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Rob James

Globe WorldWatch

EM Miners: Time to Dig Deep

WorldWatch
15 September 2021

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Emerging Markets Portfolio Manager

Covid has blown fiscal holes wide open in many emerging economies, which are now looking to plug the gap by increasing taxation of sectors benefiting from elevated commodity prices. The future of investing in EM mining stocks is more opaque and problematic than at any point since the Global Financial Crisis. Risks abound, but so do opportunities. A focus on geographies with more rational governments is the best place to start. First, get the politics right.

Long political covid will outlast the epidemiological phenomenon. The economic equivalent of the cytokine storm is brewing and Emerging Markets lie in its path. The tactics adopted to negotiate the legacy of the pandemic will be idiosyncratic, but if the past (and some of the present) is any guide, many resource-rich governments will aim to rebalance budget deficits through increased taxation of sectors benefiting from record commodity prices. Equities are always an imperfect vehicle for exploiting the latter, and current political and environmental trends in many geographies suggest they may become even more so before the pandemic is over.

There was a time, way before the fixation on demographics, emergent middle-classes, disruptors and newly-enabled consumers, when investors only visited the wilder shores of Emerging Markets to see what resources could be dug up from the ground there and carried off somewhere else where they might be useful. In the beginning, Emerging Markets were all about mining and drilling, and the close correlation between MSCI EM and SXPP still persists. From a risk perspective, it usually feels like the same trade. Emerging economies have nearly all diversified dramatically over the last three decades, but not nearly enough to avoid resorting to periodic raids on their favourite piggy bank when the money runs out. In some countries there are few alternatives to tapping resource exports for additional taxes because, like the notorious armed robber Willie Sutton replied, when asked why he targeted banks, “that’s where the money is”.  

Higher taxes pose the single biggest risk for global metal and mining companies, especially when many of the assets are operated by state-owned enterprises or multinationals in less-developed geographies. Squeezing foreign entities – taking money off Peter to pay Pablo – often makes for bad economics but good politics. Ballot box considerations and the short-termism of the electoral cycle trump sound, long-term financial planning. At this stage many commodity-exporting nations seem oblivious to the political difficulty inherent in unwinding higher taxation at the inevitable point in the future when the cycle turns. Parliamentary opposition, playing the populist joker, can hold a government’s feet to the fire when it comes to reversing tax hikes, promising simple solutions to complex problems. 

This threat, the irresistibility of what are essentially windfall taxes, explains the discrepancy between all-time highs for iron ore, copper, palladium and steel prices, and the still relatively modest valuations attached to global mining stocks, with investors demanding very high dividend yields to hold them. 

Elevated commodity prices are partly a function of longstanding supply issues in commodity markets as miners delay investment and new projects. These issues were compounded by the pandemic. While the production shortfalls caused by last year’s economic shutdowns have eased, the long-established supply constraints have now collided with a huge increase in demand, driven by a cyclical global recovery and the themes of electrification and decarbonisation, which are themselves commodity-intensive. This should ensure that most metals will trade well in excess of marginal cost for the next few years. The dilemma for fund managers is finding stocks in the right political and fiscal geographies to exploit commodity price inflation.

Peru – a case in point…

The election of a man wearing an outsized hat as president of Peru will prompt a fluttering in the dovecote of many EM investors, as well as the 49.9% of Peruvians who voted against him. Time alone will tell, but the radical manifesto of Pedro Castillo, and the Marxist credentials of some members of the cabinet he has been assembling, suggest the direction of travel is more likely towards Venezuela than Singapore. 

Swearing in the alarmingly left-wing Guido Bellido as prime minister provided no reassurance. Castillo’s campaign slogan, “No more poor people in a rich country”, summons up the spirit of Hugo Chavez rather than Adam Smith. In common with many fragile economies, the pandemic has blown a huge hole in the Peruvian budget and the instinct will be to plug it with higher taxation. Sadly, more often than not, this strategy leads to more poor people in an even poorer country. 

Peru is a case in point because it exemplifies many of the characteristics familiar to other Emerging Markets. Demagogues, worshipping the false gods of populism, promise voters the earth – and the riches to be extracted from it. Castillo is inheriting an economy still devastated by Covid. Two million people have slipped back below the poverty line since the virus arrived. For the sake of the beleaguered Peruvian economy, one can only hope he ran left for office but governs with a swing to the right. Castillo promised to renegotiate the tax stability agreements so essential to outside investment. He proposed doubling the share of profit-take to 70% in order to fund spending on healthcare, education and the reduction of income inequality. This won him the election but may deter future inward investment. The sol lost 10% and featured among the worst-performing EM currencies in the three months since he claimed victory.

