Miners may hit the rocks

The second recessionary dip that many analysts are predicting would have profound implications for the raw materials sector, writes Ceri Jones.

The likelihood of the recent downturn turning into a double-dip recession has been the subject of intense speculation for several months, but we are surely now close to an answer on the matter.

At the time of writing, a revitalised FTSE 100 was trading above 5500, making talk of a double dip appear misguided. However, the economy is weak – having slowed to 0.5 per cent annual growth in the third quarter – unemployment remains high, inflation is running at more than 3 per cent and the unions are arguing that the government, by implementing savage spending cuts, is doing the opposite of what is required.

In September, the Bank of England held interest rates at their record low of 0.5 per cent for the 18th consecutive month and kept its quantitative easing programme at the ready, feeding speculation that more easing was on the way.

The markets, however, are consumed by a post-holiday irrationality and overoptimism about mergers and acquisition activity. Brokers such as TD Waterhouse report that customer trading has risen by almost 60 per cent, amid rising interest in bid targets such as Yell Group and renewed activity in the mining sector.

However, selling these over-valued assets might be a better strategy. There is a persuasive argument that there is a substantial lag between the release of weak indicators and the market’s realisation that the news is truly awful.

Christian Tegllund Blaabjerg, equity strategist at Saxo Bank, explains: ‘Over the course of the market cycle, one of the primary areas of risk for stocks is typically the “recognition window”, where economic activity begins to deviate from the upward trend priced into the market and investors begin to recognise that an economic downturn is likely.’

His view is that the relief provoked by September’s Purchasing Managers index – a gauge of manufacturing activity – and the US Department of Labor’s employment report was an overreaction to data very early in the recognition window. The typical lead time between a deterioration in reliable measures and a fall in ‘coincident’ (business-related) economic activity tends to be between 13 and 26 weeks.

Blaabjerg believes we may even see a misleading improvement in the data in the short term before we get into the more typical window of deterioration in around two months’ time.

‘The tone of economic data does not turn all at once,’ he says. ‘Once leading indicators have clearly deteriorated, it takes a while for coincident indicators to follow. During the interim, small positive surprises in coincident indicators are unreliable.

‘My sense is that investors have abandoned concern about further economic weakness prematurely. We believe there is a great likelihood of a double dip and are convinced that the rosy picture equity markets paint of the future, given the growth expectations for earnings in 2011, will not stick.’

This opinion rings true for current trading activity, which seems oblivious to the downside risks.

‘I don’t think there are too many people overly concerned about the threat of a double-dip recession,’ says David Jones, chief market strategist at IG Index. ‘The news flow we have seen in recent weeks has, admittedly, increased the possibility of one, but most traders and investors are treating this as unlikely. The FTSE 100’s push back to a four-month high is pulling in more momentum traders, who take the view that this rally could have further to run.’

Concerns about the government’s austerity measures have eased, but they will come back into focus over the next month as the latest GDP numbers are released and more detail emerges about the nature of the cuts. Jones thinks this will not have a big impact on the FTSE 100 because of its global nature, but he expects trading opportunities in currencies such as sterling to become more volatile against the US dollar and the euro.

Investors might consider gold a defensive play. The price is $1,265/oz at the time of writing, roughly at the level of its 2010 high, and profit-takers are moving in and new traders are looking to go short, banking that the metal’s rally is over extended. However, a second dip could send the price higher.

The mining sector has experienced a shift in sentiment. The likes of Rio Tinto and BHP Billiton led the FTSE 100 higher through last year, but the sector has been treading water since April, dropping back about 15 per cent. If investors decide there is going to be further economic stagnation, raw material companies could take a further hit, which would affect the mining sector index. A short there would then be profitable.

FSA Certified Publication
Granted certification by the FSA, Money Observer is the only UK financial
magazine to submit itself to ongoing scrutiny by the Financial Services Authority