30 August, 2021
Investors often refer to Dr Copper as the bellwether of the global economy, oil as the short-term activity barometer, and iron ore as the key measure for China’s industrial economy.
Whilst some commodities have softened none have moved as much as iron ore, which has fallen 30% in the last month – the steepest drawdown on record.
The obvious conclusion is that the iron ore price is weakening because China’s economic activity has weakened.
Yes, China is indeed tightening – a sensible response to an economy that was humming as it led the western world recovery. Credit growth has slowed, and economic activity is slowing at a faster pace than in the US and Europe. But the question is, will China persist with this path or loosen policy, considering they have the firepower to do so?
On top of that the Chinese property market has been hit with policies to curb speculative demand, and property is a big consumer of steel.
China’s c. 90mt of steel production in July was the lowest in over a year, and output continues to slow in August as government puts pressure on some steel mills to reduce capacity.
But this may only scratch the surface. Curiously, and reflective of specific supply side factors, coking coal – the other necessary raw material for steel production – is up over 20% over the same timeframe.
This extreme disconnect between the move in iron ore and coking coal prices suggests a near-term slowdown in Chinese activity isn’t the only factor weighing on iron ore.
The origins of tight iron ore supply go back to early 2019, when Vale’s mines in Brazil suffered a fatal dam breach which fundamentally altered the previously well-balanced market. Australian iron ore producers have been the key beneficiary as Vale operated significantly below capacity, and COVID-19 created further production issues.
A Vale iron ore mine in Pará, Brazil.
For some time now China has had little alternative to Australian iron ore, which is why the iron ore price nearly tripled over the last year. But this is changing. Vale is on the mend, with production expected to increase by more than a third in 2021.
China’s transition from the factory to the world to a consumption and services driven economy is accelerating. New policies emphasise decarbonisation at the expense of capacity, particularly in carbon intensive industries like steel. China is even reportedly considering banning steel exports and resizing the industry to domestic needs only.
The longer-term implication is a reshoring of steel production which has a greater reliance on steel recycling (i.e. producing steel from scrap using electric arc furnaces rather than iron ore).
These two factors reduce aggregate iron ore demand.
We could be in the midst of a longer downcycle in iron ore prices than investors expect.
More stimulus incoming as investors question the cycle
In the US last week, we saw the House of Representatives advance a multi-trillion-dollar raft of stimulus plans.
President Biden’s $550b infrastructure bill is likely to be passed next month given strong bipartisan support, and the reconciliation process is likely to be used to seek approval for an additional $3.5t targeting education, childcare and green energy.
This huge new tide of US stimulus is approaching just as recent data shows the cycle in the US and Europe is moderating, albeit from a very high base. Stimulus has faded and without additional stimulus, activity could dwindle further. Cyclical stocks appear to be pricing in economic normalisation.
We’ve said we see the economic cycle peaking this year but we aren’t looking at 2022 as a ‘no growth’ environment.
The landing in 2022 can be softened by the amount of stimulus already in the system and strength of household balance sheets. US households have $2.6t in excess savings, equivalent to around 20% of current household spending.
Further, the pandemic has opened the door to fiscal stimulus and policy makers will be reluctant to shift to austerity too quickly. Vaccines/reopening give the scope to pivot to investment programs like decarbonisation, 5G and infrastructure.
Ultimately additional stimulus has to be funded. As US government debt continues to balloon there will be longer-term implications for inflation, bond yields and the Dollar.
While we continue to play reopening in a targeted fashion the economic data bears close monitoring.
The risk is excess household savings remain just that – saved not spent – and we see a slowdown in economic activity before investment-led growth gains traction.
A stock in focus | Siemens (ETR:SIE)
Siemens, Europe’s leading industrial company, is a great way to position for investment cycles around decarbonisation and infrastructure.
As the global leader in factory automation, Siemens will be a winner in a low carbon world as manufacturing lines are re-designed and re-tooled. Siemens is the best positioned company globally to provide both the hardware to make a plant run as efficiently as possible and the software to control and optimise processes – and remarkably Siemens houses the eighth largest software business globally.
Additionally, Siemens’ subsidiaries manufacture wind turbines and equipment required to strengthen grid systems, whilst the healthcare business offers structural growth in an expanding market.
At 14x 2023 earnings, Siemens is a cyclical business that can transition to a secular growth winner.