Conclusion: Our industrials team has highlighted some key inflections in Chinese rebar pricing, real defense spending and reinvestment by mining companies.
As many of you know, Jay Van Sciver recently joined Hedgeye as our Industrials Sector Head and launched a few weeks ago with his first key call being a negative view of the U.S. Airline Industry. This call is obviously particularly timely with Goldman’s bearish initiation on the Airlines today.
As part of their research product mix, our industrials team is publishing a daily “Industrials Indicator” note that synthesizes and emphasizes the key data points and events in the global industrials sector. We thought a number of their recent call outs were also particularly relevant to the global macro space, so we have highlighted them below. (If you’d like to trial our industrial team’s work and/or speak to Jay email .)
1. Chinese Rebar Prices – For those that aren’t aware, rebar is reinforcement steel that is used in concrete and masonry structures. Rebar is a critical component of any large scale construction projects – like highway bridges, parking garages, and so on. Demand in 2012 has been anemic for rebar in China, which is reflected in the declining prices that are reflected in the chart below.
China produces 50% of the world’s steel, so to the extent we can consider rebar a decent proxy for steel demand in China, and we believe we can, this is somewhat ominous for the global steel market as China may look to increase steel exports in order to stabilize prices. As well, the rebar price data is negative for iron ore, as China is the world’s largest importer of iron ore, which is the key steel input.
On a much higher level of course, steel and iron ore demand by China is a reflection of economic activity in China. As economic activity softens, naturally demand for these products will soften and lead to price declines, as we are seeing the rebar market.
2.The Mining Investment Cycle – Caterpillar (CAT) is probably the best proxy for the mining investment cycle since the start of the Millennium. Over that time period, CAT has seen a stock price increase of 393% versus mere 16.9% for the SP500. So, the mining boom has been good for CAT and its peers. The question of course is how sustainable is this cycle going forward.
In the chart below, our industrials team looks at the capital expenditures of large miners versus their depreciation and amortization. A company’s cap-ex should not greatly exceed the company’s depreciation and amortization unless growth is expected. As the chart outlines, this was the case for much of the 1990s. This isn’t totally surprising in commodity type industries where reinvestment occurs at the marginal cost. So, in theory, increased capital investment leads to higher production, lower prices, and decreased capital investment in the future.
Conversely, in the last ten years capital expenditures in the global mining sector have dramatically outpaced D&A expenditures, and on an accelerating basis. In fact, in 2011 cap-ex exceeded D&A by an astounding $50 billion across the sector. Clearly, commodity prices are in some form of an easy money-induced bubble, albeit increased demand from emerging growth economies is also a factor supporting the story underpinning market prices, but as our industrials team wrote:
“Mature, cyclical industries (mining is among the most mature) do not support high levels of growth investment in the long-run.”
3. Real Defense Spending – The U.S.’s federal budgetary issues are really no surprise to anyone that does macro research or focuses on the U.S. Treasury market (or actually reads a newspaper). Currently, the United States has ~104% debt-to-GDP, is running a deficit-to-GDP of ~9%, and ~40% of all deficit spending comes from borrowing. To narrow the budget, spending needs to decline, with defense spending being a major focus.
In the chart below, we highlight real defense spending going back to 1962. Two key points jump out from the chart. First, defense is a highly cyclical industry. There are periods of high real spending, typically during wars, and then spending declines following the war or with a change in administration. Secondly, defense spending on a real basis is at an almost all time high in the United States. Given the real level of spending and massive budgetary issues in the United States, it is difficult to envision a scenario in which the defense industry sees broad top line growth. In fact, future years of declining top line are more likely. In effect, it is an industry in which the “value trap” risk is alive and well – i.e. cheap stocks getting cheaper.
Daryl G. Jones
Director of Research