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China Worries Dampen Outlook for Mining Giants

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Even as advanced economies continue to show signs of improvement, the latest economic data from China has once again painted a gloomy picture of the world's second largest economy. A slowdown in China is a major concern for mining giants such as BHP Billiton (NYSE: BHP  ) , Rio Tinto (NYSE: RIO  ) and Vale (NYSE: VALE  ) . Moreover, the weakness in the Chinese economy could be prolonged due to a possible credit crunch. This is likely to mean another difficult year ahead for mining giants.

Signs of weakness
Economic data from the U.S. and the euro-zone in recent months has been encouraging. However, an improvement in the developed world has been accompanied by a slowdown in emerging markets.

On Thursday, a report showed that manufacturing activity in China contracted in January. The HSBC and Markit "Flash" purchasing managers' index slipped to 49.5 in January from 50.5 in December. A reading of below 50 indicates contraction. This is the first time in six months that manufacturing activity in China has contracted, which is a worrying a sign for mining giants, given that the country is the biggest consumer of raw materials.

Given the weakness in China, it is not surprising to see that prices of copper and iron ore have slipped. On Wednesday, copper futures for delivery in March on the Comex division of the New York Mercantile Exchange dropped 0.4% to settle at $3.2405 a pound. Spot iron ore prices are also trading near a 6 month low, mainly due to weaker steel prices in China. What is worrying for mining giants is that the weakness in China could be prolonged due to a possible credit crunch.

Shadow banking system
There had been growing concerns over the past year about China's vast shadow banking system. According to recent data from the People's Bank of China, the shadow banking system, which refers to unregulated lending activity, accounts for a third of new credit in China. Concerns over China's banking system mounted recently after a wealth management product issued by China Credit Trust was about to default. The fears of a default were eased at the last minute after the product's issuer managed to raise cash to pay back investors. However, the fact remains that China's financial system remains vulnerable due to a vast, unregulated shadow banking sector. Problems in China's financial system could lead to a credit crunch like the one seen in the U.S. after the housing market collapse. This could further dent China's economic growth.

The outlook for miners
Mining giants have had a difficult couple of years as the so-called "commodity supercycle" has ended. The commodity supercycle, which refers to a prolonged period of rising commodity prices, was driven mainly by China's hunger for raw materials. However, as China's economy has slowed down in the last two years commodity prices have been under pressure. Not surprisingly this has had a major impact on mining giants.

In 2013, even as the S&P 500 rallied, shares of miners such as BHP Billiton, Vale, and Rio Tinto fell 11.26%, 25.67% and 1.10%, respectively. Weak commodity prices have also forced miners to cut down capital spending and divest non-core assets. It must be said that the efforts undertaken by companies such as BHP Billiton and Rio Tinto will help in the longer run.

Recently, BHP Billiton had provided an operational review for the half year ended December 31, 2013. The report released by the Anglo-Australian company showed strong operating performance, with a 10% increase in production and volumes.

Rio Tinto also reported strong operating performance. Sam Walsh, CEO of Rio Tinto, said that the company exceeded its cost-cutting targets for targets for the year and announced or completed $3.5 billion of non-core assets sales. Walsh added that these actions, together with lower capital expenditure in 2013 and beyond, will ensure Rio Tinto is well-positioned to deliver greater value to shareholders.

Despite these efforts, my outlook for mining companies remains cautious in the medium-term primarily due to uncertainty in China. Adding to the woes for miners is weakness in emerging markets such as Turkey and India. Earlier this week, both countries raised their interest rates in order to fight inflation and weakening currencies. This will likely hurt economic growth in the near term in both countries.

Given these factors, mining companies are likely to continue to face challenges in 2014.

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Varun Chandan

I have a Master in Finance degree from IE Business School in Madrid. I use the top-down approach when it comes to investing. I like to analyze macroeconomic factors and how they impact individual companies.

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