I spent the first three days of this week in Perth, seeing investors and West Australian-based companies. It was certainly an interesting time to be there with a major LNG conference on, which attracted many of the CEOs of the world’s largest oil & gas stocks, while the Prime Minister and Federal Cabinet were also in town.

In my live TV cross to Peter Switzer from Perth on Tuesday night, I did mention that the most untold story in Australia in 2016 was the positive performance of commodities and commodity stocks (e.g. Fortescue (FMG) has doubled from its January low).

The question is: what is driving it and will it continue?

China, resource stocks and pervasive negativity

Investors have long memories and plenty of scar tissue. As such, dramatic crashes such as the GFC are never forgotten. Similarly, counter trend rallies against a backdrop of pervasive negativity are always viewed with great scepticism. The problem with an entrenched mentality is that it usually blinds you to an opportunity or a trend change.

The growling from the China permabears increased to a loud roar following the $US5 trillion equity meltdown last year. More recently, the devaluation of the Renminbi and rising debt-related bank fears confirmed (or so it seemed) that the Chinese economy was ready to implode.

Set against a background of negative Chinese sentiment and increased supply concerns, commodities have been in a bear market, since peaking in 2011. However, after plumbing multi-year lows in February, resource stocks have found new support. Indeed, since early March, the resource sector has relatively and absolutely outperformed.

Certainly, there is much investor scepticism surrounding the recent resource rally. The consensus view appears to suggest that commodities are rallying with the weakness in the US dollar.

There’s no doubt the US dollar has weakened. Gold is a prime example. But what is driving the resource and commodity recovery? Is it just US dollar weakness? Is the current move sustainable or is the rebound merely a bear market rally or a counter cyclical trend?

Signposts and reflection points

A number of data points and events have occurred recently, which, on reflection, could be viewed as turning points for both the Chinese economy and commodities.

Firstly, on March 1, the Peoples Bank of China (PBOC) announced a 50bp cut in the RRR (reserve requirement ratio), the 5th easing in the current cycle. This was a very important event, given the easing came at a time of recent capital outflows and dramatic currency depreciation. The message was clear. The government was re-committed to pro-growth rather than RMB stability.

Secondly, at the National People’s Congress on March 5, the Chinese government committed to a 6.5% -70% per annum growth target. This remains consistent with the long-term aim of doubling economic growth from 2010 to 2020. Premier Li Keqiang stated that it was “impossible” to miss this year’s growth target. Following the weakest Chinese GDP growth in 25 years of 6.9%, this was very reminiscent of the famous Draghi “ whatever it takes” comment.

Thirdly, at the same time, the National Development and Reform Commission committed an extra RMB 600b into the Special Construction Fund, up from the Q1 figure of RMB 400b.This compares to RMB 800b for the 2015 full year. In addition, the government announced an RMB 1.65 trillion road building initiative and an RMB 800b railway program.

Fourthly, after rising from 2.3% to 3% in March, the PBOC announced the possibility that the fiscal deficit-to-GDP ratio could be raised to as high as 5% in order to stimulate growth. It’s worth noting that while the economy has grown since the GFC, the fiscal deficit-to-GDP rose to 2.8% in 2009, after the massive RMB 4 trillion stimulus.

Fifthly, it appears that the government has been successful in re-stimulating growth, with a pick up in the trade balance. As a result, after a $US600bn fall in FX reserves last year, recent figures revealed March FX reserves increased by $US10b. While it’s early days, the government appears to have stabilised both the falling Renmimbi and the FX reserves outflows. This will allow a further refocus on economic growth.

Sixthly, the economy officially edged back into expansion with the March PMI manufacturing index rising to 50.2 from 49.4 in Feb. This followed a slump to as low as 47 last year.

Seventhly, Chinese iron ore import data for March of ~86mln tons, +17% month-on-month & 7% year-on-year (yoy).

Lastly, the property sector accounts for 15% of Chinese GDP growth. As such, it’s an easy policy move to stimulate housing in order to support growth. In this regard, new housing construction in Feb spiked to 13.7% yoy growth. The latest figures show that new home prices in 70 cities rose by 2% in February, the third month of rises after 15 straight months of declines. It appears that housing is recovering. This is a big positive.

New commodity bull market?

Despite the negative sentiment and doomsday scenarios, China seems to have averted yet another crisis. It appears that the lowest economic growth in 25 years was the inflection point for a government policy change from reform to growth. Make no mistake, this is an important development.

To be sure, China faces many economic difficulties, which will continue to create further uncertainty. But there is no denying the government has the firepower to stimulate growth. Clearly, growth through fixed asset investment and the housing market continues to be a priority. This is very positive, given both remain very commodity-intensive sectors.

There’s little doubt that at $15, with BHP Billiton (BHP) as a proxy for the sector, resource stocks were priced for a Chinese meltdown and recession. Maybe just the hint of a rebound in economic growth rather than a recession is enough to see new resource sector inflows money rather than short covering.

However, it’s not just a rebound in Chinese growth, which is improving the outlook for commodities and the resources sector. There are other positives.

The dramatic fall in commodity prices has already resulted in a significant cutback in exploration budgets. The result will be lower future production and, ultimately, a supply deficit in some commodities. This is already being reflected in a rise in consensus forecasts.

In addition, the huge cutbacks in cap-expenditure and expansion plans by the major resource companies have improved cash flows and supported balance sheet repair. Similarly, a reduction in dividend payments has further improved the outlook for industry profitability. Further, significant cost-out programs have been implemented to offset falling revenues. Lastly, valuations are at multi-decade lows.

It’s difficult, if not impossible, to determine in real time whether resources have entered a new bull market after a five-year downturn. Time will tell. Meanwhile, both the micro and macro outlooks are improving. That could be enough for further relative outperformance, particularly with the headwinds facing the banking sector.

Obviously, the key large cap Australian stock in this debate is BHP Billiton. Even despite this week’s bounce, BHP is lagging its two key commodities iron ore (pink) and oil (green) (see chart below). That suggests BHP has further to run to the upside and my old friend Peter Switzer was right when he thumped the table on BHP down at $15.00. My advice would be to continue to hold BHP as you have already taken the pain: from here could well be gain. The knife has stuck in the deep value floor.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.