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Iron Ore & Steel - Secular Trend Intact
There are several magic pairs which create opportunities for wealth creation. Take for example basic materials and industrials.
The Indian economy has great need for capital goods and infrastructure. The need is immense; power, housing, offices, retail, roads, hospitals, refineries, industrial equipment and much more; you name it and it is needed. Capital goods and infrastructure are ever so essential, because they are needed to expand capacity, which in turn facilitates the next phase of growth. India can be expected to provide high growth rates in demand for commodities. At the same time, demand from China remains elevated. While the growth rate in demand for commodities can be expected to slow, the gross recurring demand remains stable. And as the United States responds to structural weakness in its economy (over-consumption, high debt and low production); I expect a fundamental shift as the Country seeks to restore its primacy as a producer nation; this too should provide a significant dose of growth in demand.
Now for industrials to prosper, their suppliers must prosper too. Basic materials outperform ahead of industrials based on expectations of elevated demand. The industry is capital intensive and the investment required in mining and materials is heavy. Capex plans will not be deployed until expectations of long term prices have increased to a level where the marginal costs will be covered.
The dance continues. As the economy expands, the basic materials sector prospers; ultimately prices exceed marginal costs by a wide margin. When marginal revenues exceed marginal costs by a wide margin, competition and capacity expansion come into play. This has a major impact on the long term price expectation. At this point in time, demand from industrials contracts; projects are no longer viable at prices prevalent. Basic materials under-perform as the economy goes through contraction ahead of under-performance from industrials. Prices of basic materials contract, falling rapidly towards and below marginal cost; at this stage demand expected from industrials rises. Once the industrial sector is expected to outperform, the prices of commodities can be expected to stop falling; the sector will ultimately outperform ahead of industrials. Another interesting magical pair is the basic materials industry & price of the underlying commodity. The stock market is forward looking. Prices of stocks in the materials and mining segment fall ahead of commodity prices. Once the commodity price starts falling, it does so rapidly. As it falls below the marginal cost of production, you see a producer response. Producers will cut production in order to reduce marginal costs; at the same time falling supply will put a floor beneath commodity prices. Commodity prices at this stage will continue a gentler downdrift. But since the capital markets are forward looking, the decline in value of stocks in the material and mining sector will cease. From here, the basic materials sector will commence out-performance ahead of industrials; commodity prices will continue a drift downwards and commence a vigorous ascent as physical demand kicks in. Again, the stock market predicts direction for the underlying commodity. In recent years, trading this opportunity in pairs has become more difficult because the relationship between commodity price and physical demand has broken down. The ability to invest in directly in physical commodities has risen with several commodity exchanges around the world. The use of derivatives together with financial investor interest, means that the commodity prices are less responsive to physical demand.
In extreme circumstances, when an economy is expected to be in a long lasting contraction, material prices will continue falling even after production cuts. You will then see additional producer response; they will respond to demand destruction by cutting marginal costs - this time around they go beyond production cuts; they cut capacity. Cuts in production are temporary and easily reversed; the saving comes from elimination of variable costs. Cuts in capacity are more permanent; it is closer to dis-investment (or at a very minimum deferral of investment) and the costs saved will include both fixed and variable costs. At this point in time this is not a situation I expect to unfold; long term demand from China is stable, demand growth will slow considerably but the gross recurring demand is not at a stage where it can be realistically expected to contract. At the same time, long term demand growth from India can be expected to escalate rapidly. And as the United States responds to structural weakness in its economy (over-consumption, high debt and low production); I expect a fundamental shift as the Country seeks to restore its primacy as a producer nation. The market is predicting a protracted recession and producer cuts to capacity have come into play; in my view these will reverse by late q1 09 and metals will power on. Steel and Iron Ore are both fundamentally strong in this age where infrastructure development in India and China is critical; it is now even stronger since the developed nations will likely use investment in infrastructure as a Keynesian response to the crisis.
So you have a magical pair in industrials and basic materials. You have another in basic materials and the underlying commodity. If you hear their song and dance to their tune, you have opportunities to create wealth.
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