“No Man’s Land”

If you’ve had a difficult time assessing the economy and steel industry over the past few weeks, take solace that you are not alone.  There is a good amount of positive data that could be used to make the case for a significant rally in steel prices.  Spot iron ore has remained above $150/t for weeks, even reaching for new highs last week before markets closed for the Chinese Lunar New Year.  Over the past six weeks, one-year inflation expectations have shot up 78% to annualized expected inflation of 2.43%, Chinese spot HRC prices are up 7%, coking coal FOB Australia is up 8%, Chinese rebar is up 5.5% and pig iron in China is up 4%.  China is on fire!  In fact, the price of Chinese HRC is at a premium to that in the U.S.  Below are import differentials vs. the price of Midwest HRC and, as you can see, imports are not attractive.

Vs.	Midwest
China	+22
India	+12
Germany	+5
France	-8
Italy	-20
Spain	-24
UK	-26
Far east	-30
Japan	-35
CIS	-100
Brazil	-108

 

On January 21^st, AK Steel announced a $40/t price increase for all carbon flat-rolled steel products.  It’s rally time!  So China is going gang busters, imports aren’t a threat, the mills are increasing prices, yet during the last 5 weeks, spot HRC is down 4% and February HRC futures are down 6%.  To quote a famous Vince Lombardi sideline tirade, “WHAT THE HELL IS GOING ON AROUND HERE?”

“The Good”

Let’s talk macro-economics. The January 2013 Manufacturing ISM Report on Business PMI came in at 53.1%, up 2.9% from December, showing the second month of expansion in the U.S. manufacturing industry.   More importantly, industry groups including appliances & components, fabricated metal producers, transportation equipment, petroleum and coal, machinery and primary metals all reported growth and growth in new orders.   The U.S. durable goods report for December crushed all expectations coming in at 4.6%, rising for a fourth consecutive month.  The index of leading indicators rose in December by the most in three months and hourly earnings posted the largest back to back gain since the middle of 2009.  Cars and light trucks sold at a 15.3 million annual rate in December after 15.5 million the prior month, the best back to back showing since early 2008.  Home prices in 20 U.S. cities rose in November 5.5% year-over-year (Y.O.Y.), the most in more than six years while the median price of an existing home rose 11.5% in December posting the biggest Y.O.Y gain since November, 2005.  New home construction jumped in December 2011.  Apartment construction starts of buildings with five or more units was up 116% while the net percentage of banks reporting stronger demand for commercial real estate loans nearly doubled to 44.1% from 23.4%.  Supply of previously owned homes dropped to 1.82 million, the lowest since 2001, and 4.4 months of inventory, the lowest since May, 2005.  Finally, the Federal’s Reserve’s beige book report was relatively more positive than the previous month and reported that banks were more willing to increase their tolerance for risk.

Abroad, HSBC’s PMI numbers for South Korea (50.1), Taiwan (50.6), India (54.7) and China (51.5) all rose from the previous month and came in above of 50, indicating expansion.  In the Eurozone, the yields on Spanish, Italian and Greek bonds receded as worst case scenario for the regions debt crisis have been taken off the table while the Euro currency up as much as 3.8% in 2013, now is just above 1% after dovish language from the ECB. India cut interest rates this month and the Yen has depreciated 18% since November due to dovish comments from new leadership regarding significant monetary stimulus in the near future.  As a result, expectations for Japan’s export driven economy have increased.

Crisis averted in Europe, China’s economy rejuvenated taking Asia along for the ride while economic data in the U.S. seems spectacular.  Nevertheless, U.S. HRC prices are down.  Vince Lombardi.

“The Bad”

U.S. GDP forecasts from the U.S. Congressional Budget Office call for growth of 1.4% in 2013.  The New Year’s fiscal cliff deal increased social security taxes from 4.2% to 6.2% for all Americans.   The $85 billion in government spending reductions set to take effect March 1st are forecasted to subtract 0.6 percentage points from growth in 2013 according to the World Bank. In January, the World Bank and IMF adjusted their GDP forecasts for the following countries, except China, lower.  Below are current forecasts for Global, advanced and emerging economies as well as the 12 largest economies, in order.

