Better cyclical demand should increase conviction around base case commodity prices which together with historically attractive valuation, a four decade trough in company fundamentals and continued supply discipline, should drive equity outperformance. Raise sector to Attractive and RIO/BHPB to OW.

Stable data from China in the last few months with a potential uplift from recent financial and administrative stimulus policies should increase conviction that the 19% commodity price uplift by 2017 and the base case deck is achievable. That would be a sharp reversal from the experience in the last 18 months. This should trigger a tactical re-rating of the sector and upgrade Rio and BHPB to OW and Anglo American to EW. The sector trades at historical lows since the global recession of 1982 both in absolute and relative terms using P/B vs RoE.

"Our analysis of outperformance of European metals and mining equities pre the super cycle also shows that current valuation is very close to those periods. On our base case price deck our OW rated stocks trade on 14x PE and 9% FCF yield 2016e.That alone is not enough to drive equity outperformance. However, it is critical to force supply discipline on the industry to support rising commodity prices. We expect that discipline to be maintained. Even on our base case price assumptions, BHPB and Rio's RoCE only rises from the four-decade low of 4% post tax to just 6% in 2016",says Morgan Stanley.

Supply discipline accelerating. Weakening balance sheets and declining availability and higher cost of debt have accelerated the process of capacity adjustment. With many commodity prices still sitting so deep in the cost curve process is set to continue. Furthermore, it is believed that all cost savings made to date are sustainable and expect a partial reversal to further support supply discipline.

"September and October are seasonally weak months with destocking ahead of winter in the Northern Hemisphere. Iron ore remains a critical cash flow driver for the sector. We still expect seaborne iron ore supply growth to exceed growth in China's steel consumption. Finally, during the global recession of 1982 the sector traded on a trailing P/B of 0.47x versus 0.85x today and copper traded around the 50th percentile of the cost curve. To mitigate the impact of these risks our OW-rated stocks all have either strong balance sheets or close to net cash and continue to generate FCF on spot commodity prices",added Morgan Stanley.