In light of the recent China monetary stimulus package, we revisit our previous Rio Tinto Trade idea as we see an identical set-up both in price and narrative that led to a 12% rise in spot from our trade entry. On the back of worsening deflation coming out of China, stock market levels at depressed levels and demand nowhere to be seen, China has launched a series of monetary measures. Although these initially aim to provide internal financial stability to industries directly linked to the stressed housing market, they nonetheless signal China’s willingness to provide additional fiscal support, alleviating the markets’ extreme bearishness on the Chinese market.
Iron ore continues to be one of the worst-performing commodities in 2024 so far, on the back of weaker Chinese demand, as the in-crisis property sector makes up c.30-35% of China’s steel demand, lagging the rebound in other metals like Gold, Silver and Copper (which is more linked to China recovery). Iron ore prices are expected to benefit from rate cuts, with a 100bp decrease in US 2Y yields expected to lead to a c.4% rise in prices for industrial metals. The obvious play to our mind continues to be Rio Tinto, as the Iron ore segment generates c.78% of Rio’s EBITDA and c.95% of its free cashflow. Even though one could argue that the recent 15% run-up from the summer lows appears overextended justifying a pullback in the short term, the favourable structural improvement for the mining sector still remains attractive in the medium to longer term.
Within the major European Miners sector, Rio is attractive in terms of valuation as it is the only EU major to trade at a discount to its long-term price to book, paired with the lowest debt among the peer group, supporting its superior dividend yield. Another illustration of the depressed valuation is looking at the gap between street fair value vs. current spot, which implies a further 12% upside to spot. We believe this may be conservative as it is unlikely that they have reflected the potential for structural improvement supportive of higher iron ore prices yet.
With the stock trading at a 9% discount to its long-term P/B and 6M ATM volatility at 2YPc11 we suggest buying 2x Mar25 6000 calls financed by 1x Mar25 4400 Puts at a net cost of 0.33% of underlying (spot ref: 5249, Fut. ref 5211). Should the spot price increase by 5%, the value of the strategy would return c.20x on net premium employed, all other parameters remaining equal. Alternatively, you are left holding the stock at mid-2020 price levels, implying a 1.5x PB at a 24% discount to its long-term rating.