macro kaki: Chinese steel production angst in the spotlight

11 Oct 2021

By Mooris Tjioe, Analyst, Phillip Futures

This week in summary

  • Commodities are returning to all-time highs, with the Bloomberg Commodity Spot Index (BCOMSP) reaching its highest level since 2011.
  • China is ordering more funding for coal companies to increase output, while also importing record amounts of coal to combat crippling power shortages.
  • A near-term US government debt default has been averted, with Senate Minority Leader Mitch McConnell offering deal to raise debt ceiling into December.

Chinese steel production angst in the spotlight (6-min read)

Prices of steel are at their highest levels ever. Steelmaking stocks are soaring.

IN SUMMARY

  • Iron ore prices have gotten crushed by Chinese steel production curbs
  • Steel and mining stocks have in turn fallen thanks to low iron ore prices
  • Efforts to increase steel output in an “environmentally friendly” fashion may be years away
  • Falling steel supply from China, rising steel demand globally, and “cheap” iron ore is however seeing non-Chinese steelmakers report their highest profits in decades

Iron ore sees epic -59% tumble after Chinese production cuts

Chinese officials have ordered steel production cuts across the country since May to meet carbon emission targets, causing a 59% plunge in the price of iron ore as seen in Chart 1. After all, nearly all iron ore is used in steelmaking, and China’s is perhaps the world’s foremost consumer of iron ore, having long ranked as the largest steelmaker in the world by a very wide margin.

Chart 1: Bloomberg data on iron ore spot prices from July 2020 to Oct 2021

Furthermore, ongoing turmoil amongst Chinese property developers led by bond repayment woes at China Evergrande Group has lowered the outlook for China’s steel demand in the near-term, given the now-depressed outlook for commodities relevant to real estate construction.

Chinese steel production may be down – but steel demand remains red-hot

Chinese steel output surged to pandemic recovery-fueled highs earlier in the year as producers deliberately “front-loaded” their output in H1 2021, leading to steel production figures 12% higher than the same period in 2020. However, this also had the added – perhaps unintentional effect of attracting regulatory ire, from government officials who were at risk of being unable to meet President Xi Jinping’s demands for improvements on emissions controls, particularly to ensure clean weather and “blue skies” before the 2022 Winter Olympics in February.

When regulators demanded sharp and immediate curbs on production in May while slapping tariffs on some steel-related products as well, steel production and consumption immediately crashed back into end-2020 levels, as seen in the -30% plunge in Chart 2. Given the severity of current curbs, it is still uncertain if steel production, will recover in the coming quarters.

Chart 2: Bloomberg data on Chinese steel demand and supply across past 7 years

Taking reference to Chart 2, we should also note the Chinese demand for steel leading up to 2021 has been incredibly strong, breaching 1 billion metric tonnes for all of 2020.

Most of China’s demand for steel has also typically been met by domestic suppliers, making any curb on domestic steel production especially hard to overcome – thanks to importers being generally unable to match the sheer tonnage of steel required. To underscore the gravity of China’s current supply crunch: while regulators will be aiming to cut steel production by over 100 million metric tonnes in 2021, China only imported around 40 million metric tonnes of steel in 2020, meaning that imports may only be able to make up less than half of the impending shortfall.

TL;DR: Unless the local steel supply situation improves, Chinese manufacturers may be looking at a massive shortfall in steel supplies, both lowering the outlook for economic growth – while driving up steel price expectations.

What has this affected so far?

Mining and steel-related stocks such as Vale SA, Ternium SA, Nucor Corporation, ArcelorMittal SA, and Rio Tinto have all seen increased volatility on the news for almost the last half-year.

Chart 3: Selected iron/steel stocks % returns (above) and Bloomberg index of global iron/steel stocks (below) for 2021

From Chart 3, we can see that ‘pure-play’ iron ore miners such as Vale (-18.0% YTD) and Rio Tinto (-11.8% YTD) have fallen especially hard thanks to the epic plunge in iron ore prices. Meanwhile, ‘hybrid’ steelmakers and iron ore miners such as Ternium SA (+46.8% YTD) and ArcelorMittal (+26.7% YTD) have seen market-beating returns for the year so far, largely rising on the world’s growing post-pandemic appetite for steel.

