Author: Aldo

The Markets:  We hold out hope for a V-shaped recovery keeping in mind that the damage done to the economy is mostly in the area of consumption, especially consumer spending. We view that as easier to restart than something that affects the structural composition of the economy or the financial system.  Full stops in production, spending and activities of almost any type, are unheard of in economic scenarios.  We think this differs greatly from the financial crisis of 2009 in that it affects primarily consumers, with businesses being collateral damage.  In 2009, financial systems crashed and businesses and banks collapsed, and the consumer was damaged. Ultimately, consumer spending was affected and it was slow to return. That’s because the damage was deeply structural and caused uncertainty about survivability of the entire financial system.  In this current crisis, although much worse on the consumer presently, we see hope for a quick turnaround because restarting consumer spending can be done more easily than rebuilding the entire financial system.

The Stocks:  Minimills are very well positioned for infrastructure spending and will probably be the sector with the most plants operating in the near term.  Integrated mills are focused more on auto and appliance sales – where production is shut down – and do not participate in the construction markets for the most part.   In addition, many integrated mills are likely to be shut down for the next few months at least, and some may never restart due to non-competitive cost structures.   Minimills should have the added advantage of being able to operate in a very low volume environment as we should face near term.  Very low fixed costs make minimills much less sensitive to low volume penalties, and their selling price spreads versus scrap are usually stable because of the highly correlated price patterns of steel and scrap.  We expect metal spreads to remain relatively wide and for volume to be low, which should generate large operating losses for integrated facilities and still allow profitable operations at minimills

President Trump dropped his threat to reinstate Section 232 tariffs on Brazilian steel and aluminum.  Trump and Brazilian President Jair Bolsonaro spoke by phone on Friday.  Brazil claims to have persuaded Trump not to follow through on his threat to reimpose the 25% tariffs on Brazilian steel (including semi-finished slabs that are important imports for several steelmakers in the US.).  He made that threat on December 2nd in a surprise move.

The US was retaliating against Brazil and Argentina for currency manipulation, which Trump said gave them an advantage in global trade against the US.  Brazil is a major importer of semi-finished steels into the US and operates today under a quota system that it negotiated in 2018 in place of the 25% tariffs that were applied to all importers under Section 232 and the premise of national security threats.  In regard to currency, we did not view Brazil as a currency manipulator and it has not seen significant currency devaluation over the past year, certainly much less than Argentina has seen.trends in the currencies of Argentina and Brazil lately.

Quotas versus tariffs have made the import pattern lumpy, where used up quotas at the end of the quarter result in very low imports for the last month of the three, but then a sharp increase in the first month of the next quarter.  The pattern on imports can be seen in the monthly charts below, along with the differing trends in the currencies of Argentina and Brazil lately.

Both Brazil and Argentina have had success gaining market share in Chinese food markets against US companies that ran into tariff or other trade-related issues.  However, Argentina much more than Brazil, in our view, has also used its currency more aggressively than most in competing.  Steel from Argentina is a very small part of the US market.  Bottom line is that Trump rescinding his threat means it is back to normal in the Brazilian steel import situation.

 

Markets: Trump’s trade diplomacy style is a confidence killer.  Our nascent optimism of the past two weeks that we were beginning to see a recovery in pricing was dashed last week and this weekend by news that the trade war was heating up and the surprising upward movement of the US dollar in reaction to a rate cut.  Over the weekend, China announced that it was devaluing its currency to offset the impact of US tariffs, which we believe will only work to further strengthen the dollar.  In addition, a hard Brexit threatens the Euro, which is closely correlated with steel pricing in the US where a lower Euro/USD usually means lower steel pricing.  In the future, we’d expect a similar relationship between the Chinese RMB and US steel prices to develop.  The argument that the announcement of 10% tariffs this weekend is a negotiating tactic and could be withdrawn by the September 1st date of enactment should also be considered, but investors will understandably dismiss it as a positive since it will increase volatility further.  For now, the trade uncertainty is keeping investors and corporations on the sidelines, which is depressing steel demand.   That argues for a risk-off posture until a different path becomes apparent.

Market demand appears to be softening.  Our faith in the growth trend in steel demand is being tested by tariff threats and Chinese retaliation, the latest twists in the Trump/China trade war.   Prolonging negotiations while increasing tariffs, as Trump promised over the weekend, has been met with dismay by the markets.  And with retaliation by the Chinese a certainty, in our view, the global trade and demand picture is likely to get worse.  Demand has already been negatively impacted by the tariffs, in our view, as manufacturers and other customers of steelmakers suffer from higher tariff-induced cost pressures and intensified price competition from foreign-based importers of the same manufactured products.  The US solution to this is to propose additional tariffs on the manufactured products. The problem is that the basis of free and fair market competition has been replaced by an escalating series of tariffs. Trump’s protectionist instincts are stronger than we had ever earlier imagined and are not defendable economically, in our opinion.  Raising tariffs has long-term negative implications for productivity in all sectors of the economy.

