The federal government's latest budget makes for alarming reading! This is not because of the forecasted big budget black hole, but its expectations that the iron ore price will halve before the end of this calendar year.
The iron ore miners have been doing much of the heavy lifting on the S&P/ASX 200 Index (Index:^AXJO) as they are regarded as some of the safest stocks to buy during the COVID-19 mayhem.
That's more than what can be said for the other major ASX sector – the banks. The National Australia Bank Ltd. (ASX: NAB) share price, Westpac Banking Corp (ASX: WBC) share price, Australia and New Zealand Banking GrpLtd (ASX: ANZ) share price and Commonwealth Bank of Australia (ASX: CBA) share price have underperformed in 2020.
Government's bearish iron ore forecast
But can investors continue to count on our mining giants if the iron ore price is set to tank, as forewarned by the government?
Treasury is sticking to its US$55 a tonne price forecast for 2020. This price is free-on-board (FOB), which excludes the cost of shipping. The current spot price of around US$108 a tonne includes shipping, but if you strip that out, the implied spot FOB price is around US$100 per tonne.
The bearish prediction stands in contrast to the resilient price of the steel making ingredient, which hasn't been impacted by the global coronavirus pandemic.
Threat to big ASX miners
Strong demand from China and supply disruptions from our iron ore competitor, Brazil, have given our miners an upper hand.
But the government isn't willing to keep banking on these tailwinds and decided to take a far more conservative assumption, reported the Australian Financial Review.
If the government's projections are right, the BHP Group Ltd (ASX: BHP) share price, Rio Tinto Limited (ASX: RIO) share price and Fortescue Metals Group Limited (ASX: FMG) share price are set to crumble.
The good news is that experts aren't taking the budget forecast for iron ore seriously – certainly not as seriously as they are treating the $184 billion budget deficit the government is expecting in FY21.
Why ASX investors shouldn't worry
Treasury assumptions have a tendency to be overly pessimistic as the government has much more to gain by getting underestimating the iron ore price. This allows the Morrison government to under-promise and over deliver on its budget.
However, this doesn't mean that the iron ore price won't fall off its perch. Most analysts are pegging a price of around US$80 a tonne for the commodity for FY21.
Again, this isn't something that worries me even though I'm overweight on the sector. If the iron ore price does drop by that 20%-odd amount, the sector looks fair value.
Big earnings upgrades possible
But if the iron ore price continues to defy expectations, this will lead to substantial earnings upgrades for the three major miners.
To give you an idea of the magnitude of the potential upgrade, the analysts at Macquarie Group Ltd (ASX: MQG) estimated that at the spot price, FMG's earnings would be upgraded by around 79%, Rio Tinto by 39% and BHP is 24%.
But let's not count our chickens just yet…
