Global Iron Ore Glut Looms…

I’ve been a skeptic of the sharp rally in iron ore prices since Q4, which runs contrary to the weakness seen across industrial metals on growing global inventories and relatively weak Chinese demand, and has begun reversing. The Australia Bureau of Research and Energy Economics in its latest analysis forecasts the key 62% iron content contract price averaging US119/mt this year from a current price of US$136, but falling below $90 by 2018. In 2013, Australian iron ore exports are forecast to increase by 12% y/y, to 554mt on higher production at a number of existing and new mines. Global seaborne supply will head into surplus this year, outpacing demand by 20-25m mt, from a near 40m mt deficit last year. Heavy Australian investment in new capacity is expected to drive export growth of 8% a year from 2014 to 2018, to reach 831m mt. Where is the additional supply, equivalent to half last year’s output, going to go?

Back in the 29th June 2011 note on the Chinese steel industry, I noted that: ‘For investors in Australian resource companies, it’s worth noting that Chinese iron ore capacity is still expanding and won’t peak before 2015 at between 1.5bn and 1.6bn mt, up from less than 1.1bn mt last year and an anticipated 1.3bn mt in 2012. Even allowing for the inferior quality of local ore, as China increases its iron ore production capacity and smaller mills curtail production, iron ore imports should begin to fall as soon as early 2012, undermining global prices.’ That was pretty much the beginning of a sharp de-rating for global resource stocks sustained into Q4 last year, and that slump in iron ore prices indeed happened, before an unsustainable bounce in recent months on the China fixed investment surge and opportunistic restocking.

Crude steel output rose 9.8% last month to 2.21m mt on a daily average basis, breaking the previous record of 2.05m, set in January and versus only 1.86 million tons in December. That reflects investment in fixed assets rising 21.2% y/y in the January-February period and the auto market starting the year with a 15% sales gain. Cement and copper production have also been rising in anticipation of a renewed construction boom. However, China’s steel industry has about 35% excess capacity totaling 970m mt in 2012, while output was only 717m mt and consumption at around 700m. The government has been trying to cull capacity and consolidate the industry; Hebei, which is China’s largest steelmaking province and  accounts for more than 25% of national output, is pushing to cut its output by 60m mt this year, but implementation remains a challenge and curtailing steel overproduction will be a key test of the rebalancing/reform agenda. The Chinese government is seeking to encourage mergers and close obsolete smelters, with the aim of bringing 60% of total capacity under the control of the top 10 mills by 2015. 

Exports of Chinese steel products last month rose 25% y/y to 4.24m mt, and exports have exceeded 4m mt every month for the past year, depressing global steel product prices and profitability. Despite modestly rising prices since Q4, many domestic producers of long semi-finished steel stock reported losses of up to 300 RMB/tonne last month as prices for iron ore surged. The economics of Chinese steelmaking are clearly unsustainable without massive capacity write-offs and lower input costs. Meantime, major Australian miners are committed to significant capacity expansion over the next three years. Despite recent pro-shareholder value management changes after a spate of value destructive acquisitions and weak share price performance versus the wider equity markets and commodity prices, it would be very hard to reverse these plans. Somewhere in the region of 90m mt of additional iron ore supply will hit the market by end 2013. There is also the possibility of India lifting a ban on iron ore mining in Goa during 2012, accounting for 40-45Mtpa of exports, which would add to potential oversupply.

China’s total iron ore imports hit a record of 743.6m mt in 2012, up 8.4% y/y, even though steel output was only up 3%, versus almost 9% in 2011. The jump in Chinese demand in Q4 was partly opportunistic buying after the sharp price declines, and partly driven by a pickup in construction related output as infrastructure related FAI surged.  GDP in China at 7.5-8% should translate to a 3-4% steel output growth per annum given the historical FAI relationship, but it’s likely that the investment and thus resource intensity of that growth is now peaking. Meantime, probably about half of China’s steel industry is unprofitable at current ore prices and domestic producers continue to complain about a pricing cartel in iron ore, driving China’s efforts to directly secure its own overseas supplies.

Iron ore is essentially in a transition to structural oversupply and below-trend prices by mid-decade. Aside from the surge in Australian output, key drivers of this more subdued demand outlook are the growing role of scrap in Chinese steel production, and ongoing investment in Chinese domestic iron ore production. After its decade long production boom, China will be generating growing volumes of steel scrap through this decade, in line with historical trends in more mature economies. Secondary steel production look set to account for about 20% of total production in China by 2020, up from 12% in 2012. This implies a reduction in iron ore consumption of 140mt, all else being equal.

