Tim Treadgold: After the crash the markets will re-boot

China was the cause of the current crisis on financial markets, and if you’re prepared to look through the fog of falling prices you can catch a glimpse of the Asian powerhouse being the place where the recovery will start.

And its iron ore, copper and oil stocks likely to lead the way up.

The trick for investors will be getting the timing right with their return, and that means being confident that the worst of the correction (or crash if you prefer) is over and a bottom is developing ahead of the price recovery.

The reason for being confident that there will be a revival lies in the importance to China of a growing economy, because without growth the country could suffer social dislocation and that is unthinkable from the perspective of the Chinese government.

It’s this combination of factors which point to China moving soon to re-stimulate its economy through a massive infrastructure building program.

It’s precisely what the country did earlier this century when its economy started to gather speed and in the months after the 2008 global financial crisis.

On those past two occasions the big winners were companies exposed to selling China the raw materials needed to undertake big building projects.

And while there might be subtle differences this time around it will come back to the basics of what’s needed in a railway, bridge or high rise building: steel, concrete and copper.

Fortescue Metals (ASX:FMG), the leading pure-play Australian iron ore miner, is a prime example of a company which has probably been oversold as panicky speculators dump whatever they can, including their best quality assets, to meet cash demands from elsewhere in their portfolios after discovering that some equities no longer have a market at all.

The latest research notes from investment banks are bullish on Fortescue, and other iron ore miners, because of the expected strong demand for steel after China presses the stimulus button.

UBS which had a sell recommendation against Fortescue until early last week, has flipped to a buy tip, lifting its price forecast from $9.30 to $10.20 — almost 19 per cent higher than closing sales on Monday at $8.58.

Macquarie, on the same day as UBS made its change, refreshed a Fortescue buy tip with a target price of $12.40.

No-one can be assured that Fortescue, or any other stock will deliver the substantial gains implied by the future price forecasts of UBS or Macquarie, but what they can be comfortable with is the logic behind the optimistic views of a company selling iron ore to China as it re-starts its growth engine.

What helped influence the banks was a meeting of analysts and senior staff of Rio Tinto (ASX:RIO), which included comments from company managers that they were confident of a “major commodity stimulus in China’s response to the demand impact of COVID-19” – the coronavirus.

“Fortescue remains our preferred pure-play iron ore stock, trading on free cash flow yields of 10 per cent-to-20 per cent at spot iron ore prices,” Macquarie said.

Other iron ore stocks will also benefit from the re-boot of China’s growth engine.

“Mt Gibson Iron (ASX:MGX) and Champion Iron (ASX:CIA) offer unique exposure to the high-grade iron ore market,” according to Macquarie, which has buy tips on both.

Mt Gibson, now at 70c, is expected to rise to $1.10 over the next 12-months and Champion, at $1.80 today, is expected to almost double to $3.20.

Asset values over-shot

As with previous significant market corrections there are a number of common negative factors at work, including the obvious point that asset values had risen too far in a climate of ultra-low interest rates.

This time around (or should that be this time down) there are unique negative factors such as fear of the unknown effects of the coronavirus on consumer confidence, and the unexpected outbreak of an oil-price war.

Both the virus and the oil war qualify as “black swan” events, and in that lies a big part of the problem, because it’s highly unusual to have two “swans” land on the markets at the same time.

But, after acknowledging the problems it becomes easier to see how the recovery will play out for mining and oil companies because basic raw materials are always in demand.

Along with iron ore there are the other key ingredients in making specialty steels, including nickel and manganese, which will get a boost from the re-awakening of China.

Gold, which has been mentioned in this analysis, is a special case and remains an essential insurance policy against further instability and depreciation of major currencies, especially the US dollar which could fall sharply later this year.

Once you understand the starting point of the recovery, it becomes easier to see how it unfolds as high-demand minerals and metals re-connect with their markets, led by copper which has a vast array of uses from construction to transport and electronics.

Oil too, despite its spectacular crash of the past 48 hours, will not stay down forever, either as a result of high-cost material being forced out of the market or an outbreak of commonsense in Saudi Arabia and Russia when they discover they are the instigators of the oil-price fall and its biggest victims.

At some point in the next few months (or weeks, if we’re lucky) oil stocks will be excellent investment opportunities.

Not every commodity is going to rebound as quickly as basic raw materials.

Battery metals, for example, will take longer to recover as electric vehicle proponents discover (to their horror) that cars with conventional, petrol-burning engines, have suddenly become more competitive thanks to the oil-price collapse.

The key point in looking at the stock market today is to see it as an opportunity to get in on the ground floor of a recovery which might take time, but will move up once the bottom has been reached.