London, 29 December 2010

The outperformance of European basic resources equities seen in 2010 is likely to fade next year as demand is hit by a slowdown in emerging markets growth and likely metals price rises are factored into share prices. Developing economies, which showed strong resilience to the global economic crisis, could lose some ground next year, while China's efforts to tighten its economy could lower the appetite for raw materials in the world's largest metals consumer.

Recent rises in prices has made the STOXX Europe 600 basic resources shares relatively expensive, with their oneyear forward price-to-earnings ratio now at 13.1, against 10 times for the oil and gas sector, 10.7 times for banks and 10.2 times for telecommunications shares.

This mining sector, up 30% in 2010, is the fourth best performer out of 20 European equity sectors and is behind only automobile, personal goods and industrial goods. In contrast, the STOXX Europe 600 is up only 11% this year. "On the surface it looks fine, but I would not be overweight the mining sector," said Philippe Gijsels, head of research at BNP Paribas Fortis Global Markets in Brussels.

"If everyone is leaning in one way and a lot of good news is priced in, you will only need one hiccup to have a serious correction. You are so dependant on the emerging markets, but they are imposing credit inflow restrictions, hiking capital requirement for banks and raising interest rates."

Barclays Capital says global growth is expected to slow moderately to about 4.25% in 2011 from 4.9% this year, and more sharply in Asia and Latin America, which are likely to fall to about 6.5% in 2011 from 7.8% in 2010.

"China will continue to grow, but not as briskly as it has done. The country wants a more sustainable growth path and we have seen the reserve requirement ratio being lifted a couple of times," said Klaus Wiener, head of research at Generali Investments.

The 30% rise in the basic resources index this year outpaced a 19% gain in the London Metal Exchange index, signaling investors have factored in a portion of the potential rise in metals prices, which are set to continue on supply concerns.

"The market has priced in an essential amount of rise in commodity prices. I would be a bit hesitant to expect that the mining sector will outperform in 2011," Generali Investments' Wiener said.

CHINA FACTOR

Mike Lenhoff, chief strategist at Brewin Dolphin, said China was a risk for the mining sector next year because if the country's domestic policies did not work properly and the central bank continued to tighten, then the government could introduce active fiscal policies.

"If we find that authorities take a more assertive kind of position on the interest rate policy, that's a serious risk for the sector and the global economy. Analysts saw some bright spots in the sector, however, favouring well-diversified companies with operations in different geographical regions.

"Commodities should do well, although we do see limited upside. Much depends on China and the Chinese demand. Interesting companies are the blue chips like BHP Billiton or Rio Tinto," said Anko Beldsnijder, managing director of MainFirst Asset Management.

Citigroup says that on a surplus cash flow basis, BHP and Rio appear the clear standout stocks. It forecasts that both the companies will be in a net cash position by 2011. "Rio Tinto could easily return in excess of $10 billion of surplus capital in 2011, while we expect Xstrata and Anglo American to remain in a net debt position," Heath R Jansen, analyst at Citigroup, said in a note.

Ambrian rates Rio as its top pick among other diversified peers due to its greater earnings leverage that Rio Tinto has to price and production increases in iron ore. Ambrian raises its 12-month target price to 5,900 pence from 4,300 on the expected increase in cash flow.

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