An iron ore price recovery from a brief slump that pushed the spot iron ore price down to US$86.70 last September peaked at US$158.90/mt on February 20th; since then it has fallen to $136. The key question is whether high-cost Chinese iron ore production will be shut as iron ore production expands in Australia and elsewhere and if so at what price for iron ore. It seems unlikely that an iron ore price much above $85-90 can be sustained medium term, unless China slashes domestic mining output. Total sea-borne iron ore exports will surge from 1.15bn mt this year to 1.5bn mt by 2015. Chinese iron ore production is still expected by most independent analysts to increase by 3-5% a year over the same period, even though it is much higher cost. This is contrary to the previous consensus view that lower-cost foreign production will replace higher-cost Chinese production as it comes on stream. Miners have argued that prices will be underpinned as marginal Chinese iron ore producers shut down, but excess capacity across all sectors in China rarely obeys strict economic logic, given the role of provincial governments in supporting ‘strategic’ high-employment industries.

If they don’t shut, the likely global surpluses looks set to exceed 200m mt by 2015 and approaching 350m by 2017. A reasonable longer-term (2015-20) price projection is US$90 a tonne landed in China; given that iron ore costs about US$20 a tonne to ship to the Chinese steel mills, the only local iron ore miners that will be clearly profitable at that price are Rio, which have cash production costs of US$25-30/mt, versus Fortescue at over US$50/mt, although additional scale for the latter will bring its average cost of production closer to Rio’s.  Therein lies the industry dilemma; it makes perfect sense for the likes of Fortescue to ramp up production to reduce  marginal production costs toward industry average, even as it helps crash overall prices. The iron ore price is unlikely to sustain a move above US$100 until about 200m tonnes of high marginal cost production are forced out by cutbacks and closures though late decade, either in China or overseas, bringing the market closer to balance given global demand growth. For the leading Chinese steelmakers, a culling of domestic smelting capacity but not of iron ore output would be a very positive structural margin story.

What Ails Lacklustre Emerging Markets?

“The longer central bank liquidity is relied on to hold things together, the more excesses and distortions are being accumulated in the financial system” Institute of International Finance, in its latest analysis

That warning by the IIF is timely, because many of those excesses are building in the emerging markets, as a Fed exit looms in 2014/15. It’s a long time since the USD and global equity markets have been positively correlated for months on end, and comes as a surprise to gold bulls (de facto making a short dollar bet). As discussed in previous notes, a secular uptrend for the dollar is looming on sustained narrowing of the energy current account, shrinking fiscal deficit, early Fed exit etc. That scenario, as much as deteriorating external balances and trend GDP growth from India to Brazil, is a headwind for GEM relative performance, while the flood of Fed easy money is proving toxic for the macro discipline which was a key support for the EM debt re-rating, falling funding cost virtuous circle of the past decade.  It’s sobering to recall that the two strong uptrend periods for the USD in 1978-85 and 1992-2001 helped precipitate the Latin American and Asian debt crises respectively. In Asia, the consequences of trying to keep currencies pegged to the rising dollar were destabilizing via the banking system. Now, despite still strong official reserves, rising consumer debt and deteriorating balance of payments trends and ever soaring property prices underline the risks. An even trickier problem for EM policymakers will be coping with a sustained portfolio flow reversal as US yields rise into 2014, with negative implications for local asset prices, and notably property.

EM equities have experienced negative returns so far this year in contrast with gains in developed markets. This reflects a combination of worsening EPS and currency trends versus DM, net long global portfolio positioning and deteriorating external balances alongside a steady rise in private credit to GDP ratios and a spate of looming elections driving political uncertainty. Furthermore, we have seen accelerating local retail selling offsetting strong DM fund inflows; China, India and Brazil are down YTD even though the MSCI BRIC index is valued at 9.2x 12-month earnings estimates, or about a 30% discount to the All-Country measure, while the overall DM premium to GEM in terms of forward PER is at its highest in at least five years.

