Are we over-estimating the mining investment boom?

A famous investor once said ‘….money is made by discounting the obvious and betting on the unexpected’. This is the case regardless of whether markets are rising or declining. Over the past three months global market sentiment has deteriorated, as perceived risks appear to have increased and US, European and Asian growth rates have declined. Rising risks and slowing growth is not a good environment for risk assets. However, much of the slowdown has not been caused by long-term structural issues, but rather temporary factors such as inclement US weather, Chinese inventory adjustment, and supply and production chain shocks resulting from the Japanese earthquake.

While these developments have combined to give the impression that the global economy is heading south, with the exception of European government debt, it is hard to envisage these factors continuing throughout 2011 and beyond. Nevertheless, global data is expected to remain subdued for several more months as these trends play out, but should improve before years end.

Although domestic economic growth has been quite weak lately, the Australian economic outlook for 2011/12 is also expected to improve, driven by a once in a century mining investment boom. Between 1861 and 2010, mining investment represented an average 1% of Australian economic activity. In the next four years, that number is set to average 5.2% (see Chart 1), which is more than double the mining investment boom of the 1960s. In terms of its contribution to economic growth, the boom is forecast to add around 1.5 percentage points per annum to GDP (which is seven times more than the post-1861 average) for the next four years.
m. Between 1861 and 2010, mining investment represented an average 1% of Australian economic activity. In the next four years, that number is set to average 5.2% (see Chart 1), which is more than double the mining investment boom of the 1960s. In terms of its contribution to economic growth, the boom is forecast to add around 1.5 percentage points per annum to GDP (which is seven times more than the post-1861 average) for the next four years.

Chart 1: Australia’s largest mining investment boom is expected to begin soon

Over the past 18 months the RBA has been in the process of preparing the Australian economy for this boom and has increased official interest rates by more than any other international central bank. In their public statements, the RBA has consistently cited Australia’s record terms of trade, low unemployment, limited spare capacity and rising inflation as the catalysts for raising official interest rates. Even during the recent spate of weak domestic data, the RBA has remained hawkish, warning of further rate rises as the impending boom approaches.

At a time when everyone has factored this boom into growth forecasts, no one is asking how much mining investment Australia can undertake in any one year. The recent Capex survey indicates that mining companies in FY12 are forecast to invest around the same amount as they have in the past four financial years. So investors could rightly question if we have the capital and labour to perform this investment. Despite this, the RBA is expecting growth of over 4% this calendar year and just under that level for the following two years.

Its worth noting, however, since the start of the massive rise in mining activity in 2004, the Capex data has over-estimated the impact of mining investment on Australian economic activity. Indeed between 2004 and 2010, the Capex data has indicated an average 20% compound rise in non-residential construction expenditure, but the national accounts have only delivered a 10% per annum increase.

Over the past decade mining investment has risen from $2 billion per quarter to $11 billion per quarter and is now larger than total domestic housing investment. However, to meet current forecasts, mining investment must continue to grow at an exponential rate. According to Macquarie Equities, the rise in mining investment in the next few years would be the equivalent of increasing housing construction from 150,000 houses per year to 310,000 in just two years. Given unemployment is below 5% and the mining industry is renowned for skill shortages, supply bottlenecks and infrastructure shortages, it may be the case that the mining investment, while very large, is not as egregious as some analysts think it will be.

This could have three notable impacts. Firstly, the balance of risks to Australian economic growth forecasts will be to the downside. Secondly, while the contribution to growth may not be as high as expected, this could mean that the Capex cycle simply becomes more extended in its duration. Thirdly, interest rates may not rise as much as expected and the domestic currency would be expected to depreciate below current levels.

So how can investors gain exposure to any improvement in the growth outlook and also mitigate some of the risks? In such an environment, consistency in cash flow generation growth, dividend income growth and valuations are things to watch. Companies that can deliver these to investors should outperform in a more challenging trading environment. During this process investor sentiment may remain soft, but as another famous investor said ‘the time of maximum pessimism is the best time to buy’. It’s not always easy to think differently to the herd, but it can be very rewarding.