The sharp plunge in iron ore prices has also notably dampened investor sentiment in the mining operations of both Ternium and Arcelor Mittal, but both remain firmly in the green for the year perhaps thanks to their vertical integration with their own iron ore supplies – in stark contrast with Vale and Rio Tinto.

ArcelorMittal – the largest steelmaker outside of China, has been having a bumper 2021 so far despite the plunge in iron ore prices, most recently announcing a plan to triple their “premium” iron ore production in Liberia just last month.

Is the sell-off for steelmakers however, overdone?

Leaving China for the moment – and using the USA as a proxy for steel demand elsewhere in the world, Chart 4 showing steel prices paints a telling (and perhaps alarming) picture.

Chart 4: Federal Reserve Economic Data steel price benchmark from 2017 – 2021

Since end-2020, steel prices appear to have tripled, pushing up the profit margins of steelmakers particularly in the USA. Increased demand for steel for US housing and infrastructure – particularly in the face of President Biden’s impending infrastructure bill – is sending steel prices to its highest levels ever.

Already in the USA, skyrocketing steel prices have incentivised steelmakers to increase production, causing utilisation rates (% of steelmaker capacity) to surge to 84.8% – a massive surge from the sub-70% rates seen around the same time last year. Accordingly, steelmakers are enjoying some of the best profits they’ve seen in decades, helped along by the recent cratering in iron ore prices.

TL;DR: Even as steel prices have gone through the roof, iron ore prices have cratered. The verdict? Increasingly happy steelmakers with incredibly strong margins.

Is the sell-off for steelmakers however, overdone?

Given that the current angst in iron ore and steel markets have been sparked by the Chinese government’s desire for a “greener” economy with lower emissions (some say for at least until next February’s Winter Olympics in Beijing), short of firing up dirty coal-powered generators again, forthcoming solutions likely have to meet those same environmentally-friendly objectives.

Here we talk about two plausible solutions for the world’s largest producer of steel, and why the current situation suggests that they may not be in time to ease China’s current output crunch.

#1 Electric Arc Furnaces

One alternative that Chinese steel producers may look to is to focus more on Electric Arc Furnaces (EAF) – where furnaces are heated with electricity rather than traditional fuels such as coal.

EAFs currently make up around 15% of China’s total steel output, with traditional blast furnaces making up the rest. While this represents rapid growth – EAFs made up only 6% of China’s steel output in 2018, market observers expect the higher costs involved in EAF steelmaking as compared to using blast furnaces to slow its growth over the next few years.

Estimates from S&P Global Platts places the price of 100% scrap steel processed through EAFs to be 150 RMB/mt higher than that of conventional methods, a problem likely to be compounded by China’s ongoing efforts to wean its power grid off the already cheaper, more polluting coal-fired power generators and blast furnaces.

TL;DR: While EAFs are promising, high costs suggest that substantial adoption may be years away, even with state support.

#2 Accelerate scrap metal industry development

Another strategy that China may have to employ would be improving its scrap metal supply chain, and to increase scrap metal imports – while improving the ‘scrap utilisation ratio’ in their current set of steel mills. While this is a likelier – and cheaper option for the Chinese economy, many expect that tightness in scrap supply will be hard pressed to keep up with demand given the recent steel supply cuts, and may face difficulty in further expansion in the future.

TL;DR: Scrap metal supply chains in its current state will find it hard to meet prodigious Chinese steel demand in the near-term.

Thus – short of a massive turnaround in the regulatory posture towards the Chinese steel industry, it remains likely that global steel production will remain depressed in the near-term. Attempts to import more steel to meet China’s growing industries may also find themselves competing with demand for steel in other recovering economies around the world, thus suggesting that an upwards squeeze on steel prices from the sheer intensity of the demand spike and supply plunge may continue, heading into 2022.

Time-travelling Chinese stocks can’t catch a break (5-min read)

Stocks have been kicked back into 2017 by some measures. How much further back will they go?

