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2011-05-12-UBS-Correction-in-Mining-stocks

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					ab                                                                                                     Global Equity Research

                                                                                                        Global
 UBS Investment Research
                                                                                                        Mining & Metals
 Commodities & Mining Q&A
                                                                                                        Equity Strategy



 Unwinding the dollar/commodities carry
 trade                                                                                                                                   12 May 2011
                                                                                                                          www.ubs.com/investmentresearch
    Q1. What’s your view on commodities after last week’s correction?
 We highlighted our cautious call on the commodities and the miners in ‘After
 Midnight’, 11 April 2010. In this note we argue the commodities & miners will see                                                      Julien Garran
 another significant leg down before a buying opportunity can emerge later in the                                                                  Analyst
 summer.                                                                                                                           julien.garran@ubs.com
                                                                                                                                         +44-20-7568 3540
    Q2. What caused the sell-off                                                                                                            Tom Price
 We have started to see several of our concerns from ‘After Midnight’ emerge in the                                                              Analyst
 data and in the markets; global growth has disappointed. The Chinese authorities                                                     tom.price@ubs.com
 have committed to stay ‘tighter for longer’. And extreme positioning short the                                                          +612 9324 2189
 dollar and long commodities exacerbated reversals last week.                                                                   Angus Staines, CFA
                                                                                                                                        Associate Analyst
     Q3. Is the bad news priced in?                                                                                               angus.staines@ubs.com
 The key question we face here is whether our concerns are ‘priced in’ or whether                                                       +44 20 7567 9798
 last week’s market action a prelude to a deeper commodities correction in the
 weeks and months ahead. We call for a deeper correction.

     Q4. What will drive the next leg down in commodities?
 In the mining team we see the end of QE2, a reversal of capital flows back to the
 US, and an unwinding of the severely crowded short dollar/long commodities carry
 trade as the central roadmap for the coming weeks and months. Only once this has
 played out do we see a potential for a return to reflation and commodity
 bullmarkets later in the year.

 Chart 1: US$ short/Commodities and EM growth risk positioning schematic



                                          US QE2


                                                               Portfolio flows overseas
     Growth picks up, commodities rise
     The dollar falls, risk is on.


                                                            Financial positioning
    Banks use US$ wholesale funding                         Short dollar, long commodities
    to lend long to EM etc                                  Long EM growth correlated assets


                                Corporates borrow US dollars short term
                                To fund increased working capital
                                & commodity intense growth projects




 Source: UBS research




 This report has been prepared by UBS Limited
 ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 12.
 UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
 have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making
 their investment decision.
Commodities & Mining Q&A 12 May 2011


Q. What caused the sell-off?
A. We believe it was slowing growth, the hawkish tone of China officials
and severely crowded positioning that caused the sell-off.

After the flood of liquidity of QE2 (See ‘Game Changer, October 2010), we
now see a difficult period for commodities and mining shares as liquidity dries
up. In ‘After midnight’ April 11 2010, we highlighted four key concerns on
commodity markets and mining shares.

     1. Global growth was slowing faster than most expected.
     2. The Chinese authorities would stay tighter for longer than the market
        wished or was anticipating.
     3. The end of QE2 would lead to a reflow of capital to the US, a dollar
        bounce and risk off. Extreme positioning would exacerbate the move.
     4. MENA tensions would persist – leaving a large risk premium in the oil
        price.
The charts below show that growth disappointments accelerated since the report.
Macro surprises have rolled over.

Chart 2: UBS US growth surprise index                                            Chart 3: UBS Eurozone growth surprise index


    170                                                                               80
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                                     US grow th surprise index                                                Eurozone grow th surprise index


Source: UBS global economics, Bloomberg                                          Source: UBS global economics, Bloomberg

Chart 4: ISM inventories                                                         Chart 5: ISM new orders less inventories


     60                                                                               40
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                                       ISM inv entories (%)                                                  ISM new orders less inv entories (%)


Source: Bloomberg                                                                Source: Bloomberg




                                                                                                                                                            UBS 2
Commodities & Mining Q&A 12 May 2011


A key point is that high oil prices and bond yields in recent months have
pinched the consumer, hitting sales and causing an involuntary inventory build.
This is set to lead to falling industrial orders and destocking along the industrial
and commodities supply chains. The inventory build is visible in the chart above.
And our favoured leading indicator for the US – ISM new orders less
inventories deteriorated.

This deterioration in the leading indicators pushes us further after ‘midnight’ on
our sector allocation clock.

