Some Mining ETFs Are On Shaky Ground

Markets Benzinga

The materials sector is one of the smallest sector weights in the S&P 500, but that status is not preventing the group from turning in a solid showing in 2017. The Materials Select Sector SPDR (NYSEARCA: XLB), the largest materials exchange traded fund by assets, is up more than 13 percent year-to-date.

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Drilling down into the broader materials sector, some analysts see weakness afoot for metals and mining equities. Broadly speaking, ETFs tracking such stocks have been laggards this year, as highlighted by a mere 5.3 percent year-to-date gain for the SPDR S&P Metals and Mining ETF (NYSEARCA: XME).

XME provides equal-weight exposure to miners of gold and silver as well industrial metals miners and producers, meaning the ETF is also exposed to demand trends for the likes of aluminum and copper, among other metals.

Of Course It's About China

As the world's largest commodities consumer, China remains a key driver of price action in ETFs like XME. That may be alright for now, but some analysts believe that theme could be a problem in the not-too-distant future.

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With few exceptions, we continue to see mined commodity and miner share prices as overvalued, propped up by Chinese stimulus, said Morningstar in a recent research note. Iron ore's relative buoyancy since early 2016 is emblematic of most industrial commodities.

There are signs that China's ability to prop up demand for industrial metals could be weakening, which could signal downside for ETFs such as XME.

We do not expect this to last, said Morningstar. With China's credit growth slowing, we continue to expect mined commodity prices in general, and particularly iron ore, to fall materially and for share prices to follow. Miners we cover are generally substantially overvalued, and few trade in line with our fair value estimates.

More About XME

XME holds just 29 stocks, about 18 percent of which are gold and silver miners. While precious metals miners are typically responsive to price trends in those underlying metals, XME's exposure to gold and silver is not enough to obfuscate its potential vulnerability to industrial metals weakness.

Alone, steel stocks are 47.5 percent of XME's weight, exposing the ETF to metallurgical coal and iron ore demand trends. Aluminum equities account for 11.3 percent of the ETF's roster.

We forecast a significant deceleration in aluminum demand growth and anticipate that the impact of capacity cuts will prove far overstated, according to Morningstar. Accordingly, we forecast a long-term aluminum price of only $1,475 per metric ton (in real terms), nearly 30 percent below current levels.

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