Region	IMF	World Bank		Country	IMF	World Bank
Global	3.5%	2.4%		US	2.0%	1.9%
Advanced	1.4%	1.3%		CHINA	8.2%	8.2%
Emerging	5.5%	5.5%		Europe	0.2%	-0.1%
				Japan	1.2%	0.8%
				Germany	0.6%
				France	0.3%
				UK	1.0%
				Brazil	3.5%	3.5%
				Italy	-1.0%
				India	5.9%	5.9%
				Canada	1.8%
				Russia	3.7%
				Spain	-1.5%

Outside of the BRIC countries (Brazil, Russia, India & China), none of the other eight economies are forecast to grow by greater than 2%.  Real growth rates (i.e. adjusted for inflation) are negative for all eight countries.  Developing countries meanwhile are growing at some of their slowest rates of the past decade.

Consumer confidence plunged in January to its lowest level since November, 2011. Tax increases and discontent with Washington politics are the primary scapegoats.  This year, the average American is expected to pay $900 – $1,000 more in taxes than in 2012, which should be expected to reduce consumer spending and GDP. For example, the share of Americans planning to buy a car in the next six months fell to 10.1%, the lowest since April, 2012.  This could produce additional headwinds for the steel industry considering the bloated auto inventories and the importance strength in the automotive sector has been to manufacturing.  Moreover, manufacturing in the Philadelphia region unexpectedly contracted in January and the New York Federal Reserve data showed factory activity shrank for a sixth straight month.  The Federal Reserve’s Federal Open Market Committee statement from the January 30^th meeting called for economic growth to proceed at a “moderate pace.”

Global investors are reportedly curbing investments as many believe the state of the U.S. government’s finances is the greatest risk to the world economy.  The World Bank agreed that the U.S. budget issues pose a global risk and attributed the disappointment to worse than expected U.S. business investment and uncertainty tied to the budget policy.  While congress agreed to kick the debt ceiling issue down the road to mid-May, budget cuts look likely to take place and the bipartisan quarreling is sure to continue.  The democrats want to raise taxes and the republicans want to cut spending without raising taxes.  One story I’ve found compelling is that republicans agreed to an extension of the debt ceiling to mid-May in an effort to force President Obama to continually request an increase to the debt ceiling every couple months.  The strategy goes that over the long run, the American populous will become tired and frustrated by the repeated requests for more spending while watching an ever increasing massive deficit.  The constant reminder will lead to growing public outcry providing the momentum needed by republicans to force the democrats to agree to cuts in spending without increasing taxes.  While this strategy might prove victorious for the republicans, it will most likely have a detrimental effect on business and investment due to the continued uncertainty and resulting risk aversion. 

While the S&P 500 equity index is nearing 2007 highs, executives are less optimistic and many are lowering their financial forecasts.  A result of a December survey of CFOs conducted by Duke University and CFO magazine showed companies plan to increase investment spending by 2.6% this year, down from projections for the following 12 months of 3.7% in September and 7.8% in December, 2011.  Wall Street analysts project first quarter earnings at S&P companies will rise just 1.7% or less than half of their projections from the beginning of the year.

In Europe, markets are signaling that the worst case scenario of a break-up of the Eurozone is off the table.  Yields on Spanish, Italian and Greek bonds are seeing their lowest levels since March, 2012, November, 2010 and January, 2011, respectively, while the Euro currency traded as high as 1.37 vs. the U.S. dollar before retreating below 1.34.  The increase of the Euro currency is a concern as it escalates the costs of European exports, making them less competitive.  Moreover, different countries in the Eurozone have different fair values for the currency.  The countries that are relatively worse off, such as France, Spain and Italy for instance, have a fair value below the current price while Germany for instance has a fair value above the current price.  The result is that the already struggling Southern European countries are faced with additional hurdles.  News that the German government estimated Q4 2012 GDP may have fallen as much as 0.5% suggesting Europe’s strongest, and the world’s fourth largest, economy is on the brink of recession.  The German government also cut their 2013 growth forecast to 0.4%.  Weak economic reports out of the U.K. suggest they too may be heading into an unprecedented triple dip recession. With European unemployment already at a record high 11.8%, the economic prospects for Europe are quite dismal. Europe’s worsening economic conditions present a growing problem for automakers.  Ford warned that European operating losses would hit $2 billion in 2013. The company plans to cut 18% of European capacity and close 3 plants by 2014.  The manufacturing PMI for Europe of 46.1 is already reflecting this implying Europe’s manufacturing sector worsened in Q4 2012. The increase in the Euro currency is expected to only make matters worse for the manufacturing sector. 

