Mining earnings improvements will drive rerating, Morgan Stanley says

Metals and mining company shares have endured an "excessive pullback", said Morgan Stanley as it saw meaningful upside for the likes of Anglo American and Glencore for the first time since the start of 2017.

The sector has materially underperformed and is now trading on an attractive absolute and relative valuation, with financial risk seen as low in terms of leverage and the demand outlook marginally improved versus the section quarter with China accelerating infrastructure spending to counteract the impact of global trade friction, with infrastructure representing 30-40% of China's demand for key commodities.

"The industry has changed," Morgan Stanley analysts wrote, with capital allocation better balanced, cost efficiency prioritised and dividends now the "cornerstone" of investor returns.

Although China reforms lends support, the analysts are not yet calling for a fundamental re-rating "as more time needs to pass to convince markets this is not a fad", rather expecting improving earnings to drive a re-rating.

Glencore was upgraded to 'overweight' from 'equalweight' with a share price target of 390p, the first time it has received this rating since the stock was covered in 2013.

"We think the equity market is finally reflecting Glencore's geopolitical risks post the $5.4bn adjustment in market cap. We also reflect these risk in our estimates, but the financial impact of that is offset by consistently high thermal coal prices," analysts said, also admiring the 5.3% dividend yield.

"The company is reacting to the improved valuation of its own equity by switching from opportunistic M&A to share buy backs."

With concerns around mid-term demand holding back thermal coal industry investments in infrastructure and mines in the near-term, keeping markets tight, analysts said this increases the probability that the actual price development beats the 39% fade expected by 2020.

Glencore therefore joined Anglo American, also at 'overweight' with a target price of £20, as one of Morgan Stanley's preferred stocks.

BHP Billiton was downgraded to 'equalweight' from 'overweight', with a 1,770p target, as the equity market "now fully appreciates the value of BHP's assets in our view" and the commitment to return proceeds from its petroleum asset sale to shareholders underpinning the share price "but does not create additional value".