What an extraordinary time we live in.  The vast majority of global investors are still on the sidelines and seemingly waiting for the Greater Depression and the collapse of Western Civilisation. Yet the markets say something very different!   The Sea Change of the Great Rotation is underway!

The massive build up in bank deposits here in Australia and elsewhere and the flight to bonds (the US$17,000bn tied up in US Treasury Bonds alone, plus the Munis and corporate bonds, and another huge amount in European and Japanese bonds) indicate a risk averse public battered by weak economic performances in the OECD.  The weak economy here under the ALP Rudd-Gillard-Rudd Governments disasters has been a disgrace and so many people would be suffering from job losses, loss-making businesses or fears of future  job security.  But the results from the 7 September Election will now be bringing a totally new Australia.

How exciting!   And how things around the world are changing!

The starting point is the peaking of the bond market.  US 30 year T Bonds peaked in July 2012 at about 153 and are now about 15% lower at 130.7, and with a buying yield of only 3.8%, bond investors are about 11% worse off.  The losses on the 10 year are about 7% net of income. Yields on bonds in Europe have doubled from low levels whilst in the local market Australian Government bonds have fallen as yields rose from a sub 3% yield to over 4%.  Ouch.  Risk-free assets. Yeah, right.

Keep in mind that higher yield rates on bonds don’t make them more attractive, just means that risks are rising and after more than 30 years of bull market everyone who wants them has them and will now be thinking where to get better returns.  Here, the 31 year trend of declining bond yields is in the process of ending.

And as it brings about this Sea Change just think of some of the implications for investments.  Above all, just consider that anyone under 50 has had an entire career in an environment of only falling global interest rates!

The next stage in the Sea Change is move into equities.  The All Ords is up 28% as is the S&P 500 since those lows in yields so anyone who thinks equities go down with rising bond yields has received an interesting lesson. And the CRB CCI Index is up almost a net 3% in the same time.

The Great Rotation is underway in earnest.

This source and application of global capital is now the key to investment in today’s markets.

Out of cash and bonds and into equities and commodities.

And what is the buying power side of the equation?  Start with the US$17,000bn in US T-Bonds.  Everyone, including massive inflows from Sth America, Asia, Middle East, Russia, has sought US T-Bonds as safe haven. Then as was mentioned there are Munis and corporate bonds.  Cash deposits had also built up.  About US$25,000bn built up over 30 years.

In Australia, RBA data gives total bank deposits as just over A$1,500bn with about A$540bn in term deposits, A$520bn in savings accounts and about A$220bn in current accounts. Term deposits have been steady for about 12 months and cheque accounts are up 6% but savings accounts are up almost 19%.  Australians have saved over A$80bn (around 5%of GDP) in the past year and A$50bn in the year prior.   This A$130bn is a lot of money hidden under the bed during the last two years of Gillard-Rudd.

So, since mid 2012 as the funds have begun to be redeployed it has been into general stocks (up 28%) but, still, the riskier resources assets have been shunned (down >50%). But what extraordinary value has been created.

So what is on offer to be bought?  Well, here in Australia we have the resources sector that is valued for prices 25-40% lower than today and yet the general trend for commodities is up and is led by oil and iron ore with many other commodities about to make a strong break out.

Resources stocks have been thumped in 2013 for sentiment reasons only.  Production is rising in most places and the general comment is that every tonne is already sold.  Prices are reasonable and, yes, costs have been inflated but downward cost pressure is being seen everywhere.  Earnings are OK without being spectacular but we have seen writedowns on many assets reflecting mostly a lower A$ gold price.  Most of these writedowns are for the carrying value of investments (at the bottom of the market at end June 2013) and assets that are non–cash items and ultimately result in reduced amortisation and depreciation charges and so higher reported earnings.

So resources stocks are now very cheap indeed and should be special targets for much of that capital flow from safe havens.

