August 8, 2018 / 1:16 PM / a month ago

Commentary: Has no-one told the steel market there's a trade war on?

LONDON (Reuters) - The global trade war drums beat ever louder.

U.S. President Donald Trump speaks about trade at the Granite City Works steel coil warehouse in Granite City, Illinois, U.S., July 26, 2018. REUTERS/Joshua Roberts

The United States is set to impose 25 percent tariffs on another $16 billion of Chinese goods on Aug. 23, adding to the $34 billion already targeted since July 6.

China will respond in kind with 25 percent tariffs on $16 billion of U.S. goods as the trade dispute between the world’s two largest economies keeps escalating.

If you’re a follower of Doctor Copper, you’ll already know that he’s taking a gloomy view of how all this is going to pan out in the real economy.

Indeed, all the base metals traded on the London Metal Exchange (LME) have been hammered as they price in the potential negative impact of tariffs on economic growth, particularly in China itself.

However, no-one appears to have told the steel market, which is currently enjoying a sustained boom, both in terms of output and price.

How to explain such divergent messages from two such key pillars of global manufacturing activity?

(Graphic on relative performance between Shanghai copper and rebar/HRC: tmsnrt.rs/2vseJdu)

SUPER STRENGTH STEEL

London copper fell by almost 20 percent between mid-June and mid-July and is still hovering dangerously close to the big-number $6,000-per tonne level, last around $6,145.

In China the Shanghai Futures Exchange (ShFE) copper price is down by 12 percent on the start of 2018.

The price of steel rebar on the same exchange is up by 16 percent. Indeed, it has this week hit its highest level in six years. The ShFE’s hot-rolled-coil contract has done even better, up 17 percent on the start of January.

This is not just a Chinese phenomenon.

Prices in the United States are so strong that imports started rising again in July as, even allowing for the recently-imposed 25 percent tariffs, the arbitrage is attractive enough to entice more metal into the country, analysts at Jefferies said. (“Americas/Materials: U.S. Steel Imports”, Aug. 7, 2018)

The United States’ own production was up by three percent in the first half of the year.

But so was that in all 10 of the world’s top producing countries. Indeed, global production rose by 4.6 percent in the period and was running at a record annualised 1.84 billion tonnes in June itself.

Crude steel capacity utilisation in June was 78.5 percent, up 3.8 percentage points on June 2017, according to the World Steel Association.

It’s ironic that the steel sector, which is where the first salvoes of the trade war were fired, is enjoying such a collective sweet spot.

CHINA TO THE RESCUE?

It’s also ironic that it is China that has transformed the global steel landscape.

Accused by just about everyone else of dumping excess steel on world markets over the last decade, China has eliminated huge amounts of domestic steel capacity, much of it “illegal” and therefore uncounted in the past.

The removal of a swathe of low-quality, cheap-priced material has transformed the domestic market and boosted margins in a part of the Chinese economy previously characterised by high debt levels and “zombie” operators.

China’s official steel producers are lifting output in response to these drivers.

They are being helped by the rolling environmental crackdown on the steel production sector. While steel mills in one part of the country take enforced regulatory downtime, those elsewhere benefit, the whole process rotating through different parts of the country at different times.

Both environmental and capacity reforms are set to continue.

Beijing’s latest “Blue Skies” programme, effective through 2020, will see ever more stringent environmental regulations enforced.

Last year’s winter heating season cuts will be repeated this year and although local governments will be given greater flexibility in how to implement them, the geographic scope will be increased from the area around Beijing to the Fen-Wei plain and the Yangtze River delta.

If Beijing’s overhaul of its fragmented production sector is one part of the steel boom story, the other is the strength of Chinese demand.

Exports of steel products to the rest of the world are running at their slowest pace since 2013.

After a blip higher in June, July’s outbound flows of 5.89 million tonnes were 15 percent off the pace of 2017, while cumulative January-July flows were down by almost 14 percent.

With no significant build in inventories, the only possible inference is that domestic demand is still super-strong.

Dr Copper may be worried about the cumulative impact of Chinese de-leveraging, slowing fixed asset investment and a sliding yuan, but current steel dynamics suggest he’s wrong.

(Graphic on Shanghai rebar and market open interest: tmsnrt.rs/2MpRxDd)

IT’S ALL RELATIVE

This ever starker divergence between the base metals and the ferrous metals is confusing. Which to believe, steel or copper?

The truth is that neither may be transmitting a reliable signal right now.

Copper’s price rout has been amplified by the clear-out of fund long positions in Shanghai and by the scale and aggression of short selling by funds on the CME and LME exchanges.

The strength of Chinese steel pricing, on the other hand, is being amplified by the amount of money chasing the current bull market momentum.

Market open interest in the Shanghai rebar contract is high and rising. It’s still some way from the record participation of over five million contracts seen in the middle of last year but at a current four million contracts it matches anything seen prior to that particular spike.

Chinese funds appear to be engaged in a massive relative value trade, selling metals such as copper and zinc while simultaneously going long anything in the ferrous space, from steel rebar to iron ore.

Iron ore prices, it’s worth noting, are also on a bull charge, closing in on the $70 per tonne level for the first time in six months.

Since China is the world’s largest steel producer, this pricing strength gets transmitted along the entire global supply chain.

China doesn’t command quite that level of physical pricing power in the copper market but Chinese funds can and do set the tone for trading on both the London and U.S. copper markets.

And right now they’re bearish.

As with all relative value trades, this one will unwind when the tensions with the underlying physical markets become too extreme.

Whether it’s the copper or the steel leg of the trade that cracks first remains to be seen.

Until that happens, however, these two core components of the global manufacturing economy are going to carry on sending very different messages.

The opinions expressed here are those of the author, a columnist for Reuters.

Editing by David Evans

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