Iron Ore - Better To Travel Than Arrive?

 |  Includes: BHP, DIA, IWM, QQQ, RIO, SPY, VALE
by: Maleeha Bengali


Iron Ore has rebounded ~10%+ from its March lows in anticipation of Chinese stimulus. The announcement released was quite specific focusing on shantytown renovations and railway construction.

The Chinese government maintained that GDP is less important than job creation and tackling overcapacity is their priority for this year.

Iron Ore faces the worst demand/supply prospects going forward given the abundance of supply. Large cap miners like Rio Tinto, BHP Billiton, and Vale are credible shorts here post recent rebound.

One of the best phrases that I came across over my years of trading was "better to travel than arrive." At first I wasn't sure if it was a phrase coined by some Gordon Gekko wanna-be trader back in the 80s or an abstruse Confucius saying. Either way it baffled me, as not only was it grammatically incorrect but was also contradictory to every prose I was taught in school. After watching the P&L trajectory of my first trade, it all made sense; these were the five most powerful words in our industry!

The last few days, the market has been reacting contradictory to any bad economic Chinese data. The official PMI came out disappointing with domestic orders falling again. GDP growth in Q2 can go down to 7.1% from 7.3% in Q1. As seen in the chart below, forward-looking indicators do not show a rebound in activity.

But Emerging markets and risky assets are rallying...what gives?

Everyone has been pre-empting some sort of Chinese stimuli to be released to defend their 7.5% annual GDP growth target. This evening, the Chinese government came out with an announcement to expand tax cuts for small businesses and adopt other fiscal measures to boost job growth by renovating shantytowns and investing in railway construction to support the economy, but the devil is in the details. Government officials have repeatedly insisted that the GDP level is less important than job creation and that growth may be allowed to fall to a floor at around 7% provided that this year's target of 10 million jobs is being met. They have said that markets could be disappointed if they are expecting the types of stimulus that investors have become accustomed to, as tackling overcapacity is the priority for economic work this year.

This is in sync with the efforts made so far to improve the banking system, get rid of excess credit and slack in the system, such as closing excess aluminum and steel capacity. Controlling air pollution has been another top priority, which has serious implications for steel demand going forward. Capital misallocation is evident in the trust sector, China could allow some of these to default, which may destabilize the shadow banking sector. This would not bode well for "copper" and "iron ore" markets. According to Baml, ~ 750k tonnes of copper stocks are locked up in these warehouse financing transactions (used for collateral), equivalent to 3 months of import demand.

The other bull case quoted by momentum investors is the "seasonal" pick up in steel demand in China (using history as a guide). Iron ore at ports are at highs and we could see a destock as further Chinese deals unwind, but steel inventories are low at mills that can offset this. Even if Chinese steel demand picks up seasonally, there is supply to meet this. Maybe prices remain at best range bound, but it's possible to see a slowdown as we move through Q2.

We could very well be at the start of a turning point of a global economic recovery especially as data from the US improves vs. earlier in the year due to bad weather, but it's not a slam dunk just yet. There are opportunities no doubt, but being selective is key rather than just piling in to buy everything. Iron ore trading up 10% from mid March lows of $110/t has the most downside of all commodities facing the worst demand/supply dynamics into 2015 onwards as prices can head down to below $100/t.

Stocks that have high ebitda exposure to Iron Ore like Rio Tinto (NYSE:RIO) (80%), Vale (NYSE:VALE) (82%), BHP Billiton (NYSE:BHP) (52%), even Anglo American (44%) are credible shorts here given the recent rebound. Investors are hiding in these large cap names given the prospect of higher free cash flows and dividend yields (eventually) in 2015/2016 onwards. But near term they are still susceptible to earnings downgrades. Management will want to be prudent to see how low the cycle goes before going on a cash return spree. Despite cost cutting initiatives and restructuring plans that can help in the longer term no doubt, near term their top and bottom line will be hurt.

Investors seem like addicts looking for their next fix. Perhaps a dose of reality is better suited for them, compelling them to go back to the drawing board and focusing on fundamentals than just playing the momentum.

Disclosure: I am short RIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.