Resource and banking sectors have led the ASX 200 for months now.
Well, that’s not entirely true. There have been slight recoveries in both sectors. If we look at the S&P/ASX 200 Bank [ABAJ] since the start of March, banks have recovered somewhat. But the index is still up 6.5% for the year.
If we take a look at the S&P/ASX 200 Resource [^AXJR] Index the pattern is more or less the same as the banks. However, there are slight differences — the first being the date at which the index started to turn around: 20 January. But a major difference between the two is that one is net positive for the year, while the other is not. So does it mean that resources have performed better because they’re net positive for the year?
Not exactly. Resource stocks have managed to climb higher than banks this year. It’s most likely because of their horrible start to the year. And if we take a look at the decline for both indexes over 2015, it strengths this hypothesis.
From the start of 2015, and right through to the end of the year, banking stocks only fell 4.77%. But this is nothing compared to the falls in the resource sector over the same period. Resource stocks have decline 29.24%. Therefore, resource declines have fallen further, putting more upward pressure on resource stocks.
Why resources are positive… and why banks aren’t
Usually, once a stable stock has fallen past a certain point, barging buyers start to come in — by stable, I am not referring to prices, but the belief investors have about companies.
For example, investors don’t believe that BHP Billiton [ASX:BHP] will go out of business tomorrow. Or even in the next 20 years for that matter. They are too big to fail — this adage is common among larger companies.
And, because we are using indices that are comprised of the largest 200 companies in Australia, we can assume barging buyers will be present. Of course, other factors, other than bargain buyers, also affect resource companies.
A big factor is commodity prices. The volatility of oil, or the price movements of iron ore, has had a huge impact on investors buying habits.
Just this year, crude oil prices have on two occasions already rallied more than 10% within a day. And crude oil has rallied more than 10% within two days, on three separate occasions.
Oil prices are volatile, everyone knows that. So what?
If we relate these price movements to investors’ attitudes, it’s easy to see why oil companies would rally. The price of oil rallies…which is good for oil companies…so investors buy up oil company shares. In turn, this process rallies the resource index.
But the oil companies are not alone. Mineral companies are in the same situation.
While it is hard to obtain the daily price of iron ore, we can look at prices through this year instead. Heading into 2016, iron ore was trading around US$44 per tonne. At its peak this year, iron ore reached as high as US$63.74.
That means iron ore has jumped as much as 44.71% this year.
This would have likely driven investors to buy mining companies invested in iron ore. These two factors are just another reason why resources are in a net positive position this year.
Now that I’ve explained why the resource stocks have outpaced banks, let’s look at some of the pessimism surrounding the two.
Woes from all over the world
While certain commodities have had their comebacks in recent weeks, there’s no denying that prices are still low. And it’s putting extreme downwards pressure on resource companies.
Below is a graph of three different commodity indices. The first is Bloomberg’s index comprising of 22 commodities, representing seven sectors (orange). The second is CMCI’s index, which tracks 27 different commodity futures contracts (blue). The third is Thomson Reuters index, comprising of 19 different commodities all being differently weighted (red).
All three indices have lost half —if not more — of their value in a little over five years. If we talk about oil or iron ore prices picking up, they have a long way to go before they return to levels seen even in the aftermath of the global financial meltdown.
It’s obvious to see that this general decline is affecting resource companies at a fundamental level.
Just as a side note, I’m using the word fundamental to refer to their financial statements.
These sustained, low commodity prices have hit the earnings of individual companies hard. Just this year, BHP posted a half-year loss of US$5.7 billion. And the same goes for Origin Energy [ASX:ORG], making a statutory half-year loss of $254 million.
This point then leads me into a major reason why banks have been sold down recently. This year, the global banking sector has been sold off heavily, with the majority of selling taking place across European banks.
Who was doing the persistent selling? It wasn’t the big hedge funds. It was sovereign wealth funds. Now, just for simplicity’s sake, think of these wealth funds as government institutions (which they are).
