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  1. Home
  2. / Investing

Surging Steel Stocks Might Be Set for a Cool-Down

The red-hot sector is now running into a number of headwinds that could hamper further growth.
By KEVIN CURRAN Nov 08, 2021 | 06:30 AM EST
Stocks quotes in this article: NUE, CLF, X, SLX

Steel stocks have been a solid support for investors in 2021.

Indeed, after a protracted period of underperformance from stocks like Nucor (NUE) , Cleveland-Cliffs (CLF) , and U.S. Steel (X) , a post-pandemic pop in demand and subsequent price surges have helped each stock to healthy returns thus far in 2021.

According to some leaders in the industry, the rally may not be near its end either.

"Continued bullish outlook for 2022 and beyond and expectations for a super-cycle continuing put us in a position to move faster on the next phase of our strategy execution while beginning to reward stockholders with direct returns," U.S. Steel CEO Dave Burritt told investors in an earnings call at the close of October. "Whether you're looking only at next year or our ability to build long-term value, we believe that investors are undervaluing our progress and potential."

However, as some macroeconomic, supply-chain, and investor appetite issues loom, there could be reasonable qualms about the current trajectory of the "super-cycle."

Super Performance Amid Supply-Chain Situation

To be sure, it is hard to characterize the present trend of steel stocks as anything other than "super" for investors.

While the VanEck Vectors Steel ETF (SLX) is up over 20% thus far in 2021, its performance underplays the performance of its most prominent components. U.S. Steel, Nucor, and Cleveland-Cliffs are all pushing past a 50% return. For both the ETF and the individual securities, the returns are about triple that figure over the one-year period.

In terms of these drivers of the super-cycle, the story is not necessarily unique to just steel.

"The biggest driver of commodity prices increasing has been twofold -- the reduction in production early in the pandemic and the current supply-chain backlogs," Stratus Wealth Advisors founder Sam Brownell told Real Money. "When you combine decreased production with increased demand, you expect to see a rapid increase in prices. Combine this with a global supply chain that was overwhelmed as people shifted their spending patterns and you have the recipe for record price increases in sectors that received a large increase in demand -- such as steel and other building materials."

The dynamics are perhaps clearest in context of the price shocks that rippled across many material inputs to the construction industry. The most visible among these was lumber, where prices surged to a historic bubble in late 2020 into early 2021.

However, just as that bubble popped, there is reason to be cautious about approaching another industry that may have already reached its zenith.

The Best Is Behind Us

Overall, this can leave one with a feeling that the steel rally is one that investors now eyeing the sector have unfortunately missed.

Brownell explained that while the jump in sales might not be transient it is not enough to carry investors as even a cycle that can continue into next year is likely already priced in. Further, as margins likely stay the same, the investment thesis was not appetizing enough to entice investment from his firm.

"Today's stock price already accounts for future cash flow projections discounted back to the present at an appropriate risk factor, so an investor has to be certain that commodity prices will continue to outpace expectations in order to expect continued excess returns," he explained. "We think the probability of this happening is decreasing."

There is also a strong possibility that the highly cyclical steel industry could encounter a downturn sooner than anticipated by many industry CEOs. Given the massive run-up in prices over the past year, the risk-reward to this end is not encouraging.

ESG and International Agreements

Furthermore, there are recent developments on tariffs that have actually been a major boost to the steel industry in America that could negatively impact many of these stocks' performance. Last weekend at a G20 conference that centered on many climate issues, the U.S. and European Union reached a deal to ease tariffs on steel and aluminum imports.

"In the past year, the cost of steel used by America's auto and appliance manufacturers has more than tripled, creating increased costs for consumers," U.S. Commerce Secretary Gina M. Raimondo acknowledged in the agreement. "Today's news will provide much-needed relief for those workers and industries, the workers and businesses who were threatened with overwhelming retaliatory tariffs of 50 percent and American consumers, who are worried about increasing prices."

While the deal is indeed good news for many of the industries that rely upon steel, the steel producers will be less encouraged as it may allow the issue of overcapacity to re-emerge and drive prices back downward. 

"Driven by global overcapacity in steel, repeated surges in steel imports over the past decade threatened our industry and the jobs it supports," The American Iron and Steel Institute wrote in a letter to President Biden ahead of his meeting with EU leaders. "The steel tariffs and quotas imposed in 2018 reversed this trend and worked to stabilize the domestic industry, allowing many previously idled steel mills to restart and rehire laid off workers."

Now that the agreement is signed, those concerns appear to be back on the table. For investors, this could mean accelerating the current cycle towards its close.

However, the tariff issue is arguably subordinate for investors. The larger long-term issue is likely one of environmental concerns, which was also brought into the remarks on the trade resolution from both the U.S. and EU delegations.

"The global arrangement will add a powerful new tool in our quest for sustainability, achieving climate neutrality, and ensuring a level playing field for our steel and aluminium industries," EU Commission president Ursula von der Leyen said. "Defusing yet another source of tension in the transatlantic trade partnership will help industries on both sides. This is an important milestone for our renewed, forward-looking agenda with the U.S."

The statement also goes on to chide the steel and aluminum industries as "one of the highest carbon emission sources globally." If the U.S. is to pursue EU-like measures, heavy fines could be in store for the worst offenders.

While companies such as Nucor and U.S. Steel have taken significant steps in moving towards new low-carbon steel production via electric arc furnaces rather than the older, coal-fired blast furnaces, the transition will remain costly.

In a best-case scenario a race to reform production will likely bifurcate the industry between those firms that can successfully move into a new low-emission standard-driven era and those that cannot. In the early stages of the transition, however, it is likely that almost all firms will be impacted to some extent.

With the industry marking a historic rally over the past year and now running into a number of headwinds set to hamper growth, stockpicking might best be advised after a bit of air comes out of the bubble.

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TAGS: Regulation | ETFs | Investing | Markets | Politics | Stocks | Materials | Europe | U.S. Equity | ESG Investing

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