There’s a lot going on at the moment. In the interests of brevity, we’ll confine our thoughts in this Weekly to just two of the many topical issues exercising investors’ minds at the moment.

 

Ukraine

Russia’s effective invasion of the Crimea triggered a sharp fall in Russian stocks and the rouble.

In response the Russian central bank hiked rates by 150 bps in an attempt to defend the currency. The SPDR S&P Russia ETF (a share that tracks the Russian share market) was at an all time low yesterday:

There seem very few, if any, good options open to the West here. With no appetite for any sort of option using force, it would seem most likely that the West will make a bit of noise but ultimately find it in their interests to not push Russia too hard. For example, 30% of the Euro bloc’s gas comes from Russia via the Ukraine. Ultimately we think realpolitik calculus will prevail and we’ll be back to “business as usual”; such as it is in this part of the world.

However, if the new Ukrainian regime decides to challenge the Russians and/or clashes break out between Russian speakers/ethnicity and Ukrainians/Tartars, within the Ukraine, then we can expect a further sell-off as Russia gets pulled into a messy civil war. Russia’s short war with Georgia in 2008 arose in part because of this type of miscalculation by the Georgian government. Under these conditions the risk of strategic mistakes and overstepping ratchets up markedly; and consequently the risk of a major conflict in the heart of Europe.

 

Iron Ore

As we’re referred to in past Weeklies, the whole iron ore complex continues to look weak:

To recap. Iron ore prices fell sharply in the first half of last year when it appeared likely that China was at last getting serious about rebalancing its economy. Then halfway through 2013 Beijing hit the button on a stimulus program, as the Politburo lost its nerve and elected to kick the can down the road on reform once again. A desire to effect a smooth leadership change played a role in this decision. In a very happy and fortunate coincidence for iron ore exporters (like Australia), India shot itself in the foot and banned iron ore exports at the same time; thus removing a chunk of competing supply.

However, as we argued at the time, this should have been looked at as a short lived reprieve for the Australian economy and a chance for us to start getting our own economic rebalancing going. The secular story now appears to be reasserting itself. In more recent times the price of the end product, steel, has also fallen sharply:

 

 

 

Iron ore inventory at Chinese ports has built up markedly (in 10,000 tons):

An added wrinkle here is that it appears at least a portion of this iron ore stacked up at the ports is being used as collateral for loans by credit starved Chinese steel mills (and others). This is another sign of the Chinese credit bubble, and how difficult it is for even the supposedly all powerful authorities in Beijing to deflate it smoothly.

There are, of course, the usual suspects touting the usual explanations of why we should not be alarmed by all of this. The most common one we hear is this is just the usual seasonal destocking by the steel mills. However with the all the new capacity coming on line in the iron ore market most analysts are forecasting the iron ore market to move into oversupply in 2014 as shown below:

Rest assured, we will export a lot of iron ore in the coming years, and as Australia has the world’s lowest cost of production, this will be profitable. But probably not as profitable as is currently assumed.

 

Justin McLaughlin, Chief Investment Officer

Hamish Bell, Senior Research Analyst

 

 

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