The Impact Of Economic Turbulence In China On Metals And Mining Stocks

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The past few days have seen a sharp decline in the U.S. stock markets with the S&P 500 down nearly 8% over the course of the last ten days at the close of trading on August 26. [1] Fears of an economic slowdown in China, the devaluation of the Yuan, and the potential impact of these events on U.S. equities have weighed heavily on investor sentiment. The recent sell off in the stock markets has certainly negatively impacted metals and mining stocks. China is the world’s largest consumer of nearly all metals and fears of weakening demand from China is certainly material to the fortunes of these companies. In this article, we will take a look at the implications of the weakening Chinese economic prospects for metals and mining companies.

Macroeconomic Situation in China

As per forecasts made by the IMF in July, Chinese economic growth is expected to slow to 6.8% and 6.3% in 2015 and 2016, respectively, from 7.4% in 2014. [2] Slowing Chinese economic growth is particularly evident in the manufacturing sector, as indicated by the Manufacturing Purchasing Managers Index (PMI). The Manufacturing PMI measures business conditions in the manufacturing sector of the concerned economy. When the PMI is above 50, it indicates growth in business activity, whereas a value below 50 indicates a contraction. The following chart illustrates the weakening prospects of the Chinese manufacturing sector.

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Chinese Manufacturing PMI, Source: Trading Economics

 

In an attempt to revive growth through boosting exports, the Chinese central bank devalued the Yuan by around 2% against the Dollar earlier in the month. [3] This move will make Chinese exports cheaper in Dollar terms. The move was also viewed as a confirmation of weakening Chinese economic growth, which has negatively impacted most metal and mining stocks.

Starting with iron ore and steel, we will take a look at the implications of these events for prices of various metals and related stocks.

Iron Ore and Steel

The markets for iron ore are characterized by an oversupply situation, with global iron ore majors such as Rio Tinto (NYSE:RIO) and Vale (NYSE:VALE) continuing to ramp up production in the face of weak demand. Since iron ore is the chief raw material for the steel industry, demand for the commodity by the steel industry plays a major role in determining its prices. Benchmark international iron ore prices are largely determined by Chinese demand, since Chinese steel mills purchase nearly two-thirds of the world’s seaborne iron ore supply. [4] As per estimates made by the World Steel Association (WSA) earlier  in the year, Chinese steel demand growth is expected to decline by 0.5% in 2015, following on from a 3.3% decline in 2014. [5] With the prospects of the Chinese manufacturing sector continuing to weaken, as indicated by the manufacturing PMI numbers shown earlier, Chinese demand for steel may decline faster than WSA estimates. Weak demand for steel indirectly results in weak demand for iron ore.

The devaluation of the Yuan has further dented the prospects of iron ore companies, making Dollar-denominated iron ore dearer in Yuan terms, which is likely to weaken Chinese demand for the commodity even more. This is reflected by the decline in iron ore stocks post the announcement to devalue the Yuan on August 11. The exception is Cliffs Natural Resources (NYSE:CLF), since the majority of the company’s revenues are derived from the North American steel industry and a weakening of Chinese demand for iron ore does not directly impact it. Further, Cliffs’ stock has already fallen considerably over the last year or so.

Iron Ore Stocks, Source: Google Finance

The devaluation of the Yuan has given a fillip to Chinese steel exports, making them cheaper in Dollar terms. This has negatively impacted the prospects of steel producers such as ArcelorMittal (NYSE:MT) and U.S. Steel (NYSE:X). The North American operations of both these companies were already suffering from rising steel imports from China, competition from which has negatively impacted steel shipments, pricing, and margins for the North American operations of these companies. Domestic steel producers claim that steel imports from China are priced unfairly low and have filed anti-dumping duty petitions against them. In the absence of anti-dumping duties against these steel imports, cheaper steel imports driven by a weaker Yuan are likely to further worsen the prospects of steel producers. The stock prices of both ArcelorMittal and U.S. Steel have declined considerably post the announcement to devalue the Yuan on August 11.

