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Rio Tinto looks vulnerable to overweight iron ore exposureJuly 19 2014, 9:44am
It has been a strong week for equities, with the Dow Jones hitting fresh all-time highs, as strong corporate earnings and Chinese data heightened demand for risk assets.
Financial stocks gained support after Goldman Sachs, Citigroup and JPMorgan’s quarterly earnings came in ahead of expectations, while a recommended bid for Shire, the Dublin based drugs group, bolstered general sentiment.
Official data from China revealed the world’s second-largest economy grew 7.5% in the second quarter from a year earlier, ahead of a median forecast of 7.4%, as a burst of government stimulus paid dividends. China’s fiscal expenditure surged 26.1% in June, accelerating from a rise of 24.6% in May, reflecting government efforts to shore up the economy.
Meanwhile, reports from the US on consumer spending and manufacturing indicated that growth momentum appears to have carried into the third quarter. Core sales increased 0.6% last month after rising an upwardly revised 0.2% in May, the fifth consecutive month of gains. In another report, the New York Fed said its Empire State general business conditions index jumped to 25.60 this month, the highest since April 2010. New orders edged up, while factory employment and shipments surged, although there were signs of inflationary pressures.
The rapidly improving labour market and traces of inflation have, however, prompted fears of earlier rate hikes. The Fed’s semi-annual monetary policy report, which accompanied Yellen’s testimony to the Senate Banking Committee, detected a small change in language, suggesting that if recent trends continue, it may mean that the federal funds rate would be raised sooner than currently expected.
Yellen also noted that overall US stock valuations were generally at levels not far above their historical average, although she warned that valuations in the social media and biotechnology sectors remained “substantially stretched”, in spite of a notable first-quarter correction.
Similar concerns have been seen in Britain accentuated by inflation surging to a five-month high last month, prompting investors to increase bets on an interest rate rise before the end of 2014. Consumer prices rose 1.9% on the year in June, up from a four and a half year low of 1.5% in May. A separate report, compiled by financial data firm Markit, revealed British households are at their most downbeat about their finances in six months, citing the prospect of interest rates finally going up as the catalyst.
The Eurozone continues to spook the market, with investors braced for more mini-crises in the Euro area’s periphery, like that triggered by worries about the financial health of Portugal’s Banco Espirito Santo. It was a timely reminder to those that have driven down peripheral bond yields to pre-crisis levels that the deep structural problems their economies and financial systems face have yet to be fully resolved.
Investors in Germany remain sceptical on the prospects for the Eurozone’s biggest economy, according to the influential Zew survey, which fell to 27.1 in July, the seventh consecutive monthly fall to its lowest level since December 2012. The July ZEW survey compiled the views of around 240 analysts and institutional investors about their current assessment of the economic situation in Germany, as well as their expectations for the coming months.
Technical analysis of the FTSE 100 illustrates the choppy trading experienced on low volumes over the past fortnight, with the index slipping through support to lose over 200 points last week on European woes, before bouncing back 150 points this week on strong global data. The rising oscillators indicate an improvement in momentum, although they remain mid-range and volumes are traditionally low at this time of year, so the market is likely to remain choppy. Support is seen at 6695 and 6650, while 6880 is still seen as the logical resistance level.
The UK market continues to lag the other major global indices, with US and Australian markets closing at fresh multi-year highs this week, although Sterling could be largely to blame after recent interest rate hike speculation. The global macro-economic backdrop remains supportive of further strength in equities, although investors should keep a close eye on European bond yields and talk of interest rates, as they are cited as the biggest potential headwinds.
The recent improvement in Chinese data, the world’s largest metals consumer, has boosted the price of raw materials, sending the mining sector to the top of the leaderboard over the past month, with many stocks trading at their best levels for 12 months. Gold recently reached a four-month high, while zinc touched its highest level for three years, although strategists suggest that metal prices are now looking overbought on a technical basis.
Rio Tinto (Epic: RIO), one of the world’s leading global mining and metals companies, has rallied over 11% in the past month, assisted by improved data from emerging markets and a solid second quarter update on 15th July.
The mining group is now digging more iron out of the ground than ever before, although China remains crucial to the Rio Tinto investment case. The country imports more iron ore than any other, to feed its hungry steel mills. Steel is essential for the massive infrastructure projects and urban developments that are currently taking place across the country, although analysts are concerned that the Chinese property sector is yet to show signs of recovery despite recent efforts by the government.
Production in the iron ore division, which accounts for around half of group revenues, was up 10% over the year at 139 million tonnes, although the company remains vulnerable to excess supply in these bulk commodities and a weaker Australian dollar, which are weighing on prices.
The chart of RIO illustrates the improvement, with the shares nearing the top of their nine-month range of 3410p. The oscillators are also nearing overbought territory, with the RSI touching its highest level since February, suggesting the recent buying could be nearing exhaustion.
RIO currently trades on 10x earnings, a slight discount to its major peers, although the company’s heavy reliance on iron ore is a concern and warrants the discount. Analysts have had a mixed reaction to the update, with Goldman Sachs and Liberum reiterating their sell rating on the stock and lowering their target prices respectively.
The high beta sector looks vulnerable to a short-term correction after a strong month. At the time of writing the share price is 3334.5p and I believe a short trade with a tight stop-loss above the upper band of the trading range at 3434.5p offers an attractive risk / reward bias. Near term targets are seen at 3201p, 3105p and 3038p.
This report was written by Mark Allen – Head of Derivatives at Simple Investments Stockbrokers. The writer does not hold a position in Rio Tinto, but client accounts may. The material in this report has come from Simple Investments internal data sources, Simply Charts and Rio Tinto’s corporate website.