The bullish view on economies, equities and commodities presented in these notes has not changed for some years so I don’t have to come up with a reason for changing my mind on the outlook.  You know that.  The long term economic growth rates favour developing countries and now that emerging economies (or Non-OECD if you prefer) already exceed OECD consumption for most raw materials.

Most new economies have room to move through governments that are too young to have really draconian regulations so their economies continue to grow strongly. The growth rates of most emerging countries seem to be in alignment with China and all should benefit as capital leaves its US$ haven.

The GFC was unexpected given that oil, gold and other commodities were strong into mid 2008 whilst most other equities were weakening but then they too crashed into late 2008.   The recovery rally and the strong performance of gold and gold stocks (new alltime highs in 2011) showed some life and a spirit that said all was not lost.  The next two years were then of course horrid for my sector of the market which has been well and truly trashed for whatever reasons and the rationale for these reasons continues to escape me.

The commodities just did not collapse.  Despite commentary that they had, and would.  And now they are rising again.

Recent Dawes Points have highlighted this sell off into the June 2013 lows in gold and gold stocks and the conviction that the medium term lows are in place for both gold and gold stocks.

So if lows are in then the very large cash levels should allow funds to be directed towards the sharemarket along with property and retail spending.  But resources sector shares now offer the lowest prices, best value and, very importantly, lowest risk if sufficiently funded.
Also highlighted has been the underlying strength in the iron ore market as shown by the high production rates of crude steel in China and elsewhere and the resulting recent US$154/t and the current US$134/t for iron ore.  I expect new highs are coming in iron ore as expressed a couple of times previously.  What are all those knowledgeable iron ore analysts in the big investment banks thinking now with their sub US$90/t forecasts?  Resigning, or just `upgrading their forecasts’.

Have a look at these charts.  China much bigger than the US or Europe.:-

Can you see the slowdown in China and the collapse of the iron ore price?  I can’t.

So why are iron ore stocks rated so lowly?

The above data suggests new highs are coming for iron ore.   There were over 100 iron ore companies with >80% as just hopefuls awaiting infrastructure, port access and capital.  Some are probably a real chance now.   At US$134/t there are many companies where you can buy iron ore resources for just a few cents per tonne.   And CBA and Woolworths are more attractive than Fortescue (which is up 50% from its June 2013 lows)?

I can give you a dozen reasonable quality and value iron ore stocks if you were to ask me now.

And magnetite is my favourite iron ore play.  Why is this?  Chinese iron ore output is only magnetite concentrates.  About 350mtpa of domestic ore in about 1300mtpa of iron ore needed to produce almost 800mtpa of crude steel.  Ore with just 12-15% Fe as magnetite Fe3O4 needs grinding to get ~68%Fe concentrates. But recoveries aren’t so flash so about 8-10 tonnes are required to produce 1 tonne of ~68% Fe magnetite concentrate.  And overburden of at least 2:1.  Compared to Australia’s 61% haematite Fe2O3 1:1 strip ratio direct shipping ore this ore is expensive and uses lots of electricity.  15-18 kWh/t grinding at US$0.15/kWh is about US$2.50/t but with 8 tonnes ore /tonne of cons this is U$20/t cons just for grinding.  Then mining 9 tonnes for one tonne is US$18-24/t.  With 2:1 stripping is another US$20-30/t.  Transport by rail is more expensive than by sea.   No wonder China is the highest cost producer as shown in the above price and cost structure graph.
But why magnetite?  Quality.  68-70% Fe magnetite fits 12-15% more Fe units into the blast furnace volume than 60% Fe haematite.  The grinding and the magnetic separation also strip the ore of alumina, silica, phosphorous and water, so better quality ore results.

Higher density and quality and fewer deleterious elements saves a lot.

So accept the problems at Sino Iron as a poorly managed project rather than a problem with magnetite.  Keep watching Gindalbie and also Magnetic Resources and note that FMG has brought in a JV partner from Taiwan to develop its magnetite.

