Immaterial Materials Blues

Story Highlights:

• Some folks fear the run Materials stocks had is over.
• Despite recent slowdowns in production, longer-term global supply and demand fundamentals—and therefore prices—should remain firm.

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Lately, it seems Materials stocks have a case of the summertime blues, as the sector has been hit by falling commodities prices and other worries. Will the slowdown deepen, or is it just temporary? We think the latter: Evidence suggests fears of a longer-term pullback are likely overwrought.

Many folks fret falling demand will sink resource prices over the longer term, citing lowered Chinese production as evidence of a coming widespread slowdown in developing countries. But we think this misses the mark. While Chinese production has slowed, causing a short-term drop in global demand, consider the circumstances: China shut hundreds of factories in recent months to improve air quality for the Olympics, amounting to a 20% cut in steel production, as well as cuts in many other industries. There's widespread uncertainty over whether restrictions will lift after September's Paralympics, but circumstantial evidence supports the notion they will.

To us, it's a good sign the Chinese government signed a hefty year-long iron ore contract in June, at a price 85% higher than the previous year. Remember, the Chinese economy is still centrally planned. If the Chinese government decided to stop building, there would be no incentive to pay such a high price for iron over the next year. Long term, we don't see much reason to fear a deep slowdown in Chinese demand.

But while China is a large component of global demand, it's not the only driver—the rest of the world is bigger. The fact is overall supply and demand fundamentals remain extremely tight globally. Fast growing emerging markets are driving massive infrastructure build-outs, with no evidence of a slowdown. This is in addition to massive infrastructure rebuilding and maintenance which continues throughout the developed world. High global demand for Materials isn't departing anytime soon.

And supply remains constrained. New capacity is hampered by multi-year lead times for building mines and mills, energy shortages are causing production limits in South Africa and China, and nationalization of industries in places like Venezuela threatens future supply expectations. Plus, skilled labor is in short supply, as labor strikes regularly stop production in some countries. In other words, there's a reason commodities are at historically low inventory levels. Sure, prices might drop a bit more in the extreme short term, but longer-term, they should remain firm.