Steel Stocks, Source: Google Finance

Copper, Aluminum, and Oil

China is the largest consumer of copper, aluminum, and the second largest consumer of crude oil in the world. Copper and aluminum are metals with diverse industrial applications. Weakening Chinese manufacturing growth has negatively impacted the demand for these metals. In addition, a slowing Chinese economy has dampened Chinese demand for crude oil, the prices of which have tumbled over the last twelve months due to oversupplied global markets. Pricing for all of these exchange traded commodities is denominated in Dollars, with sales contracts linked to exchange traded prices. The devaluation of the Yuan is expected to negatively impact Chinese demand for all of these commodities and consequently, their prices. This has negatively impacted the prospects of Freeport McMoRan Inc. (NYSE:FCX), which sells copper and oil and gas products, and Alcoa (NYSE:AA), which sells aluminum based products, as indicated by the sharp decline in their stock prices post the announcement of the devaluation of the Yuan on August 11.

FCX and AA Stock Prices, Source: Google Finance

Gold

Gold prices have been under pressure over the course of 2015 due to expectations of an interest rate hike by the Federal Reserve. An interest rate hike is likely to reduce the investment demand for gold as investors shift towards interest bearing assets. China is the world’s largest consumer of gold. A weakening Chinese economy has tempered the consumer demand for gold in China. Jewelry demand for gold fell 5% year-over-year in China in Q2. [6] Weakness in GDP growth has retarded the expansion in networks of jewelry retail chains into smaller Chinese cities. Further, stock market turbulence in China has also dampened the demand for gold. Investments into a booming Chinese stock market reduced discretionary spending on gold jewelry in the early part of Q2. Moreover, the sharp correction in the Chinese stock market in June wiped out capital gains made by investors, damaging consumer sentiment and reducing discretionary spending on precious metals. [6]

As discussed previously in the article, macroeconomic weakness in China, and the devaluation of the Yuan, have weakened the demand and pricing environment for most metals. Cheaper commodities, a stronger Dollar, and a weaker Yuan, have put downward pressure on imported inflation in the U.S., developments that may delay or moderate the Fed’s decision to raise interest rates. [7] As mentioned previously, gold prices have been under pressure due to expectations of an interest rate hike by the Fed. A delayed or moderated interest rate hike would boost gold prices. In light of recent events, it remains to be seen whether, and by what amount, the Fed raises interest rates in 2015.

Conclusion

The recent stock market turbulence and devaluation of the Yuan are symptomatic of a slowing Chinese economy. Weak Chinese demand for copper, aluminum, steel, and oversupplied global markets for iron ore and crude oil, were already negatively impacting pricing for these commodities before the latest bouts of economic turbulence from China. However, a weaker Yuan and a further slowdown in Chinese growth will worsen the demand-supply dynamics of these commodities, negatively impacting pricing. Copper, aluminum, iron ore, and crude oil are currently trading at multi-year lows, and prices are close to, or have approached, production costs. Pricing for these commodities may deteriorate further, but with prices having fallen considerably over the last twelve months and approaching production costs, any further declines in pricing are likely to be muted. The recent sell off in metals stocks may have been slightly exaggerated, since a slowdown of the Chinese economy was already factored into stock prices. It is perhaps the uncertainty about the extent of the slowdown that has created the latest bout of panic. However, regardless of the extent of the slowdown, with economic growth floundering in China, a significant improvement in the prospects of metals and mining companies looks unlikely in the near future.

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Notes:
  1. S&P 500, Google Finance []
  2. World Economic Outlook, IMF []
  3. China Moves to Devalue Yuan, Wall Street Journal []
  4. China Plans Iron Ore Subsidy for Miners Amid Rout, News Says, Bloomberg []
  5. Short Range Outlook 2015-2016, World Steel Association []
  6. Gold Demand Trends, World Gold Council [] []
  7. Devalued Yuan May Complicate Fed Tightening, Wall Street Journal []