Chart 6: European sector allocation clock


                                           0.20           Above trend & expanding                                                                                 Above trend & contracting


                                           0.15                                                        RealEst
                                                                  Div Fin             CapGds
                                                                                                                                           we are
                                                                            Transp         Banks
                                                                                                                                            here
                                           0.10                       ConDur
  correlation to level of ISM new orders




                                                                        Semis             Mining
                                                                                                   Paper
                                           0.05                                                             Insur
                                                                                                            S/w are
                                                                                                                                   TechH
                                                                                               Auto
                                                                                                                                                    ConMat
                                           0.00
                                                                                                                   Chem       C&Pack        Utilities

                                           -0.05                                                   Media
                                                                                                                                                          Telco


                                                                                                              ConsS                                             Hcare
                                           -0.10                                                      Bev                                      FoodP
                                                                                                                                                                                   Energy
                                                                                                                                                                         HH&Pers
                                           -0.15                                                             CommS                                        Tobac

                                                                                                                                           FdRet
                                                                                                                                                                  Pharma
                                           -0.20
                                                                                                                          Retail
                                                          Below trend & expanding                                                                               Below trend & contracting
                                           -0.25
                                                   0.25        0.20            0.15        0.10             0.05           0.00        -0.05            -0.10           -0.15      -0.20    -0.25

                                                                                               correlation to change in ISM new orders

Source: UBS research


On China, we also saw a marked reversal of sentiment on China policy – in the
wake of further hikes to reserve requirements, and a number of hawkish official
comments.

We felt that the authorities would remain hawkish in the face of

                                   •          Persist inflationary pressure in food
                                   •          Cost push inflation in power as a result of the drought


                                                                                                                                                                                             UBS 3
Commodities & Mining Q&A 12 May 2011


     •     A structural increase in wage costs and follow through price inflation in
           light manufacturing exports and in urban services.
In our view two of the three inflationary pressures in China will persist over the
next two to three months, the third will persist indefinitely. Persistent
hawkishness is clearly negative for sentiment on commodities in the short term.
We would argue at the very least, that risk/reward in commodities will remain
poor until a seasonal slowdown in 3Q11, some easing of power bottlenecks, the
possibility of easier food markets in the late summer and concerns around a
broader risk-off event provide the Chinese authorities with greater scope to ease
its policy stance.

Chart 7: China CPI inflation y/y                                          Chart 8: China food CPI inflation y/y and 3m/3m

                      China CPI (monthly y /y change-%)
                                                                             50%
                                                                             40%
   10%                                                                       30%
    8%                                                                       20%
    6%                                                                       10%
    4%                                                                        0%
    2%                                                                      -10%
    0%                                                                      -20%
   -2%
                                                                            -30%
   -4%
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                                                                                                    China food CPI (monthly y /y change-%)
                               China CPI (monthly y /y change-%)                                    China food CPI (3m annualised change-%)

Source: Bloomberg                                                         Source: Bloomberg


We are also seeing tighter monetary conditions on view in other BRIC
economies, which will likely constrain commodities demand going forward.

Chart 9: Russia industrial production growth vs M2 money                  Chart 10: Brazil industrial production growth vs M2 money
supply                                                                    supply


   60%                                                                       40%                                                           80%
   40%                                                                       20%
                                                                   100%                                                                    60%
   20%                                                                        0%
    0%                                                                                                                                     40%
                                                                   50%      -20%
  -20%                                                                                                                                     20%
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                    Russia IP (3m annualised change-%)-LHS                                    Brazil IP (3m annualised change-%)-LHS
                    Russia M2 money supply (3m annualised change-%)-RHS                       Brazil M2 money supply (3m annualised change-%)-RHS

Source: Bloomberg                                                         Source: Bloomberg




                                                                                                                                                UBS 4
Commodities & Mining Q&A 12 May 2011


Q. What will drive the next leg
down in commodities?
A. In our view a chunk of the growth slowdown, and the change in
sentiment on China’s policy stance are in the price. But we think that the
drivers of the next leg down; the impact of the end of QE2 on global capital
flows, the dollar and risk attraction in commodities are not.

The dynamics are almost exactly the opposite to those in play as the US
embarked on QE2 in Q4 2010.

The Fed’s view, and our view in the UBS mining team is that QE2 operates
through portfolio choices. When the Fed buys treasuries, it lowers yields relative
to other risk assets – forcing portfolios to shift up the risk curve.

That shift incorporates strong capital flows overseas – which can be seen in the
dramatic rise in foreign exchange reserves in recent months.