The AXJ index is slightly down this year versus high single digits gains across DM, but most ASEAN markets have continued their stunning domestic consumption driven re-rating, with the Philippines, Indonesia and Thailand again leading the way within AXJ, up respectively 16%, 11% and 9% YTD in USD terms. Asia’s most cyclical markets – China, South Korea, Taiwan and Malaysia – have been among the worst performers in Asia, with the slumping JPY a key factor behind Korean and Taiwanese weakness, while Malaysia is seeing a political risk premium ahead of elections and after the bizarre and pretty incompetently handled mini-invasion of Sabah by Filipino militants.

The key issue is one I’ve long highlighted, which is the rapid rise in GEM credit (and real estate prices) as a function of ultra-easy DM policy; the BIS has just published a new database looking at this key topic. In a previous analysis, the BIS warned that: Measures of debt service cost suggest that high EM debt levels could be a problem. The fraction of GDP that households and firms in Brazil, China, India and Turkey are allocating to debt service stands at its highest level since the late 1990s, or close to it.’ As the US has deleveraged, we’ve seen emerging economies leverage up; on a 3 year rolling basis we’ve seen compound credit growth, we’ve seen high single to mid double digit growth from Indonesia and Brazil to Turkey and Thailand, with China of course in a credit league of its own closer to 20%, as its overall leverage ratio has reached 200% of GDP.

A rising credit ratio may in principle represent “financial deepening” as the banking system captures household savings and reallocates then into productive investment, but can easily spill over into excessive consumer spending and asset speculation, boosting the value of collateral and thus driving further credit acceleration. The benign impact of rising exchange rates and imports plugging the gap between expanding domestic demand and a limited supply response has reversed from India to Indonesia, driving widening current account deficits and sliding currencies. In emerging Asia, credit ratios have risen further and faster than they did before the 1990s crisis, but bank loans haven’t outstripped deposits this time while domestic investment has generally matched domestic saving. In other words, a sudden withdrawal of foreign capital would be less destructive and Asia’s surplus countries should have enough resources to replace it, although the process would not be smooth. However, we’re at the point when the credit surge of recent years is beginning to show up in inflation pressures, and ‘stagflation’ is becoming the broad trend, with falling trend growth and sticky supply side inflation.

We’re entering an era where GEM country risk will become much more dispersed, as the commodity terms of trade boost of recent years has been squandered in Indonesia, Brazil etc. on overconsumption, and countries like South Africa face potential rating downgrades. Within Asia, Indonesia is the economy to watch; despite surging minimum wages, labour unrest is becoming commonplace while inflation rose 5.3% y/y in February, led by food prices (and prime office rents are up 70-80% y/y in Jakarta). Back in the 29th January note on Indonesia, I concluded that: ‘The government has been spending more on energy subsidies than on infrastructure or social welfare. Keeping fuel prices artificially low has boosted domestic demand, which, combined with record annual average Brent prices in 2012 and the weak rupiah, has inflated the oil product import bill and widened the current account deficit. So far investors have been indulgent in funding that deficit, but in the absence of subsidy reform that may well change by H2 if the central bank is perceived to fall behind the inflation curve…’

That danger remains very real; core inflation so far remains stable at 4.3%, but rising wages and higher electricity tariffs (expected to increase 15% over the year) will drive cost-push pressures, and both inflation and the current account deficit will be exacerbated by on-going IDR weakness. At this stage, inflation could average well above 5% for the year, and with the economy expanding around its long-term trend, fuel subsidy reforms now pushed back to post election and a rather controversial new BI governor likely, foreign investor enthusiasm for Indonesian bonds will be tested. This year, Indonesia expects to consume between 12-14bn gallons of subsidized fuel, compared with 11bn gallons in 2012. The subsidy bill cost $22bn last year and contributed to the $24bn current account deficit via oil product imports. Even if we don’t see a major reversal in portfolio flows, a tightening cycle taking rates above 6% within a year looks a good bet. I’ve been overweight Indonesian equities in the quarterly AXJ model portfolio since late 2011, but will be removing that bet. Elsewhere within Asia, factors ranging from domestic politics to the path of the JPY rather than earnings will be pivotal in driving re-rating potential.

The electoral exit of the long ruling National Front party in Malaysia would represent a potential buying opportunity as Malaysia desperately needs structural change to widen its tax base and reduce the chronic fiscal deficit, and tackle the dire impact on trend productivity of pro-Malay economic policies. The Philippines now trades at an 80% premium to the MSCI Asia ex-Japan on a forward PER basis. Indonesian stocks are priced at a near 30% premium and while Thailand overall still trades at only a 10% premium, its consumer stocks trade at almost 20x on average.

