How should mining and steel equity investors look to China now?

Metal commodity prices and industry equities have seen a sharp decline over the past few weeks, with sentiment weighed down by global recession fears and a dim outlook for Chinese economic growth.

For Bradesco BBI, a conflicting news stream has weighed significantly on investor sentiment, with moments of greater pessimism about demand, while in others there is a recovery with expectations of stimulus in the Asian giant.

With such uncertainty, at the end of last week, iron ore traded on the Dalian Stock Exchange reached a level below US$ 100 a ton, the lowest since December 2021. With this scenario, companies such as Vale (VALE3) and steel companies register strong fall: in July, VALE3 has losses of around 10%.

In order to shed light on the main topics that impact the sector, Bradesco BBI outlined the latest developments in China and the prospects for metallic commodities.

The bank points out that the Chinese government is under increasing pressure to promote economic growth and increase public confidence in its ability to do so, without giving up on containing Covid-19 cases.

That said, the bank’s analysts reiterated the view that economic activity and demand for metals in China should
improve in the second half of the year, driven by stimuli on different fronts (infrastructure, real estate, automobiles, general availability of credit), which should raise metal prices from current levels.

Bradesco BBI highlighted its preference for steel and aluminum versus iron ore and copper, as it believes that these commodities will have tighter supply versus demand dynamics in the coming months. “We note, however, that the path should not be linear, especially in the short term”, assess the analysts, who reiterate Gerdau (GGBR4) as their preferred choice in the sector.

Thiago Lofiego, Isabella Vasconcelos and Camilla Barder, analysts who sign the report, do not expect China to ease its Covid-zero policy, as the focus remains on preventing an out-of-control contagion.

“As such, we should continue to see mass testing and restrictions in the coming months, especially with the more contagious BA.5 variant gaining more relevance in China.” However, after the peaks in cases in March/April and the consequent very strict lockdowns, they estimate that the Chinese government is trying to strike a better balance to make the strategy less impacting for the population.

In addition, the Chinese government has to build trust. Despite all the stimulus granted in recent months, the Chinese economy has not yet recovered, they point out. One of the key issues is consumer confidence, which remains at low levels. The People’s Bank of China’s second-quarter survey showed Chinese households’ income and employment expectations below levels seen in the 2015 crisis and levels seen after the first wave of Covid-19 in 2020.

More than 58.3% of surveyed households were more inclined to save than spend or invest, versus 42.4% in 1Q22. “It is likely that the Chinese government will continue to announce fiscal and monetary stimulus in an attempt to strengthen the economy and generate jobs, but an important variable to be observed in the short term will be the evolution of consumer confidence”, they reinforce.

Meanwhile, the real estate sector remains a major source of concern; but the BBI assesses that the government still has room for targeted stimuli.

The sector (which accounts for about 35% of Chinese steel demand) has been a major source of concern for nearly a year now, with much data for the sector remaining very weak, while buyers’ confidence is shaken (recent news for some buyers failing to pay mortgages on unfinished real estate projects until developers resume construction).

On the more positive side, June saw a rebound in home sales as some Covid-19 restrictions were eased (albeit a 22.2% year-to-date decline), while China has been implementing
targeted stimulus measures (decreasing mortgage rates, local governments with new home purchase subsidy programs) and with room for additional measures (such as total reduction of mortgage rates).

“In short, despite a slowdown in the sector (we already consider a drop of around 20% in steel demand from the sector in 2022), the Chinese government must continue to make use of available tools to avoid a hard landing before returning to a path of deleveraging”, they evaluate.

High infrastructure

As for infrastructure, China has been vocal about the fact that it sees investment as a lever for growth in 2022, with a likely effect in 2023. Investment in infrastructure in the first half of the year rose 7.1% year-on-year.

The government has accelerated the issuance of local government bonds for investments and is expected to sell another 1.5 trillion yuan ($220 billion) of special bonds in the second half of the year. In addition, China’s top economic planning body would be asking local authorities to expedite project submissions and speed up construction whenever possible (even if only scheduled for 2023).

Excavator production has recently started to increase (up 50% in May on a monthly basis) but remains weaker compared to 2021 (down 40% from May 2021). “We note that investing in new infrastructure (especially green infrastructure) is also of strategic interest as China moves towards meeting its decarbonization targets,” the analysts point out.

For BBI, Chinese industry has been recovering from April lows and the bank expects it to continue to rise. In June, industrial production grew 3.9% year-on-year, following 0.7% growth in May, with improvements in key segments.

The auto market, analysts point out, has been on a strong upward trend recently, with vehicle production up 30% month-on-month and 28% year-on-year in June to 2.5 million units. Demand is also expected to be supported by government stimulus (China has already cut about 7.1 billion renminbi in taxes in the first month of its new tax incentive policy for the auto sector).

On the other hand, export demand is likely to weaken as global economies slow down, which could weigh on the recovery.

“Steel demand remains weak for now (also impacted by seasonality), but we expect an improvement over the second half of 2022 and first half of 2023”, projects the BBI.

Steel price dynamics have recently been hampered by weaker market sentiment regarding prospects for Chinese economic growth, as demand did not increase significantly in June, impacted by weather conditions (summer months often lead to activity weaker construction and June has already seen several heat waves, which continued into July).

Steel: recovery prospects

Currently, steel margins remain in negative territory, but BBI sees room for prices to recover in the coming months as production is likely to remain flat/down while demand recovers.

However, risks remain significant if growth continues to lag materially. “If the measures taken by the government fail to spur confidence and economic growth in the coming months or if Covid-19 cases increase and new widespread lockdowns need to be implemented, even weaker sentiment and demand would continue to weigh on the global market. commodity prices and, consequently, in the actions of the sector”, they assess.

However, if the data starts to improve, BBI analysts point out that investor sentiment could change quickly, reducing risk premiums and boosting stocks.

Analysts reinforce Gerdau as the main choice in the mining and steel sector in Latin America, but they also have an outperform recommendation (OP, performance above the market average, or equivalent to purchase) for other securities in the sector, as shown in the table below:

Source: Bradesco BBI

Featured Valley

Pedro Acioli, commodities analyst at the manager Mantaro Capital, pointed to the InfoMoney a cautious scenario iron ore.

“The deleveraging measures imposed on real estate companies by the Chinese government were the trigger for a strong slowdown in the sector, with several developers facing serious financial problems. Property sales in China are already down more than 20% year-to-date, while construction starts are down 30%. This scenario brings negative prospects for the demand for iron ore, since the real estate sector accounts for 30% of steel consumption in China”, he evaluates.

This scenario is relevant for Vale, Brazil’s main ore producer, he says. In the company’s micro, some points are of concern, according to Acioli: the mining company has not yet managed to significantly resume its post-Brumadinho production capacity in Minas Gerais and is now also facing licensing and mineral quality problems in the Carajás operation.

Operational deleveraging, generalized input inflation and increased freight significantly increased Vale’s cost of production. With ore on the rise in recent months, these operational inefficiencies were not evident in the company’s latest results, but should come to light, he points out.

The company releases its operating figures for the second quarter of 2022 this Tuesday (19), after the markets close.

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