?

Industrials: Baking In Too Much Optimism

Real Estate: Through the Noise, Opportunities Exist

Technology: This Firm Is the Newest Software Empire

Utilities: Still High Even After Bonds' Withdrawal