Central Banks pumping liquidity into the market is fine, but losses are being crystallised and we have been seeing the liquidation of other assets, including shares and commodities, to meet the losses.

We can expect share prices to be volatile over the next month or two as investors wait to see what exposure financial institutions have to the sub-prime market and the extent of any emerging losses.

With limited available data, the market tends to focus on worst-case scenarios and is driven by day-to-day sentiment. At any rate, there does not appear to be any quick fix and investors have to decide whether they will ride out the storm.

We have long been an advocate of the ‘Stronger for Longer’ theme, supported by all major resources houses and driven by the increasing demand for commodities from China, and in the future, India.

While this is intact, as acknowledged by Rio Tinto recently, there will be hiccups along the way.

Market linkage

China’s strong growth is due to internal spending on infrastructure, city residential construction with the rural-city migration and an overall increase in living standards.

In particular, the country’s huge population – 1.3 billion – has an exciting multiplier effect. Its drive to increase living standards, material possessions and infrastructure has an enormous effect on the global demand for commodities.

But a key driver of Chinese growth has also been US consumer demand with lower cost Chinese exports keeping US inflation rates in check. Of course there is no consumer like the American consumer, who in 2005 spent $8.7 trillion.

Their consumption was 20% higher than Europe’s and a little more than three times that of Japan. It was also nine times higher than China’s consumption, and an amazing 17 times that of India.

Which leads us back to the US sub-prime crisis; with that country’s declining house prices exacerbated by sub-prime market mortgagee sales, we envisage American consumer confidence will be severely dented. The recent falls in Wall Street will only add to this mood.

A dampening of US consumer confidence is likely to reduce demand for Chinese exports, partly reverberating back to Chinese demand for commodities.

Hedge funds have also been a player in commodity markets and have been profiting from rising commodity prices on the Chinese economic backdrop. As mentioned earlier, hedge fund losses on the sub-prime market are likely to lead to the liquidation of other assets including commodities and equities.

Subdued short-term outlook

In corrections, market sentiment is an overriding factor and falling markets generally carry all shares lower, irrespective to some degree of company fundamentals. The problem is the above factors can contribute to further sell-offs, particularly given that commodity prices have yet to substantially fall.

This degree of vulnerability overhanging the market is unlikely to disappear in the short term as there needs to be evidence emerging out of China that growth and commodity demand remains robust and current metal prices are sustainable. It is unlikely that these data will be reported in the short term as the market will want to see the impact of events occurring now in the US.

Relative performances

The first chart accompanying this article highlights the performance of the Dow Jones Industrial Average and the ASX All Ordinaries Index, both indexed to 100 two years ago.

The stronger performance of the All Ordinaries Index over this period is evident in the chart and this stems from the Australian index’s significant resource sector components.

The second chart compares the performance of the ASX 100 Resources Index, the Mid-Cap Resources Index and the Small Cap Resources Index along with the All Ordinaries over the same two-year period. The graph highlights the strong performance from both the Mid-Cap and Small Resources Indices relative to the ASX 100 Resources Index. As always, it is generally the higher risk companies that under-perform during a correction.

Going forward

The weakness in the market has been driven by falls on Wall Street stemming from a collapse in the sub-prime mortgage market and widespread exposure to this market.

While seemingly unrelated to commodity demand, there are links through US consumer confidence which continue to make resource and commodity markets vulnerable.

In particular, the oil price is likely to soften given many hedge and commodity funds have exposure to forward oil contracts and where liquidation can provide quick funds to meet redemptions.

We do not see a quick fix to these problems but there will be a time when reinvestment in resources will be attractive – as usual the key will be to pick the bottom of the market.

We are anticipating a further correction in commodity markets before this timing will emerge.

Meanwhile we recommend a ‘sit and wait’ approach knowing the ‘stronger for longer’ theme remains intact and many companies have been sold down on sentiment without any reference to inherent value.

Companies with underlying inherent value will recover quickly when sentiment recovers.

Stephen Bartrop is joint managing director of Stock Resource www.stockresource.com.au

First published in the September issue of Petroleum magazine