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  1. Home
  2. / Investing
  3. / Basic Materials

How to Invest in Steel and Iron Ore on Trade Wars

Selective mining stocks are looking cheap now.
By MALEEHA BENGALI
Jul 17, 2018 | 07:34 AM EDT
Stocks quotes in this article: RIO, ANFGF

As the market is obsessed with U.S./China Trade wars, all things "trade" and "China" related have been slammed, as investors fear risks of a recession looming. This is a typical knee jerk reaction as traders are taught to act first, ask questions later. It is useful in some situations, but once the dust settles, it is important to ask "Do the fundamentals support this move?"

The iron ore price is down about 18% from its highs reached in Feb 2018 of $78 a tonne, and it is now trading closer to $64/tonne. In March, Trump imposed tariffs on steel and aluminum imports. Cleary the "Made in China 2025" ambitious plan to overtake U.S. economically by 2025 rattled Trump's "Make America Great Again" policy, as he refuses to let China remove it from its economic pedestal in just short of 10 years. The whole idea behind these trade wars is to secure better trade deals with the EU and China, reducing the trade deficit. If not by negotiation, then by force. These are playground bullying tactics.

Exports of steel and aluminium to the U.S. represent just 0.05% of the EU's GDP, but if one includes tariffs on cars, the impact could knock 0.4% from U.S. growth and 0.3% from EU growth. Taking a step back from the adrenalin-gripping headlines, let's take a look at fundamental pricing for a bit.

According to Metal Bulletin, last week benchmark 62% fines iron ore prices jumped 1.1% to $64.06 a tonne, the largest increase since June 26. It now sits at one-week high. These gains are being helped by a surge in Chinese steel prices. Rebar futures in Shanghai surged to as high as 3,990 Yuan -- the highest level since September 2017 -- before finishing the session at 3,976 Yuan.

So what 's going on in the steel futures market? According to Reuters, China's cabinet has launched a new cross-ministerial leadership team that will draw up plans to reduce pollution in northern regions. On top of that, temporary cutbacks in the major steel-producing region of Tangshan is further supporting steel prices. And so, Chinese inventories are drawing. Absolute inventories amongst distributors are at one of the lowest levels in a decade for this time of year. Only in 2016 and 2017 were inventories at these levels, and both times saw increases in steel prices over the next six months.

iron ore is a raw material component used to produce steel, and so naturally rises when steel prices do. The inventory balance for iron ore is perhaps less tight than say copper, due to its deteriorating supply outlook, but it is robust. And prices need to be above $60/t to incentivize sufficient volume growth.

But it is not about rising prices. Base metal stocks are down anywhere between 10%-15% since the trade wars began while the actual underlying commodity has not changed much. Large-cap companies like Rio Tinto (RIO) , Kaz Minerals and Antofagasta (ANFGF)  all have solid balance sheets, healthy free cash flow and stable organic growth -- even in flat commodity prices. When fear sets in, there is widespread selling. Equities get hit the most given they are instruments that discount future cash flow returns. One needs to take a step back and dust off those fundamental models. After all, Economics 101 do still matter, even though Trump tweets help them deviate from their pre-ordained path from time to time.

It's incredible how the press and sell-side reports today are smeared with calls of markets dropping by catastrophic amounts and other doomsday scenarios. What happened to all the bullish reports few months ago talking about secular themes in electric vehicles or copper demand post-Trump-infrastructure spending and construction plans? One needs to separate the cyclical from the structural. Selective mining stocks are looking cheap now, but unfortunately given their beta, they do get hit the hardest in times of despair -- creating lucrative trading opportunities.

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TAGS: Commodities | Markets | Basic Materials | Investing | China | Futures | Stocks

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