Chart 11:China foreign exchange reserves                                     Chart 12: World ex-China foreign exchange reserves


   3500                                                                         7500
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                           China foreign ex change reserv es (US$b)                               World ex -China foreign ex change reserv es (US$b)


Source: Bloomberg                                                            Source: Bloomberg


Emerging market authorities tend to print domestic currency to buy dollars, to
prevent excessive currency appreciation. This then raises deposits at banks,
inducing a lending boom, which in turn is very commodities intense – bullish for
commodities, with knock on effects on commodity currencies and speculative
flows (See schematic below).




                                                                                                                                                       UBS 5
Commodities & Mining Q&A 12 May 2011


Chart 13: UBS schematic of capital flows under US reflation/QE

                                            Capital flows
                                           out of the US to
                                          emerging economies




 US authorities
                       This attracts more        Raises central bank
     reflate
                          Capital flows         Reserves at commodity
                                                      exporters




                                         This bids up
                                       commodity prices
                                                                 Global central banks’
 Growth picks up,                                                    reserves rise
 Asset prices rise




                                           Local banks lend
                                          to local consumers
                                              & businesses


Source: UBS


When the Fed ends QE, treasury yields rise relative to other risk assets – making
them more attractive, and forcing portfolio shifts back down the risk curve. That
induces capital to flow back to the US – directly boosting the dollar.

It forces emerging market central banks to retire domestic currency as the
dollars exit, leading to stalling bank deposit growth and stalling loan growth.
And this in turn triggers a reversal of speculative flows. It also tends to
precipitate credit stress among weak credits – who, like in a game of musical
chairs, are left standing when cheap credit runs out.

Our bear market rule of thumb is that a nine month self-reinforcing cycle up
(August 2010- April 2011) will take about three months of a self-reinforcing
cycle down to unwind (May-August 2011).

This pushes our tactical macro asset allocation clock down from zone one
(Long commodities and emerging markets, short the dollar and bonds) into zone
two (Long the dollar and bonds, short commodities and emerging markets).




                                                                                         UBS 6
Commodities & Mining Q&A 12 May 2011


Chart 14: UBS resources allocation clock




                          Absolute trades                         Relative trades


                    US$s Out Risk on                      US$s Out            Risk off            Very

                                1                                         3                       positive
                                                                                                  emerging
                       Reflationary boom                   Inflationary bust                      markets
                                                         Long; Commodities, commodity             and
                 Long; Commodities,
                          emerging markets               currencies, emerging markets             resources
                 Short; dollar, bonds                    Short; US bonds,
                                                                   debtor currencies

                    US$s In           Risk off            US$s In             Risk on

                                2
                                                                                                  Very

                    Deflationary bust
                                                                          4
                                                            Disinflationary boom
                                                                                                  negative
                                                                                                  emerging
                 Long; US bonds, US dollar                                                        markets
                                                          Long; US equities, ‘growth’,
                 Short; Commodities,                               bonds,                         and
                          emerging markets                Short; Commodities,                     resources
                                                                   emerging markets




Source: UBS research


This process can then become self reinforcing to the downside. As the dollar
rallies it stresses all those with speculative or structural dollar short positions. It
will also stress portfolios that are excessively positioned in ‘short dollar’
correlated trades.

UBS head of currency strategy Mansoor Mohi-uddin highlights the exceptional
short positioning in the US dollar as a key driver of their constructive dollar call.
The charts below show the extent of that positioning

Chart 15: CFTC net positioning US Dollar                                                Chart 16: CFTC net positioning data, Australian dollar


  50000                                                                                  110000
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                                 US$ positioning (contracts)                                                              AUD positioning (contracts)


Source: CFTC                                                                            Source: CFTC


We always get concerned when the market positions itself so aggressively, and
we suspect that short dollar trades, and risk trades that are set to benefit from
dollar declines are now heavily crowded across all asset classes. The schematic
and the bullet points below highlight the multiple ways that investors, corporates


                                                                                                                                                                   UBS 7
Commodities & Mining Q&A 12 May 2011


and governments have got short the dollar. The dollar has become the funding
vehicle for a massive carry trade. And much of the long risk part of that
carry trade has directly, or indirectly, found its way into commodities.
Chart 17: US$ short/Commodities and EM growth risk positioning schematic




                                                             US QE2


                                                                               Portfolio flows overseas
   Growth picks up, commodities rise
   The dollar falls, risk is on.


