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Iron ore: what’s likely to happen next and how it will impact investors

What are the major factors impacting iron ore prices, what’s likely to happen next and what role should big miners play in a portfolio right now? Pendal’s Brenton Saunders explains

  • Falling iron ore prices depressing the miners’ stock prices
  • Outlook hinges on Beijing policies
  • Strong dividends make sector hard to ignore

A dramatic fall in iron ore prices has delivered a swift turn in fortunes for the big mining companies that only months ago were enjoying posting record profits.

We asked What is the outlook impact for inevstors and

The price of the steel-making commodity has almost halved from its July record of nearly $220 a tonne to trade briefly below $100 in recent days as a change in China’s demand for the commodity drives lower prices.

The decline is raising questions about the prospects for the three big Australian iron producers, BHP, Rio Tinto and Fortescue Metals Group, which until recently have used their inflated margins to reward shareholders with all-time-high dividends.

“There are not many large businesses whose revenue can double and halve inside of 12 months — and these are some of them,” says Brenton Saunders, an analyst and portfolio manager at Pendal who follows the iron ore market.

Investors should take a step back to understand the recent history of the commodity and the ebbs and flows of steel production in China which make up half the global demand for iron ore, he says.

A change of gears

“Iron ore has been through an amazing change,” says Saunders, driven by Covid-related stimulus in China.

“We just absolutely changed gears,” says Saunders. “China implemented a range of fairly old-school stimulus measures that resulted in a further acceleration of housing and infrastructure investment.”

The result was that much of 2020 was characterised by enormous iron ore demand from China, compensating for pandemic-related shutdowns elsewhere in the world.

“Then by the third quarter of 2020, the rest of the world had also implemented a large amount of stimulus and was starting to recover from the first Covid wave.

“That created the perfect storm — China was taking all the iron ore the world could offer and the rest of world was starting to recover.

“There just wasn’t enough iron ore to go around.”

Then China changed its tune.

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China moves to lower demand

The price of iron ore got so high it was starting to cause dislocations in the downstream products that steel is used for, and Beijing took a strategic decision to lower demand and bring prices back down.

One move was to target improved environmental outcomes and improved air quality by limiting steel production. The second was the tightening of controls around property developers’ leverage.

Both moves worked.

“They announced they were going to limit steel production to the same level as 2020,” says Saunders.

“That seemed an impossibility, but steel production in China has fallen so far that it looks like we will get pretty close to flat year on year, which means the decline in the second half of 2021 has been about -12% on 1H 21 and -17% from the peak in May.”

It was that decline that brought about the initial downdraft in the iron ore price, which was then compounded by a deterioration in sentiment in the property industry which accounts for around a third of steel demand in China.

“It created the perfect storm in the opposite direction,” says Saunders.

What it means for investors

The question is what happens next?

Saunders says he expects Chinese property construction to enter a sustained decline.

Land sales — a leading indicator and normally hotly contested — are seeing low clearance rates and lenders are less inclined to make credit available.

Environmental and air quality concerns will likely also see steel production capped, especially with Beijing hosting the Winter Olympics in February.

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Chinese steel production will remain depressed until at least the end of February next year before a more fundamental rebound, Saunders says.

“But by that stage, the Chinese supply chain in steel is going to be fairly heavily depleted and will need to be restocked.

“There is the potential for a much better end of first quarter next year — but it could get worse before it gets better.”

Portfolio point of view

So, given that background and volatility, what role can iron ore stocks play in a portfolio right now?

Are they a must-hold or something investors can safely ignore?

“The volatility is intimidating at times,” says Saunders. “But the volatility can be offset by high, fully-franked yields.”

Fortescue Metals Group will pay a fully franked yield of more than 10 per cent over the next year for shareholders buying now. That yield may well be unsustainable, but it is a substantial fillip to a portfolio’s income.

BHP and Rio Tinto’s dividends will also be high, approaching 10 per cent and underpinned by the fact both businesses have significant non-iron ore operations.

BHP’s metallurgical coal operations are still enjoying strong price rises even as iron ore prices fall. Rio’s massive, vertically integrated aluminium operations produce one of the world’s fastest growing metals that is critical to the transition to net zero carbon emissions.

Saunders says the trick to making portfolio decisions on iron ore is to have a well-held view on the value of the big companies based on a “through-the-cycle”, long-term iron ore price derived from cost-curve analysis.

From there, a cyclical overlay tells you whether to buy or sell at any given point.

And right now?

“I’d have to say it’s a relatively easy and low-risk decision to buy the iron ore stocks at the moment,” says Saunders.

“The valuation overlay is attractive as the stocks have come back significantly, and the forecast yields are high.”


About Brenton Saunders and Pendal MidCap Fund

Brenton is a portfolio manager with Pendal’s Australian equities team. He co-manages Pendal MidCap Fund and our natural resources portfolio, drawing on more than 25 years of expertise in resources, derivatives, investment banking and private equity. He is a member of the CFA Institute.

Pendal MidCap Fund features 40-60 Australian midcap shares. The fund leverages insights and experience gained from Pendal’s access to senior executives and directors at ASX-listed companies. Pendal operates one of Australia’s biggest Aussie equities teams under the experienced leadership of Crispin Murray.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

Find out more about Pendal MidCap Fund here

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This article has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and the information contained within is current as at September 30, 2021. It is not to be published, or otherwise made available to any person other than the party to whom it is provided.

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