IN SUMMARY

  • The Hang Seng Tech Index (HSTECH) recently reached a record low – lower than when it launched in July 2020
  • The current drawdown in Chinese stocks is (perhaps unbelievably) consistent with historic trends
  • Bear markets are also a nearly-annual occurrence – with the MSCI China Index still outperforming the S&P500 over a 20-year timeframe

Chinese technology stocks have lagged all benchmarks since February crash

The Hang Seng Tech Index (HSTECH) is perhaps a good barometer of Chinese technology stock sentiment, having heavy weightage in several familiar names.

HSTECH ConstituentsWeightYTD
Pos.Company(%)(%)
1Alibaba Group10.6-32.5%
2Sunny Optical9.09+9.3%
3Xiaomi Corp8.30-40.0%
4Meituan7.71-12.7%
5JD.com7.70-13.6%
6Tencent Holdings Ltd7.43-15.5%
7SMIC5.38+1.2%
8JD Health4.70-49.5%
9Kuaishou3.86-71.3%
10Shenzhen Kingdee3.73-17.6%
Table 1: Top 10 Constituents of HSTECH

And as the foremost index tracking Chinese technology stocks (apart from perhaps the NASDAQ Golden Dragon China Index (-31.0% YTD)), the index has somewhat captured the cratering in Chinese technology stock sentiment rather well, given its heavy weightage in stocks that have been singled out by Chinese regulators for censure in recent months.

Chart 5: HSTECH vs HSI % returns for 2021

From the above chart – despite the Hang Seng (-8.8% YTD) falling from 31,000 points in February to around 24,800 points at time of writing, the HSTECH (-26.0% YTD) has notably fallen even harder.

Accordingly, the HSTECH recently reached record lows, having bottomed out at around 5,860 to 5,890 points twice – once on the 20th of August, and again on the 6th of October. Notably, this is sharply lower than even when the Index was first launched on the 27th of July 2020, at around 6,770 points.

However, the benchmark Hang Seng Index – and even Chinese stock benchmarks such as the CSI 300 (-5.6% YTD) and the FTSE China A50 Index (-10.9% YTD) tracking Chinese A-Shares are all also lagging stock markets elsewhere, such as in India, Europe, and the USA.

Believe it or not, these drops are normal for Chinese stocks

However, when looked at from a longer timeframe, these drawdowns in Chinese and Chinese-related stocks appear to be a (unfortunately) normal occurrence within the Chinese stock market.

Chart 6: MSCI China against S&P500 % returns across a 20-year timeframe

Chinese stocks make the US stock market look like an oasis of calm

From Chart 1, a few trends become obvious:

  1. Chinese stocks tend to regularly see massive drawdowns – in 2007, 2011, 2015, 2018, and more recently, in 2021.
  2. Short of making the observation that there appears to be a somewhat-regular 3-year interval between drawdowns, bear markets (at least -20% corrections) can also be observed in around 17 of the last 20 years.
  3. The outsize performance/gap between Chinese stock returns against the S&P500’s seems to be converging – from delivering over 10 times the returns of US stocks in 2007 (albeit a bubble-fueled surge), to less than double since the pandemic recovery began.

The all-important question: Is the bottom in?

Important: Perhaps beginning with an equally important disclaimer – nobody knows how long more the current slate of crackdowns will continue for, given that most analyses had called an end to the so-called “regulatory season” by May-June this year, which has obviously not played out.

Chart 7: HSTECH against the HSI as a ratio across a 5-year timeframe

Looking at the how the HSTECH (back-tested data, as the HSTECH was only launched last July) has been performing against the wider HSI – the HSTECH has fallen since peaking at 0.35 (as a ratio) in February, but notably may have further to fall, given that it only started outperforming the rest of the HSI in mid-2020.

Thus, the bottom may likely not be in for Chinese technology stocks yet.

Under the bearish scenario, investors may wish to exercise caution as opposed to having expectations of a “buy-the-dip” recovery in the coming months, as the Chinese technology stocks may yet continue underperforming the wider stock market.

