Tuesday, October 19, 2010
There is a *lot* of talk going around the market of bubbles these days. The FT is making a lot of noise about bubbles in EM which frankly we could have written ourselves:
“The degree of euphoria surrounding some emerging economies is already troubling. The Indian and Indonesian stock markets are trading at price earnings ratios of over 40 times, based on ten-year average earnings. You would surely need a hundred years of fortitude to buy Mexico’s recently-issued 100-year bond at a yield of 5.6 per cent. Bubble and bust in China, on which the world is now so dependent for growth and optimism, would likely tank the commodities markets, set off a second round of deflation, and end the emerging markets boom in the most spectacular way possible.”
That, of course, is hardly the only one they are positing, others include:
TMM are finding plenty of anecdotal evidence these days from positioning in BRL forwards, AUD and other carry currencies and, conversely, the amount of effort central banks and governments in these countries are putting into vain efforts to slow appreciation here. To wit, look at the efforts of Brazil here, South Africa’s towel throwing here, to say nothing of Korea, Japan and the Panda in the room, China.
That being said, while valuation is often a good guide its generally a shocking indicator for timing. Many equity markets are now historically expensive (Southeast Asia, India, list goes on) and EM local FX yields continue to get ground down by the weight of capital flows. Short of putting a 100% tax on all interest and capital gains from their bonds, it’s hard to see exactly what they can do in a world this starved of carry. Once again, while TMM are leaning
to the short side now this kind of navel gazing doesn’t appear to have an obvious resolution: leaning against the CBs makes a lot of sense and while the equities aren’t cheap so long as you aren’t limit long exporters you won’t have to come into work one Monday, see “Plaza II” on your screens and have 15% of your book facing a world in which their FX is 15% higher and their net income margins just went negative in perpetuity.
To that end, TMM are holding off a bit on the anti-bubble trade obvious positions and going for slightly more subtle and less volatile crosses – short AUDSGD, short EURCHF are a lot less hair raising than USD crosses for now. However, we have found one corner of the market that has now conclusively jumped the shark – rare earth metals.
Rare earth metals have been covered extensively elsewhere, but a wiki is not a bad place to start. The long and the short of this market is this: these elements are crucial in a number of applications for which they make up almost none of the cost. As a result, demand is pretty inelastic and buyers will take what they can for what they can and are not all that fussed about pricing, hence the market is very much a supply side driven game.
The supply side has been in the news a lot because China has recently worked out that it owns about 85% of world production and has decided to start flexing its muscles, particularly with respect to Japan where Hitachi Metals is from. See the production history below:
Hitachi has the patent on neodymium-boron magnets which are used for just about everything and which require neodymium, a rare earth metal. In an effort to move more manufacturing for high-tech products to China and probably due to no small amount of Japan bear-baiting China has restricted exports of these products.
TMM have one thing to say: bad move. Putting on our consulting/industrial organization hats for just one second if you 1) own a market 2) have customers that couldn’t care less about pricing within reason why would you cut them off and give them no choice but to create competitors? This kind of behavior is the quintessence of short term greedy which may work at a hedge fund but hardly makes for great strategic thinking. Cue the ramp in rare earth metals like Cerium seen below:
From what TMM understands has made the likes of the hedge fund / commods trading houses like Trafigura, Glencore, and Red Kite very happy these days. Not that equity punters haven’t had a good time with it, see Lynas Corp, an emerging Australian producer seen below:
The only problem with this trade is this: if prices stay even vaguely close to these levels for an extended period of time then every single prospective mine in this space WILL get built. Additionally, after the Chinese experience it seems that end users of these products are very much inclined to throw in the towel on buying at spot and instead vertically integrate by buying a deposit at an earlier stage of development for less. As most industrial organization and antitrust experts could tell you there isn’t much difference between a monopoly and an oligopoly in terms of pricing especially when their cash costs are much the same. You might not get cut off, but you will get gouged.
To that end, TMM are calling out those who value these companies assuming current spot metal prices for what they are: idiots. The mother of all squeezes for physical in this space does not translate to permanently higher prices and while there are no futures or ETFs for these metals those piling into LYC and the like are asking for trouble. TMM’s informal poll of the Asian metals and equities trader space finds this position to not be incredibly crowded with a large number of momentum monkeys and not the kind of guys you like to see in these trades, i.e,. - the guys who trade physical. TMM instead prefers to play the takeout game and judging by recent price action in the likes of Greenland Minerals and Energy, we aren’t far from wrong.
Big deposit held by junior in need of funding is a much better story than big deposit held by funded mid cap that is already in development for the likes of Hitachi.
As we go to press, China have offered another of their pre-G20 offerings with a rate rise. Now we may not see this do anything more than give them a negotiating feather, considering its effect on commodities and Chinese shares, it may just be enough to help us deflate the rare earth metals bubble.