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Digging Up From Rock Bottom

After months of decline, commodity prices could finally get a lift, as China tries to kick its economy into higher gear.

If you're looking for a sign that the metals and mining sector may finally be turning around, start by counting the number of construction cranes and bulldozers in China. Amid its own faltering economy, Beijing seems to be fast-tracking infrastructure projects and offering incentives to spur growth.

For the battered commodities market, such news couldn't come at a better time. Eighteen months into one of the worst declines since 1982, more than a few indicators now point to better prospects for the metals and mining sector, according to a recent Morgan Stanley Research report, "Metals & Mining: Turning Tide."

In addition, Morgan Stanley’s China material analyst, Rachel Zhang, mentioned in her recent report, “Greater China Cement: Demand Bottoming and Consolidation Lead to Price Recovery, Time to Buy Cement,” that recent central government policies on infrastructure-funding and pushing local governments to start projects on time will likely lead to stronger infrastructure demand in the remainder of 2015 and the first half of 2016.

“Emerging markets and China in particular remain key to commodities demand," says Menno Sanderse, Morgan Stanley's European metals and mining equities analyst. “In the next few months we expect the perception around this demand to improve."

While most of us follow the rise and fall of the broader equity markets, the commodities market has been quietly tanking for nearly two years. As the world moved out of the last recession, metals and mining companies began ramping up operations to meet renewed need for materials, flooding the market with product in the process.

The China Factor

As demand from China, the world's largest consumer of metals, and other emerging markets eased, commodity prices took the hit, tumbling to recent near- or record lows. Metals and mining stock valuations have followed suit. In fact, we have to go all the way back to the historical lows of the 1982 global recession for comparative levels, both in absolute and relative terms, Sanderse says.

The sector seems due for a bounce.

China, once again, will be counted on for some heavy lifting. The country, which had been building roads, cities, factories and other metal-hungry projects at a historic pace—accounting for between 84% and 122% of commodity consumption growth over the past 14 years—remains the main driver of growth in global commodities, Sanderse says.

Having recently reported its first quarter of less than 7% economic growth since 2009, China is now focused on regaining momentum. Its state banks have issued 300 billion yuan (around $47 billion) in government bonds to support local infrastructure spending. The government is also trying to kick start home sales with lower down-payment requirements for buyers. Spurred by this renewed demand, Morgan Stanley analysts forecast that commodities prices could rise by 14% in 2016 and 19% in 2017.

Supply Discipline

Commodities equities would stand to benefit. However, metal and mining companies’ ability to control supply is a crucial piece of the equation. When prices began falling last year, companies responded by closing mines, shuttering smelters and reducing production, in addition to cutting costs (the oil sector has responded similarly). This so-called supply discipline needs to continue for commodity prices to rise.

Morgan Stanley analysts also caution not to expect hockey-stick sector growth. “This is not a call for a fundamental change in the industry's fortunes," Sanderse warns. The sector still faces many risks from seasonal destocking efforts by metal processors, which boost supply and threaten prices, to continued concern about sluggish global growth and China's ongoing transition to a consumer-based economy.

However, signs of improvement abound, and after a rocky road, the metals and mining sector may be in for a smoother ride.

For more Morgan Stanley Research on the outlook for the metals and mining sector, ask your Morgan Stanley representative for the full report, “Metals & Mining: Turning Tide" (Oct 7, 2015), or a Financial Advisor to discuss your investment goals and strategy. Plus, see more of our Ideas.

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