In Japan, the manufacturing PMI sank to a near four year low of 45 in December while the Bank of Japan downgraded its assessment of local economies in eight of its nine regions in January. Japan’s new government will likely increase taxes on its wealthiest citizens and implement aggressive monetary stimulus packages in the near future.  In response, the currency markets have pushed the Yen down 18% since November.  While this could greatly benefit Japan’s export driven economy, the volatility is causing distortions throughout global economies and talk regarding “currency wars” is rampant.  In other news, tensions between Japan and Russia as well as Japan and China have elevated recently.  In the past few weeks, Japan accused Russian fighter jets of intruding its airspace for the first time in five years and accused China’s navy of locking weapons-guiding radar onto Japanese naval vessels twice in the last month.  The U.S., Japan’s largest military ally, is bound by a six decade old treaty to defend Japan from an attack.  In addition to elevated military tensions and heightened fears of a military conflict between the second and third largest world economies, Chinese nationalism has been detrimental to Japanese exports to China.

China looks to have emerged from last year’s soft landing and is again expected to grow above 8% this year.  With China’s new leadership communicating strong support for continued infrastructure spending, iron ore, coal and steel prices have experienced an intense rally.  New home prices in China rose in December in the most cities in twenty months and inflation accelerated more than forecast to a seventh month high as the coldest winter in twenty-eight  years damaged vegetable crops and disrupted shipments.  Food prices (which accounts for a third of China’s consumer-price index basket) in China’s major cities have risen consistently for almost three months.  These developments are not encouraging for additional stimulus and may lead their central bank to raise interest rates in the second half of the year to limit inflation.  Additionally, increased financial risks due to excessive growth in China’s shadow banking system have elevated levels for Chinese credit risk.  According to S&P, “excess investment combined with declining returns places China in the “high risk” category for a correction in growth. “  China’s ratio of investment to GDP of 48% in 2011 is significant and abnormal.  Bonds issued by local-government controlled financing vehicles increased by 148% to just over $100 billion while loans from trusts to fund infrastructure spending rose $60 billion in 2012 after contracting by $3 billion in 2011.

The Feldstein

The disconnect between the massive increase in demand for steel and the price of iron ore, rebar, HRC and coal in China relative to the decrease in demand for steel and the price of scrap and HRC in the U.S. is perplexing.  Especially with respect to the price of iron ore, which has rallied almost 80% since last September, when a global glut of iron ore at the time was causing massive volatility and concerns of significant depreciation in the price of ore.  Since then, the flood of global monetary stimulus has had a chance to work its way through the system and China’s economy has emerged from its economic funk. Reports that Chinese steel mills books are strong provide an explanation to the irrational exuberance we’ve seen in the ore market. That being said, I’m extremely skeptical.

China’s steel sector PMI for January declined to 49.3%, down 6.2% from December and showing contraction.  Moreover, the new order index decreased 10.6% MOM to 49.4% and the production index declined by 10.3% MOM to 49.1.  The CISA announced that daily crude steel output for the last 10 days of January dropped to 1.906 million metric tons per day.  Something doesn’t add up. Vince Lombardi.

The phrases “animal spirits” and “irrational exuberance” might be a good place to start to find an explanation.  While the rest of the world has been wallowing in the doldrums of the 2008 financial crisis and the European debt crisis for years now, China has been providing consistent abnormal returns, especially in real estate, making market participants overly-confident, somewhat impervious to loss and deluded by the actual risk they’ve assumed.  Typical to bull markets fueled by excessive risk taking include individuals taking on excessive leverage and committing fraud.  Reportedly strong Chinese mill’s order books might be reflecting multiple orders for the same steel as buyers attempt to get a jump on lead times or are simply speculating on further price increases.  Last fall, some steel warehouses collateralized multiple loans with the same steel asset. Prices dropped and the scheme was revealed.  More recently, cases of individuals taking leveraged bets on real estate and owning an excessively speculative number of properties are being uncovered.  Apparently, Chinese police officers assisted a woman to use multiple identities to purchase 41 properties. Other anecdotal stories like this exist and where there is smoke there is fire.  If this is rampant, at some point a correction, see above, will ensue and as Warren Buffet says, “You never know who’s swimming naked until the tide goes out.”  If a correction does occur, and an interest rate hike in the fall could be a strong impetus for one, assuming that weak global economic growth doesn’t do it first, expect some fierce volatility as over levered investors and frauds like the ones mentioned above could lead to violent downward spirals in asset prices similar to the one in the iron ore market late last summer.  If this scenario does play out, the ramifications for global markets, especially the prices of ferrous commodities could be disastrous.