                                                                           Financial positioning
   Banks use US$ wholesale funding                                         Short dollar, long commodities
   to lend long to EM etc                                                  Long EM growth correlated assets


                                              Corporates borrow US dollars short term
                                              To fund increased working capital
                                              & commodity intense growth projects




Source: UBS


Financial investors

        •        Direct exposure; speculative short positions in the US dollar vs all
                 currencies.

        •        Commodity exposure; long positions in precious metals, base metals,
                 oil and agricultural commodities.

Chart 18: Net copper positions                                                            Chart 19: Net gold positions

  30            Thousand Contracts                                                         300             Thousand Contracts

  20                                                                                       250

  10                                                                                       200

   -                                                                                       150

 -10                                                                                       100

 -20                                                                                        50

 -30                                                                                          -
       Nov 05



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Source: Bloomberg                                                                         Source: Bloomberg


        •        Equity exposure; Underweight US equities vs overweight emerging
                 markets. Pro-cyclical sector exposure vs underweight either defensive



                                                                                                                                                                    UBS 8
Commodities & Mining Q&A 12 May 2011


         of US focussed growth (tech, media – which benefit when the US dollar
         rallies).

    •    Fixed income exposure; short term US dollar borrowing to fund
         deposits in higher yielding currencies. Credit skew towards EM vs
         underweight US. Trades betting on widening rate differentials between
         the US and commodity rich countries/EM.

Governments

    •    Diversification of reserves away from the US dollar into
         gold/euros/commodity currencies. Hoarding of ags and other
         commodities for ‘strategic purposes’.

Banks

    •    Commercial banks; increased short term US dollar funding for
         wholesale banking activities. This is a form of the carry trade practised
         particularly by the Euro area banks, which have increased their short
         term dollar borrowing to fund longer term lending to European
         sovereigns and corporates, as well as lending to the Middle East, Asia
         and emerging markets. This indirectly promotes commodity intense
         growth

    •    Investment banks; raising risk exposure, including commodities,
         through the use of wholesale dollar funding

Non-financial corporates

    •    Raising working capital (a form of long commodity bet) especially
         when funded by short term dollar borrowing.

    •    Emerging market corporates – switching from longer term borrowing in
         domestic currencies to short term trade finance borrowing denominated
         in dollars. While data on this type of activity is often hard to come by,
         we know that the incentive to do it rises as emerging market authorities
         tighten credit, as forward differentials between those countries and the
         US widen, and as sentiment on the dollar deteriorates. All these
         conditions have been firmly in place since last August, and
         consequently we suspect that dollar borrowing has been rife.

    •    The use of commodities (copper/soybeans) – as collateral for loans – in
         order to benefit from commodity contango/appreciation and cheap
         dollar funding/dollar declines. Tao Wang, UBS China economist and
         John Clemmow from our macro team have highlighted that we have
         seen this practise in widespread use in China over the past six months.
         Tao suggests that this trade accounted for much of the US 90bn of non-
         FDI capital inflow into China in Q1 2011

Overall, there is a dual incentive behind all these positions; an increased
attraction towards risk, and an increased bearishness on the dollar.




                                                                                     UBS 9
Commodities & Mining Q&A 12 May 2011


When carry trades unwind
In our view carry trades – in this case short dollar/long commodity and ‘EM
growth exposure’ risk become exceptionally dangerous when they become
extended, and they become exceptionally dangerous when they are heavily
crowded.

Simply by becoming overextended, the trades start to offer weaker risk/reward
opportunities. Then any precipitating factor undermining the trade can lead to
profit taking at the margin.

The past fortnight has seen three key precipitating factors. First, as we
mentioned above, was the clearly hawkish tone from the Chinese authorities.
Second, was the deterioration in global macro data – which threatened to tighten
forward rate diferrentials between the US and Europe. Third, was Trichet’s
remarks indicating that the ECB was in no hurry to do further rate hikes,
combined with the re-emergence of peripheral European debt concerns.

We now think that a reversal of global capital flows associated with the end of
QE2 will drive a further unwinding of the carry trade, a move that will become
self-reinforcing.

Any profit taking can incur losses both on the long risk positions, but also on the
short dollar/dollar funding positions. And those losses in turn can trigger forced
liquidation of trades, further driving pricing against remaining position holders.

The dangers of excessive positioning, and its potential to cause market moves
with seemingly ‘impossibly small’ probabilities have been documented several
times – most notably by Benoit Mandelbrot in his book ‘Market Misbehaviour’,
and most recently by Antti Ilmannen in his book ‘Expected returns’.