South Korean exports on a combined January and February basis to smooth out the impact of the Chinese New Year grew 0.6% y/y, marginally better than the 0.4% decline recorded in Q4. Similarly, Taiwanese exports increased 2.1% y/y in the two months, compared with the 2.5% rise recorded in Q4. Investors are betting that both countries will lose significant market share to Japan in autos and consumer electronics, but those fears are probably exaggerated given Japan’s loss of underlying competitiveness in many sectors and offshoring to the US and China of manufacturing by Korean and Japanese manufacturers. Meantime, the dramatic recent yen move is likely to consolidate in coming months. Overall, country, sector and only then stock selection matter more than ever within a GEM portfolio as the ‘rising tide lifting all boats’ scenario of the past decade ebbs and relative macro performance begins to diverge widely and with it local market performance. The upside is that it should provide an opportunity for active strategies to outperform passive broad GEM index led ones… 

China’s Mysterious Floating Pigs, as Hard Landing Risks Recede…

On my recent visit to Shanghai, a scandal was breaking involving carcinogenic dyes being used in primary school uniforms; since I left, over 3,000 pigs have been discovered floating downriver toward the city, following a police campaign to curb the illicit trade in pork from diseased animals, which are meant to be buried or incinerated. That backdrop of on-going public health outrages and a blatant disregard for product integrity by domestic suppliers is underlined by HK’s strict new limit on mainland purchases of baby formula, as mainland mothers have been paying a huge premium for reliable HK sourced product rather than the all too often adulterated local version. Coming on the heels of record airborne urban pollution in recent months, the environmental remediation bill for China’s headlong boom is rising fast. All of these disturbing and bizarre stories point to the fundamental lack of trust and strictly objective regulatory oversight within Chinese society as a fundamental issue retarding the next stage of development.

Attempting to establish some semblance of either will be critical to reforming the economy, but implies for the first time imposing formal legal constraints on the party and its wayward officials. Investors are more worried right now about floating shares than pigs, as a record A-share IPO backlog builds, with a surge in issuance threatening to overwhelm equity inflows and net earnings upgrades, as in 2010/11. The Public Offering Review Committee (PORC, how appropriate) at the CSRC determines whether a listing can proceed, and the regulator differs from its global peers in investigating an IPO candidates financial status directly and bearing responsibility for investigating potentially fraudulent activity as part of a 10-step review process. Of over 800 companies applying to the CSRC for a listing, 90 are at the final stage before approval, but more significantly, the new leadership is likely to push further SOE privatisation via secondary and primary A-share listings. Overall, while the IPO pipeline will re-open this year after a long hiatus to restore investor confidence, it is in Beijing’s interest to boost levels of activity and valuations via deregulation of domestic institutional investment rules etc. in order to absorb the much bigger SOE deals likely in 2014 and beyond.

 

As expected, bank lending slowed in February, to 620bn RMB, but February total social financing growth of Rmb1.07trn was 9.7% higher than January 2012, when the last New Year fell and the combined two-month total was a record, despite a still narrowly based FAI led recovery.  Wealth management products (WMPs), the deposit-like instruments that banks offer to customers at higher interest rates than savings accounts, saw issuance fall 24% in February m/m, a decline that was exaggerated by the New Year holiday but it seems likely that regulatory efforts on bank reporting of off balance sheet activities etc. are tempering the growth of shadow banking. The banks allocate the WMP-raised funds to investments in bonds, money markets and trusts to generate higher returns; much seems to have found its way into local government funding vehicles to pay for infrastructure projects and provincial SOE real estate activities.

This is the area of the shadow banking system that has most concerned regulators because it risks default scandals as poorly understood lending risks blow up for naïve retail investors. Regulators in Shanghai have gone so far as to make local banks register all the WMP products they issue, and there also have been discussions about quotas on overall issuance. However, on the demand side, depositors face the reality of negative real rates again; CPI has averaged 2.6% y/y YTD, while the one-year deposit rate at Chinese banks is currently capped by the government at 3.575%.  Overall, hard landing fears are misplaced near-term and China looks set for a 7-7.5% GDP growth year, as last year’s investment project approval surge sees funds disbursed and concrete poured but to sustain investor enthusiasm and inflows, tangible reform news flow will be crucial.