While 2016 was a pretty good year for resource markets, there was little sign of “irrational exuberance” that normally accompanies the top of cycles. It is certainly possible that the rally was just a bear-market bounce, but the signs and construction of the rally is much more akin to a new bull market given:
I. The rally started following the complete capitulation in between November 2015 and January 2016 which came after almost five years of decline;
II. It was reasonably broadly based amongst higher quality names;
III. 2016 has still been filled with a lot of resource sceptics;
IV. Most of the investors and money flow has been from investors that you would expect to invest in such stocks and understand the risks;
V. Capital investment by companies is still low, and the capital that has been invested has generally been highly productive/successful;
VI. Management of listed companies are still happy to meet all and any investors;
VII. It is not apparent why commodities are doing better (the consensus economic narrative is that the world economy is struggling and commodities should still be weak);
VIII. Other sectors in the market are well past these milestones (eg East coast property, global fixed income). Resources traditionally perform well late in the economic cycle as interest rates begin to rise.
So, we expect the rally in resources to continue in 2017. Throughout the year a new consensus view of why investors should be adding resources to their portfolio again may begin to emerge. We are not sure what the narrative will be, but that also doesn’t matter. Our guess is that the narrative could be around the commodity intensity of battery storage and electric vehicles (eg substantial increases in global copper and nickel demand).
Alternative narratives be around India, China, Africa, inflation, global re-armament, portfolio diversification, under-investment, currency proxies, or something else.
Once the consensus view is that it is wise to invest in resources again, we will be closer again to the end than the beginning. However, for those that understand resources, the formation of a positive consensus view towards resources in 2017, if it eventuates, should be welcomed. It normally would mean it becomes increasingly easy to identify stocks and to attract capital again for the remainder of the cycle. 2017 could be the year for resource companies to raise capital, and resource investors to trade heavily.
Our preferred commodities are traditional base metals (copper, zinc, nickel), oil, and gold. The minor new energy metals (lithium, cobalt, graphite etc) could also do well, as at some point there is likely to be a brief panic shortage (which is the history of commodities) and another tremendous price spike.
However, the sector is risky because the industry is still so immature and the speciality metals markets so small, that predicting the timing of shortages is very difficult (markets could just as easily be balanced for several years before the spike). Base metals that are exposed to battery storage are a safer way to play, in our view. Traditional energy is still the largest under-invested stock market sector, in our view (oil, gas and uranium), and is where contrarian investors should focus for 2017.