Amaranth, the hedge fund that was excessively positioned in natural gas futures,
saw a 12 standard deviation event go against it. Something that, according to
standard VAR calculations, should not even happen once in the lifetime of the
universe. Last week’s sell-off in oil was, by contrast, a mild five standard
deviation event, that should happen once in 5000 years (basically once in
modern human history). One of the most interesting elements of Mandelbrot’s
book was his analysis of why low probability sell-offs such as these tend to
‘cluster’. In short, volatility begets volatility, because volatility generates stress.
And the more crowded the trade is, the greater the potential for stress.

The additional macro factor involved in this process is that the reversal of global
capital flows that this entails tightens liquidity in emerging markets, restricting
growth in commodity intensive industries, triggering destocking at corporates
and precipitating a deterioration in commodity fundamentals.

We believe that the unwinding of the dollar/commodities and the dollar/risk
carry trade will drive the next leg down for commodities in the weeks and
months ahead.

We see much better risk/reward in the summer, once positioning has pulled back,
once the dollar has bounced, once markets have corrected further, and once
growth has slowed again. In short, once the conditions are in place for the


                                                                                          UBS 10
Commodities & Mining Q&A 12 May 2011


Chinese authorities to ease policy, and for the Fed to debate a further round of
quantitative easing.

A final word on the mining stocks. An important reason behind the post
Fukashima rally in mining stocks was that a divergence had emerged between
earnings momentum – which was positive, and the poor performance of the
shares.

Copper prices have this week broken down through their 200 day moving
average.

Chart 20: Copper price and 200 day moving average


  11000
  10000
   9000
   8000
   7000
   6000
   5000
   4000
   3000
   2000
        09




                                              10




                                                                                 11
                             9




                                                           0
         9




                            09




                                               0




                                                                  10




                                                                                  1
                             9




                                                                   0
         9




                                               0




                                                                                  1
                          l-0




                                                        l-1
       -0




                                             -1




                                                                                -1
                        v-0




                                                              v-1
      -0




                                            -1




                                                                               -1
     n-




                                           n-




                                                                              n-
                         p-




                                                               p-
    ar




                                          ar




                                                                             ar
   ay




                                         ay




                                                                            ay
                    Ju




                                                      Ju
  Ja




                                        Ja




                                                                           Ja
                      Se




                                                            Se
                      No




                                                            No
 M




                                       M




                                                                          M
 M




                                       M




                                                                          M




                    Copper price daily (US$/t)   Copper price 200 day mov ing av erage (US$/t)


Source: Bloomberg


We now anticipate that earnings momentum will deteriorate sharply, as base
metals prices have fallen below many analysts forecasts, and as cost pressures,
which we think the market is systematically underestimating, continues to power
forward.




                                                                                                 UBS 11
Commodities & Mining Q&A 12 May 2011




   Statement of Risk

We point out to investors the potential risks inherent in commodities markets,
including but not limited to, their volatile nature, which may differ materially
from expectations. Furthermore, this asset class is exposed to political, financial,
operational and liquidity risks, each of which has the potential to significantly
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part of his or her compensation was, is, or will be, directly or indirectly, related
to the specific recommendations or views expressed by that research analyst in
the research report.




                                                                                       UBS 12
Commodities & Mining Q&A 12 May 2011


Required Disclosures

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UBS Investment Research: Global Equity Rating Allocations
                                                                                                     1                                2
 UBS 12-Month Rating                   Rating Category                                     Coverage                      IB Services
 Buy                                   Buy                                                       52%                             41%
 Neutral                               Hold/Neutral                                              40%                             37%
 Sell                                  Sell                                                        8%                            20%
                                                                                                     3                               4
 UBS Short-Term Rating                 Rating Category                                     Coverage                      IB Services
 Buy                                   Buy                                               less than 1%                            30%
 Sell                                  Sell                                              less than 1%                            17%
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UBS Investment Research: Global Equity Rating Definitions
 UBS 12-Month Rating                   Definition
 Buy                                   FSR is > 6% above the MRA.
 Neutral                               FSR is between -6% and 6% of the MRA.
 Sell                                  FSR is > 6% below the MRA.
 UBS Short-Term Rating                 Definition
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                                       because of a specific catalyst or event.
                                       Sell: Stock price expected to fall within three months from the time the rating was assigned
 Sell
                                       because of a specific catalyst or event.




                                                                                                                                UBS 13
Commodities & Mining Q&A 12 May 2011


KEY DEFINITIONS
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Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report.




                                                                                                                             UBS 14
Commodities & Mining Q&A 12 May 2011




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