Basic-Materials Sector Could See Rougher Ride in 2010

Basic-materials stocks were among the top performers in 2009, with the group soaring on renewed Chinese demand for commodities. But the ride may get a lot bumpier in 2010.

While investors believe last year's gains among miners and other basic-materials stocks dovetailed with the global recovery, a number of factors will make a repeat performance challenging. Chief among them: Governments and central banks are expected to start dialing back emergency measures that have helped drive the global recovery. That will inject uncertainty into the outlook, which may undermine the growth in commodity prices.

"The U.S. might be thinking of raising rates in the second half of the year," says Ted Scott, director of U.K. strategy at F&C Investments. "And this would be bad news for cyclicals." Cyclical stocks, which include basic-materials issues, tend to advance ahead of and during the early parts of recoveries and retreat ahead of recessions.

Basic-resources shares, as measured by the pan-European Dow Jones Stoxx 600 basic resources index, have more than tripled from the March 9, 2009, close, and are up about 150% over the past 12 months.

China bulls remain optimistic about that nation's appetite for commodities such as copper, iron ore, gold and aluminum. A combination of investment and stimulus packages have helped revive China's economy. Recent Chinese trade data showed imports surged 56% in December from a year earlier, while exports grew 17.7%.

But China's growth may face some obstacles of its own. China's central bank recently raised reserve requirements with an eye toward reducing speculative lending. Such moves could curb China's growth and, by extension, its appetite for commodities.

Kevin Lilley, European equity fund manager for Royal London Asset Management, is undeterred by such moves and says the building of China's infrastructure, including everything from high-speed rail projects to new power plants, will continue. "Those projects are committed and already started and will be seen through to fruition," Mr. Lilley said.

He remains overweight in the basic-resources sector, which has a 12.9% weighting in his fund. Mr. Lilley's top picks for 2010 are steel companies ArcelorMittal and Salzgitter, which he gives 3.3% and 1.2% weightings in his portfolio, respectively. He says they have "massive upgrades" to come.

Colin McLean, manager of SVM UK Absolute Alpha fund, is also remaining overweight the basic-resources sector and has increased his exposure to gold miners in the past year.

His top picks in the sector are Rio Tinto, Anglo American and Antofagasta, which he gives a 4% weighting each in his portfolio. "Rio has achieved a lot of its refinancing and restructuring, and I think Anglo still has the potential for that," he said. Mr. McLean also believes the cost-cutting that will ensue from Rio's joint venture with BHP Billiton may be greater than anticipated. He likes Antofagasta for its exposure to copper. "At the moment, the way in which copper and iron ore have moved (up), we still see the stocks undervalued," he said.

The greatest risk to mining stocks, of course, is the fragility of the current global recovery. Economies in Europe remain sluggish and the U.S. isn't out of the woods, and policy makers are looking to reduce or eliminate emergency measures.

Nicholas Brooks, head of research and investment strategy at ETF Securities in London, a provider of exchange-traded funds, sees a more challenging year ahead for the basic-resources sector. The key risk to basic resources and commodities-related stocks in general would be disappointing growth numbers from developed countries in the West, particularly the U.S., Mr. Brooks says.

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