It remains to be seen how the multinationals react. The tactic employed by the likes of Anglo American, Freeport McMoran and Chinalco – all of which have significant exposure to Peru and long-term tax stability agreements – has been to keep schtum and ‘wait-and-see’. Until recently, Peru was considered the second-best mining jurisdiction after Chile and occupied the cheaper half of the tax regime table.

The problem for global mining companies and equity market investors is that no one raises the tax burden in isolation. Indeed, much of what threatens to develop in Peru was inspired by a change in the investment climate next door in Chile. There, popular protests against the cost of living and income inequality forced the government into social spending promises that could only be met with increased taxation of the mining sector.

Earlier this summer the Chilean lower house approved a package of measures which included royalties on copper and lithium sales, as well as a mechanism on marginal rates as copper prices rise above $4/lb that would be the world’s highest at almost 80%. The progressive tax on revenues, instead of on EBIT, would result in higher tax rates. The new effective tax rate of 21.5% won’t be introduced until 2024 as some major agreements expire the year before and the Chilean government is clearly at pains not to risk abrogating contractual commitments from which its reputation may never recover. Some of the more extreme measures – feared if Communist party presidential candidate Daniel Jadue had been nominated – will not now materialise after he recently lost to a more moderate left-wing representative in the primaries. The relief felt by the stockmarket was palpable and immediate. 

Still, with Chile accounting for almost a third of world copper production at 5.7mt pa, and Peru contributing another 2.2mt, the colossal impact of this shift in taxation will be felt across the global supply chain. Even economies like Australia and Russia, which carry a fiscal surplus and operate under less pressure than Chile and Peru, will find it difficult to resist the temptation. They can afford to lift taxes incrementally and still remain competitive. The overall trend, therefore, will be upwards. Most of the tinpot dictatorships or more volatile democracies in Africa have long been unpredictable and turbulent partners for foreign direct investment, but the decline in reliability in regimes perceived as more consistent is a worrying development for the global majors.

Elsewhere in LatAm, the Brazilian government also made tax reform proposals in June, eliminating the Interest on Capital benefit. Zambia, Mongolia and Papua New Guinea are exploring options for upping the tax-take. Russia, never slow to impose extractive tax policies when commodity prices boom, duly went ahead and slapped a temporary export duty of approximately 15% on steel, aluminium, nickel and copper. Nothing can become more permanent as the temporary. While they are at it, they are also contemplating similar measures on precious metals and a mineral extraction tax. The Russian government has always regarded a contract as merely the first stage in a series of negotiations, and investing in resource stocks here is always likely to demand a leap of faith from the fund manager. 

Colbert’s maxim stated that the art of taxation was plucking the maximum amount of feathers with the minimum hissing, but some of the majors are starting to squawk. BHP’s president in the Americas has warned, with admirable euphemism, that “the reforms being put forward (in Chile and Peru) right now will be really quite damaging to the industry”. For their part, the miners could play a smarter game and adopt more adept PR. They could comply more readily with environmental guidelines and engage more pro-actively in social programmes to alleviate some of the frequently justifiable criticisms leveled at them.

Ironically, a focus on some regimes hitherto regarded as high-risk may prove advantageous if, for example, the Chinese exert influence there and have economic purchase on governments, forcing them to adhere to contractual obligations. Some more autocratic governments may transpire to be easier to deal with if they have fewer concerns about being re-elected.

For asset managers, though, the future of investing in EM mining stocks is more opaque and problematic than at any point since the Global Financial Crisis. Commodity prices remain elevated and demand robust, but fiscal, environmental and regulatory challenges are mounting. As a result, share prices will likely continue to lag the underlying commodities. However, there are parts of the market where this risk is more than fully discounted in our view. Take Impala Platinum, for instance, which during the 2005-2008 bull cycle averaged an EV/EBITDA multiple of 8x. Consensus currently prices it uncharitably at around 2x 12m forward. Unsurprisingly given the chaos of the past 18 months, risks proliferate, but so do opportunities. A focus on geographies where governments are either rational now – or may be soon – is the best place to start. First, get the politics right.

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