The higher iron ore prices are reflecting higher demand volumes and coal is also showing some signs of life on price.  Volumes have been rising and the very large extra coal requirements from India are still coming closer.

The seaborne freight market is also improving as the slack after a massive 2008 increase in shipping capacity is finally being absorbed.  The Baltic Dry Freight Index is showing good signs of life and is up more than 130% since June 2013.

The ASX Metals and Mining Index has had a sharp fall since April 2011 and fell 57% into its June 2013 low.  It has bounced 20% but is still 46% below the highs.

A further rally is expected up towards 3800 before some consolidation and then it should recover strongly.

Interestingly, the market share of XMM against total ASX All Ords turnover is down to a very low 16-18% suggesting that interest and holdings are quite low.   The turnover share is down over 35% from the averages prior to mid-2012.   Low relative turnover means underweight positions.

With the Gold Sector we still have extreme undervaluation with prices back to 2003 levels and whilst the gold index has rallied over 40% from the June lows it is still 67% below the April 2011 highs.

Note that the trading statistics for the Gold Index show rising weekly values, volumes and transactions over the past year but the moving averages ( 5 and 12 week) also show that Gold Sector turnover was down to 2.5% market share of the All Ords in almost four years of decline so it is very obviously underowned by the market.  Expect a major pick up in value and volumes and also in market share of turnover.

And the continuing growth in energy consumption has led to a surge in oil prices that will bring very good earnings to new producers and particularly in the Cooper Basin where production is rising and with costs below A$30/bbl for many, the operating surplus is very attractive.  Just 3000bopd can give an A$90mpa  operating surplus.  Think BPT, SXY and DLS.

So as the Great Rotation continues in this Sea Change these resources stocks, especially the small cap versions, should be extra special opportunities. These are clearly unloved and underowned.

As noted in earlier Dawes Points many small resources stocks are priced at levels of less than 20% of the NPVs of their assets on prices set at below levels of today.   At today’s prices and then at probable future prices the discount to NPV is well over 90%.  So expect many 10 baggers and the occasional 50 bagger.

One other aspect of the Sea Change is the need for a US$ safe haven currency is rapidly diminishing.  And the market is letting us know.  This sharp little breakdown is saying something very important.

This second graph says is that the US$ is in a major long term downtrend channel from 160 in 1985.

It has been trading within the clearly defined (to me!!) middle channel for 10 years and the recent rally was unable to break up through this channel.

As it has been unable to break up it will now run out of energy and fall to touch the lower downtrend channel line which comes in at about 72.  It will bounce and rally but will eventually fall with increasing momentum to the lowest trend line over the next 10 years.

The main reason for capital leaving the US is that it is no longer needed as a safe haven and better opportunities can be had in the booming economies of Asia, Sth America, Africa and Australia!!

The other reason is that the US Government has too much debt and funds will flee the bond market and buy equities and commodities.
So the A$ will be very strong!

Here the A$ has broken a downtrend a 90 year downtrend against the US$.  The energy associated with a change in a very long term trend is massive and will be reflected in a very strong A$ against the US$.

I see it at US$1.50 within 10 years.

The drivers will be a big jump in export revenues from higher commodity volumes (iron ore, coal, LNG) and then higher prices for most commodities, especially gold.

Then it will be portfolio investment into Australian assets, then it will be currency diversification into A$ and then it will be speculation!
And at the same time the US$ will be bleeding because of all its debt and a declining bond market.  Gold will be very strong.  Simple really!  It will be Australia’s Century in the Pacific Century!

Paradigm is now becoming active in the market especially in small cap resources and capital raisings for them after a couple of years of restrained activity with everyone correctly happy to stand aside while the heavens bucketed down on us all.  Extraordinary value is obvious and now is the time to re-enter the resources market while prices are cheap, value is strong and risk is relatively low.  The opportunity for 20 and 50 baggers is now.

If you want to participate please get in contact with through phone or email.  +61 9222 9111 and bdawes@psec.com.au.