PMIs a boost for China's iron ore but hide steel overcapacity
While manufacturing PMIs are looking up, the steel production indicator goes the other way
Iron ore and steel prices have been buoyed by the strength of the mainland's manufacturing indices, but there is a risk the market is focusing on the wrong indicator.
The mainland's official purchasing managers' index hit an 18-month high of 51.4 last month, while the HSBC measure reached a seven-month peak of 50.9.
Both PMIs indicate improving conditions in the mainland's vast manufacturing sector and this was enough to spur gains in iron ore and steel prices.
But at the same time that the manufacturing indices were looking up, the PMI for the mainland's steel industry was heading the other way.
The steel PMI dropped for a second month, falling to 47.5 last month from 49.2 in September, according to the China Federation of Logistics and Purchasing, which compiles the index.
The decline to well below the 50-point level that separates expansion from contraction on a monthly basis was driven by falls in overall production, finished product inventories and new orders, according to a Morgan Stanley research report that was released on Tuesday.
The decline in the steel PMI fits with some other evidence that not everything is rosy in the sector, with average steel output falling 1 per cent to 2.107 million tonnes in the second 10 days of last month.
The drop was the second consecutive decline, following a 1.1 per cent fall in output in the first 10 days, according to data from the China Iron and Steel Association.
The volume produced was also the lowest since the 10 days that ended on July 31.
There are also indications that steel inventories are rising, with association figures showing stocks at 13.2 million tonnes, rising 3.1 per cent since the end of August.
It is likely that this inventory build-up has continued in recent weeks, meaning that the mismatch between steel output and consumption may be increasing. It also does not appear to be the case that exports are taking up some of the slack, with steel product exports dropping 4.4 per cent year on year in September to 4.92 million tonnes, according to customs data.
Year-to-date exports are still up 14.6 per cent, but this strength seems to have been built on exceptionally robust shipments in July and August, which recorded gains of 19.1 per cent and 44.9 per cent, respectively.
So, what should the market believe? The emerging strength in the manufacturing PMIs or the weakness in the steel PMI?
As is often the case, the contrasting PMIs are not necessarily at odds with each other.
It is certainly possible to have improving conditions in manufacturing and weakening fundamentals in steel at the same time.
In theory, an improving industrial sector PMI should act as a spur to the steel industry by boosting demand for metal products, but it still may be the case that the mainland's spare steel capacity is larger than any potential increase in consumption.
What the steel PMI shows is that there is still probably over-production happening in the sector, which means the recent rebound in benchmark Shanghai Futures Exchange rebar may not be sustained.
The contract is up 2.5 per cent since hitting a four-month low of 3,585 yuan (HK$4,560) a tonne on October 28, closing at 3,673 yuan on Monday.
Iron ore prices have outperformed steel, with spot Asian iron ore up 3.5 per cent since October 28 and the new Dalian Commodity Exchange's most active contract gaining 3.7 per cent over the same period.
If there is a contrast in the steel sector, it is between the continuing robust demand for iron ore and the weak profitability of steel producers.
The mainland's iron ore imports were up 9 per cent year on year in the first nine months of the year, with the third quarter recording the first, second and fourth-highest monthly totals.
Imports were also likely to have been strong last month, given the 3.2 per cent month-on-month rise in September shipments from Australia's Port Hedland, the main export port for iron ore.
However, at some point soon the overcapacity in the mainland's steel sector will have to be addressed.
While the recent gains in the manufacturing PMIs provide the possibility of rising demand in coming months, the problem of structural overcapacity remains.