Reports of another analyst calling for a steel mill price hike hit the wires last week when Anthony Rizzuto of Dahlman Rose & Co. published a report that strength in raw material prices, improving lead times, unattractive import pricing, etc. will embolden the mills for a new round of price hikes.  For those who are actually in the steel and manufacturing business (as opposed to financial services) are witnessing first-hand the anemic demand for steel and see that not only did the last price increase not work, but also that things have worsened. The announcement has simply delayed the inevitable.  Before we discuss the inevitable, however, let’s pick this latest call apart.

Raw material	% Change 1/18 – 2/15	2/15/2013	1/18/2013
ORE 3m futures	8.26%	$150.75	$139.25
IODEX ore	7.25%	$155.25	$144.75
Pig Iron China	3.86%	$454.25	$437.35
Zinc	2.94%	$15,925.00	$15,470.00
Coking coal FOB AUS	2.68%	$172.50	$168.00
Pig Iron Brazil	1.33%	$380.00	$375.00
WTI Crude	0.31%	$95.86	$95.56
Busheling	-1.29%	$382.50	$387.50
Shred EC	-1.42%	$347.50	$352.50
Pig Iron Black Sea	-1.78%	$391.25	$398.33
Shred MW	-3.12%	$372.50	$384.50
HMS Turkey	-3.59%	$389.00	$403.50
HMS Rotterdam	-3.97%	$363.00	$378.00
HMS 80:20	-4.42%	$389.00	$407.00
Natural Gas	-11.58%	$3.15	$3.57

 

As you can see from this cross section of raw material and input prices over the past month, iron ore has continued higher, coking coal is up, pig iron is mixed, crude oil is unchanged, scrap prices are lower and natural gas is much lower.  As a basket, not a compelling argument for higher raw material prices, especially for EAF mills whose costs look to be decreasing. 

 

The import argument is much stronger as seen above.  China is at a premium and every country’s differential worsened from the standpoint of importing to the U.S.  That being said, the January 9^th differential for every country other than Japan, Brazil and the CIS wasn’t attractive to draw imports then and it isn’t now.  This line of thinking didn’t provide support to the January hike; I’m not so confident it will if a new hike is announced either.  Further, CISA data showed a ninth consecutive week on week increase in steel inventory levels in China to 18 million metric tons.  The big question is if and how that gap reverts.  Does weak U.S. steel demand and decreasing prices pull down China or does China lift the U.S. out of its current malaise. 

Regarding lead times, our models indicate lead times have increased by .25 weeks, or about 2 days, since the AK  Steel announcement.  Also, mills have been managing production on relatively slim lead times for at least two months now.  While Mr. Rizzuto’s argument has a weak leg or two to stand on, the fact remains that the demand side is not motivated to buy steel at these prices.  One glaring difference between OEMs and steel mills is the hefty cost mills incur to shut production.  A mill might have to take a loss on a certain amount of steel in order to avoid this larger cost of shutting down a furnace.  Therefore, the more prudent strategy for the mills would be to discount steel prices, taking advantage of the decrease in February scrap prices, find an equilibrium price that will induce buyers and then build out lead times to a more acceptable level.  Once the lead times are increased, mills should retain pricing power and then will price increases will have a much higher probability of be accepted.

So why is demand down?  As indicated above, growth is weak globally.  There is also a strong sense of risk aversion that has carried over from the financial crisis.  While central banks are doing their best to push investors into riskier assets, business owners don’t seem to have the same confidence as equity investors, for instance, and the only aggressive risk takers (“animal spirits”) seem to be in China.  If you look to “The Good,” there are definitely some positives signs emerging in the economy that will be monitored closely.  However, there have been so many fits and starts over the past few years, whether it be U.S. unemployment improvements, progress regarding the Eurozone debt crisis or global manufacturing PMI numbers hopping on either side of the 50 contraction/expansion line, that business leaders and investors seem to have been desensitized to aggressively jumping on the first sign of good news after being burned so many times in the past few years.  Add the global economic weakness, downside risks to the economic outlook and the political uncertainty in D.C. to the equation and it isn’t unreasonable to agree with many economists that I follow who think 2013 is going to be another year of muddling along at a “moderate” pace.