And here they come. Note from UBS:
Sell: macro headwinds with Fed hawkish & China acting to deflate commodities
We downgrade RIO to Sell (from Neutral) with an unchanged A$104/s target. The stock has generated a TSR of 79% over 12mths driven by the strong iron ore price (+104%) & record cash returns; we estimate it now discounts an iron ore price of $80-90/t vs our long-term price of $65/t. RIO generates significant cash flow (spot yield ~25% interactive model) & shareholder returns should stay elevated in 2021. However, in our view current FCF & dividends are not sustainable as we expect the iron ore price to fall by >50% (from >$200/t to ~$90) over 12-18mths; we do not believe RIO’s valuation is compelling at a ‘normalised’ iron ore price (FCF yield 5.5% @$80/t). Near-term risks for the commodity complex are increasing with the Fed turning more hawkish & China taking action to deflate commodities (eg by selling strategic base metal reserves note); we expect this to accelerate the unwinding of the ‘reflation trade’.
Iron ore: China tightening & deflating commodities, Brazil supply recovering
We believe iron ore is approaching an inflection point as: (1) China is taking action to deflate commodity prices (incl steel); in our opinion, the exceptionally high steel price is the key reason why iron ore price is close to all-time highs; steel demand is also set to moderate in 2H with China tightening credit (note). (2) Brazilian supply is lifting with Vale’s shipments +14% YTD (based on UBS Evidence Lab data); (3) Iron ore China port inventory is now higher vs 2019 & 2020. Medium-term we see three major headwinds that will drive iron ore prices back to the cost curve (~$65/t): (1) Latent capacity: the majors will add ~160Mt over 3yrs & the juniors (eg MinRes) potentially 30+Mt; (2) Scrap: China aims to lift steel scrap supply from ~220Mt to 300Mt by 2025; this will displace ~90Mt of iron ore demand. (3) Simandou could add ~200Mt from 2025-30.
Catalysts & risks: 2Q mark-to-market upside but 2022 outlook unchanged
Next catalysts are 2Q production on 16-Jul (iron ore shipments are soft note) & 1H21 results on 28-Jul (which should be strong with cash returns elevated due to high iron ore prices); RIO may delay the Oyu Tolgoi start-up (Oct-22) as it still awaits approvals from the Mongolian govt. Key risks to our cautious view is a ‘stronger for longer’ scenario with China steel production & prices holding up into 2022 despite the tightening.
Valuation: Sell; cash returns attractive but macro backdrop deteriorating In our opinion, the risk/ reward has deteriorated despite high cash returns.