Government wealth funds are just like any other wealth fund. They actively trade within the market, holding many types of securities. But it wasn’t every single government around the world selling down banks. Instead, it was mostly those nations deriving their incomes from oil.
Low oil prices were hampering nations like Norway, Saudi Araba and parts of Africa. So what was the logical step they took to maintain steady national incomes? Selling off what they deemed to be risky assets. And European banks fit this description.
Some European banks fell more than 40%. However, it created a chain reaction. Global banks were experiencing share price dips largely because oil nations didn’t want to keep European banks on their books.
Banks are not tied to oil through sovereign wealth funds alone. They also invest heavily into oil companies themselves. Since the oil price decline, dozens of companies are either behind on projects, or have gone bust.
And who do you think offers loans to these companies?
Our very own Commonwealth Bank of Australia [ASX:CBA] has an AU$11.6 billion exposure to oil companies. And other Australian banks are also in a similar position. The estimated loss of loans attributed to oil and gas companies for the first half of this financial year is $31 billion.
It’s a huge liability to have on the balance sheet. And it is just another factor that has contributed to the decline of the ASX 200 banking index this year.
But, of course, oil isn’t the only reason investors have sold banks. Liquidity within financial markets has started to reduce. New capital regulations have hampered banks, imposing them to keep more capital on hand.
How is keeping more capital a bad thing?
The money that sits there is nothing more than wasted capital to banks. There are investment opportunities popping up all the time. And the fact that banks can only use a limited amount of capital on these investments has hampered their ability to earn.
This has turned into a vicious cycle. Banks are spending less, giving rise to more investment opportunities. Why? Because banks can’t swoop in and use hundreds of millions to make small percentages worth it. They need to keep capital on hand to stick to new regulations, becoming more resilient in the process.
Let me use an example to explain.
Investment opportunities are available to all of us, but sometimes they’re just not worth it. If we believe we can make 5% on an investment on $5,000, for instance, it can be discouraging to say the least. If you were successful, you’d only make $250 with that $5,000 dollars investment.
Now let’s say you have more money to play with — $5 million. Your expected gain is now $25,000. This is what banks are able to do. If you put more money into an investment, then your returns will be higher.
But I want to be clear; I’m not saying that banks just throw money at investments until they achieve decent returns. If they did, they’d lose money like it’s going out of fashion. What I am saying is that it’s more encouraging for banks to be able to use larger amounts of money to make their total capital returns more attractive.
But all of this information doesn’t tell us much if we cannot interpret it.
To buy or not to buy…that is the question
We cannot answer the question ‘should you buy bank and resource stocks?’ until we determine if the fall in banks and resources is justified.
Why do we need to do this?
If we want to find out whether banking or resource stocks will be a profitable investment for the future, we need to know why they’re declining in the first place. Is it just scared investors selling out because of rumours and market volatility? Or is it smart investors making decisions because of fundamental shifts in the global economic environment?
As I highlighted before, there are some fundamental shifts that have happened in both sectors. For resources, it’s the fall in commodity prices. For banks, it’s tighter regulations on capital requirements. These are two changes that have directly affected both sectors.
The remaining factors I’ve explained above have indirectly affected these two sectors. For resources, it could be a dividend cut, or a rating agency comment that sparks a sell off. For banks, it’s sovereign wealth funds selling down banks because of low oil prices.
When it comes down to it, do you really think commodity prices will be at their current levels forever? Of course they won’t. Fluctuations in oil, coal, iron ore and copper prices happen all the time.
If you accept this line of thinking, which commodity is likely to make a comeback then?
Already we have seen iron ore surge up on increased Chinese buying. Investors that believe demand for this commodity will continue to increase, they might be thinking about investing in iron ore-producing stocks.
The same applies to the banking sector. Will these capital controls pester banks for the long term? Investors that believe that capital control will remain a problem probably aren’t planning on investing in banks just yet — and vice versa.
Of course, no one really has the solutions, but making an educated hypothesis can answer a lot of questions for the average investor.
Junior Analyst, Money Morning
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