Chart of the Week

Chart 8: Bloomberg Commodities Spot Index (BCOMSP) across past 14 years

Adding to supply chain jitters, the BCOMSP – that tracks 23 energy, metals, and agriculture futures contracts, has now broken past 2011’s record highs. Recent spikes have been led by energy commodities such as natural gas, which has surged massively amidst shortages in Europe and China, which are both heading into energy-intensive winter months.


What we’re reading

(with no paywalls!)

  1. Standard Chartered values Ethereum at between US$26 – $35K
  2. China energy crisis hitting global supply chains of… everything?
  3. Natural gas and petroleum prices are seeing massive spikes
  4. Screws tightening on Facebook globally, led by whistle-blower in Senate
  5. Korea now has the worst-performing stock index, weighed down by China

Earnings in sight

TuesdayFastenal CompanyPre-market
12th Oct  
WednesdayBlackRock IncPre-market
13th OctJPMorgan Chase & CoPre-market
ThursdayBank of America Merrill Lynch CorpPre-market
14th OctCitigroup IncPre-market
Morgan StanleyPre-market
Wells Fargo & CompanyPre-market
Walgreens Boots Alliance IncTAS
 Domino’s Pizza IncTAS
FridayThe Goldman Sachs Group IncPre-market
15th Oct 
TuesdayBank of New York Mellon CorpPre-market
19th OctJohnson & JohnsonPre-market
Silvergate Capital CorpPre-market
United Airlines Holdings IncPre-market
Interactive Brokers Group IncPre-market
Intuitive Surgical IncEstimated
Netflix IncEstimated
The Procter & Gamble CompanyEstimated
 Phillip Morris International IncEstimated
WednesdayAbbott LaboratoriesPre-market
20th OctCSX CorporationPost-market
Lam Research CorporationEstimated
Paypal Holdings IncEstimated
American Airlines Group IncEstimated
Skechers USA IncEstimated
 IQVIA Holdings IncEstimated
ThursdayIntel CorporationPost-market
21st OctChipotle Mexican Grill IncPost-market
Microsoft CorporationEstimated
Nucor CorporationEstimated
Tesla IncEstimated

CFDs we offer

1ArcelorMittal(MT5: ARCELOR-NYSE) 
2Vale SA (MT5: VALE-NYSE) 
3Ternium SA(MT5: TERNIUM-NDAQ) 
4Nucor Corporation(MT5: NUCOR-NYSE) 
5Rio Tinto Group(MT5: RIOTINTO-NDAQ) 
6Alibaba Group (MT5: ALIBABAGRP-HKEX) 
7Sunny Optical Tech Group (MT5: SUNNYOPT-HKEX) 
8Xiaomi Corp(MT5: XIAOMI-HKEX) 
9Meituan Dianping (MT5: MEITUAN-HKEX) 
10JD.com Inc(MT5: JDCOM-HKEX) 
11Tencent Holdings(MT5: TENCENT-HKEX) 
12JD Health International Inc (MT5: JDHEALTH-HKEX) 
13Kuaishou Technology(MT5: KUAISHOU-HKEX) 
14Kingdee International Software Group(MT5: KINGDEE-HKEW) 
15China A50 Index(MT5: CN50) 
16Hang Seng Index(MT5: HKG50) 

Shares CFD is available for trading on Phillip MetaTrader 5 (MT5).

Features of trading CFD

  • Trade in both the bull and the bear markets
    The ability to enter a long and/or short position allows traders to take advantage of both rising and falling markets.
  • Smaller barrier to entry
    CFDs typically have flexible and smaller contract sizes. This means that traders will be able to enter into a CFD contract with a modest amount of capital.
  • No expiration date or risk of delivery
    Unlike futures which commonly have a fixed expiration date, CFDs allow traders to perpetually hold the position(s). CFDs are cash settled, no need to worry about the delivery of the underlying asset.
An Exchange Traded Fund (ETF) is a marketable security that is formed to track nearly anything, ranging from a specific index, sector, commodity, or increasingly, theme. They are most commonly used to track a basket of stocks, and can typically be accessed through the same channels as regular stocks. ETFs are typically separated into passively-managed ETFs that simply mirror the security they are tracking (e.g. the STI), and actively managed ones that attempt to deliver higher returns or specific investment objectives, often with a pre-specified theme in mind (e.g. ARK Invest’s Innovation ETF).