The US Commerce Department just gave us two examples of their new aggressiveness in protecting American businesses from foreign competition that might be unfair. First, it just self-initiated a trade case against the Chinese aluminum producers that will not make its way through the system much like the steel cases did starting 18 months ago.  This speeds up the process because the companies affected don’t have to wait to show injury before filing and indicates that the department is already sympathetic to their fate.  The second instance was the ruling in the Vietnam circumvention of tariff case.  This is where US steel mills charged that the Vietnam mills were selling cold-rolled and galvanized steel products made from Chinese hot rolled steel, and were shipping it to the US as Vietnamese product and free of the large Chinese tariffs that would normally apply.  The Vietnam defense was that converting hot rolled steel into cold rolled steel and into galvanized steel constituted a material transformation of the product, and thus the country of origin becomes Vietnam, not Chins were the steel was originally produced.  Not so says Commerce, and is applying the 200%+ Chinese tariffs to Vietnam.  That’s pretty big news and positive for steel pricing short-term.  But one must wonder where that definitional change in transformation will take us.  Can one now expect say a lawn mower made in say Thailand from steel that was made in China, transformed somewhere else, and fashioned into a lawn mower in Thailand to be burdened with 200%+ tariffs due to the origin of the steel?

Ministers at the G20 forum were arguing about whether China’s acknowledged shutdown of 100-150 million tons of steelmaking capacity (more than exists in the entire US market) was enough.  China says it has taken leadership while the rest of the world claim not enough.  We think the argument is being fought over the wrong subject….it’s not the capacity, its the production.

Capacity may have been reduced in China, but it wasn’t the capacity that was operating.  It was already shut down.  That’s why China can claim capacity shutdown of such magnitude but at the same time report that steel production year-to-date in 2017 is up about 5%, and that in the summer that pace accelerated a bit to 6.7%.  How does that happen?  Lots of overcapacity exists, maybe as much as 300 million tons.   Closing half of it is great, but if it wasn’t operating in the first place the impact on steel markets is likely to be nil.

Now if production is reduced by even 5% in 2018, that would have a meaningful impact on global steel in many ways.  It would reduce steel supply by up to 40 million tons, and would probably cut China’s exports in half again or maybe by more (total about 60m tons annually now, down more than 50% from a couple of years ago).

We think steel markets get better in 2018, and part of the reason is expected reforms in China’s oversupply.  The argument about capacity reduction should switch to production growth and the level of net imports and exports.  China has the benefit of command and control, and can affect change quickly.  They also worry more lately about air pollution, and have ordered production cutbacks in Hebei in the Northeast, where over half of the country’s steel is made.

That air pollution concern typically peaks in November – March, when colder air traps noxious fumes near the surface and residents start wearing face masks and driving in the daytime with their headlights on.  That should get more attention than a meeting of ministers in Berlin.  Seeing negative year-to-year producton comps in the months ahead would give quite a lift to steel market optimism.

We’re hearing from some steel traders that salespeople from some mills, especially some directly affected, are saying the DRI outage at Nucor’s Louisiana site could force them to step up scrap purchases by about 500-600k tons.   That seems a bit high to us, and depending whether the DRI usage is 30% of melt or 10% of melt, we’d say that number sounds like about 2-6 months of replacement, allowing for a fairly significant outage.

Steel salesmen are pushing prices saying that scrap prices will rise and push HRC to the mid-$600s.  We’d say possible but not likely sustainable given the slow demand trends here and the premiums that would then come into place versus current foreign pricing.  With US HRC at $600 now, and maybe bouncing $580 on the low side, there isn’t much incentive for foreign steel to make its way here and thus, we’d say not much downside risk to pricing from import supply growth.  That could change with a sharp spike, so while the upside may be pleasant beware the reaction from global supply.

Steel markets continue to show reasonable demand trends and limited supply from imports and domestic production.  Although momentum for added protectionism has faded since the summer, we don’t think the US steel producers are in dire need of protection as much as they are in dire need of some demand stimulus.  With steel prices in the US only slightly ahead of global price levels, we expect relatively stable pricing ahead and limited import competitive supply.