Why should I trade in ETF CFDs?

  • ETFs have been growing in popularity over the years. 2020 was the best year for ETFs yet, with global equity ETFs seeing more than $1T in inflows within a 12-month period. Using CFDs to gain exposure to ETFs allows for greater capital efficiency because only a portion of the contract value is required as margin to establish a position.
  • ETFs are particularly popular with investors seeking a relatively hassle-free investing experience, while desiring exposure to a range of specific and relatively understandable securities. Trading ETF CFDs brings greater convenience by eliminating the need for traders to hold multiple currencies in order to access global ETFs.
  • An investor wanting exposure to the post-pandemic economic recovery could open a position in the well-known SPDR S&P 500 ETF (SPY), which tracks the performance of the S&P 500. Another investor that may be convinced of the future importance of Environmental, Social and Governance concerns (ESG) may find the increasing selection of ESG-themed ETFs that track a basket of high ESG-rating companies to be a good investment, rather than cherry-picking individual equities by hand. ETF CFDs can act as a powerful tool for traders can profit from both directions of the market by taking on long or short positions.

A look at two ETF CFDs we offer:

1) Has the ARKK been sunk?

ARK Innovation ETF (ARKK) ARKK is an actively managed ETF by ARK Invest that invests in a range of companies based on their innovative and industry-disrupting potential. ARKK’s largest holdings are in companies such as Tesla, Square, and Zoom. ARKK is down around -33% from peaking on 12th Feb and is currently in the red for the year to date as the market experiences a risk-off outflow of funds. Superstar fund manager Cathie Wood has however been consistently doubling down on her bets, buying even more shares in growth stocks that are going through their own tumultuous periods such as DraftKings, Peloton, Teladoc, and Tesla. In her view, ARKK is playing the long game, and remains steadfastly convinced in the long-term prospects of these growth stocks beyond this current bout of volatility. Similarly on outflows, investors are still betting big on ARKK as ARK Invest has only lost about $1.2B in assets this year across all its six funds, compared to seeing an inflow of $15.1B during the same period. Recently, investors have been nervously eyeing ARKK’s basket of tech stocks as their future earnings potential remain vulnerable to erosion through high inflation – the dominant concern of the market in recent weeks. As commodities – the major contributor to the recent heightened inflation fears – drops sharply from record highs, are investor concerns over hyperinflation overblown?

2) Searching for exposure to Asian equities?

iShares MSCI Asia ex Japan ETF (AAXJ) The AAXJ is currently trading -10.6% adrift of all-time highs seen in February, giving up gains in tandem with an Asia-wide equity sell-off at the time. Given that slightly over 40% of the ETF’s holdings are based in China, the ongoing tumult seen in Chinese equities currently have carried over nearly perfectly in the AAXJ, as Chinese investors take a breather after the stellar gains made over the past year. Looking ahead, Asia – and particularly China, is steaming ahead with its economic recovery. China is widely expected to be one of the best-performing major economies this year, providing a major boost to the outlook for corporate earnings. As the rest of Asia and the world gradually opens up their own economies, AAXJ is likely to again benefit from strong Asian outperformance amidst a strengthening trade outlook.

CFD is available for trading on Phillip MetaTrader 5 (MT5).

Features of trading CFD:

  • Trade in both the bull and the bear markets
    The ability to enter a long and/or short position allow traders to take advantage of both rising and falling markets.
  • Smaller barrier to entry
    Flexible and smaller contract sizes. This means that traders will be able to enter into a contract with a modest amount of capital.
  • No expiration date or risk of delivery
    Unlike futures which commonly have a fixed expiration date, CFD allows traders to perpetually hold the position(s). CFD is cash settled, no need to worry about the delivery of the underlying asset.

 

Benefits of using Phillip MT5:

Trade at zero commission on a dynamic platform that offers low spreads. Integrated with Autochartist and Trading Central Indicators, and available on mobile, web and desktop app, you will never miss a trading opportunity with Phillip MT5.

Register for a FREE 30-day Phillip MetaTrader 5 Demo Account

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