The Blows Keep Coming For Basic Materials

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 |  Includes: AKS, BHP, EWA, FXA, MT, NUE, PCXCQ, RIO, VALE, X
by: Paulo Santos

Having written what seemed like an endless string of different articles showing why the developments in China were negative for several basic materials, and having taken a fair amount of flak because of it, it seems that right now the thesis I was espousing is becoming mainstream.

The recent news of China downgrading its growth objective from 8% to 7.5%, the services PMI coming in at 48.4, and property developer China Vanke's sales slumping are among the many tidbits. The resulting grief for steel, iron ore, copper and coal stocks was, in the end, predictable.

Yet, the news doesn't end there. There are a few more developments that continue to suggest this particular thesis is far from over:

  • One is that China will be seeking to contain expansion of production capacity in the automotive, steelmaking, shipbuilding and cement industries. This is not a coincidence - the Chinese leadership knows that these industries will be under a great deal of overcapacity in a short time, and thus want to try and restrain such overcapacity. But obviously, breaking the expansion of these industries guarantees slower, or even receding, demand for the same basic materials I've been talking about (indeed, the industries are the same as the ones I've been talking about, no surprise there).
  • And in a further blow to the already teetering property market, China might be seeking to expand property taxation from present trials in Shanghai and Chongqing. This might serve as a way to finance local authorities, which are mired deep under debt mountains, but it will also pose a further problem to the property market, lowering the incentive to buy and hold property.

Market Consequences

The thesis remains the same - prices for residential real estate in China are dropping, activity is sure to follow (is following). There is also weakness in auto sales and production, and there will be substantial weakness in shipbuilding. This will have wide-ranging consequences, such as:

  • Steel prices worldwide will be pressured, since China accounts for 46% of the worldwide production in steel, steel travels reasonably well and it's thus predictable that many Chinese producers will try unloading their production in foreign markets. This is a clear negative for U.S.-quoted steel stocks, such as United States Steel (NYSE:X), AK Steel Holding Corporation (NYSE:AKS), Arcelor Mittal (NYSE:MT) and Nucor (NYSE:NUE). As a counter-point, one should add that steel does have travel costs, the housing and auto markets are recovering in the U.S., and import tariffs might hit Chinese steel. The steelmakers in many instances already have low market capitalizations and thus betting against them is somewhat riskier.
  • Iron ore prices will plunge. Steel production in China is set to stagnate or fall (presently, it's falling), while iron ore production is set to expand. This kind of mixture in a fungible, high-ROE, market does not end well. Iron ore producers, such as BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO) and VALE S.A. (NYSE:VALE) have a long way down if this thesis remains in effect.
  • Coal producers, especially metallurgical coal producers, will continue to be hit. Patriot Coal (PCX) shows what can happen here. Still, speculating on much lower prices is speculating on bankruptcy, so although that can happen, it's a different game altogether. Thermal coal presents a murkier picture. China should continue to invest in power generation, thus taking in greater amounts of thermal coal, but obviously China is not the only thesis hitting coal - there's also the low natural gas price in the U.S. market due to shale gas exploration.
  • Chinese companies in the property sector, cement producers, etc. There are many other obvious victims, however, these don't have U.S. quoted stocks and thus become harder to speculate or invest in. Cement does not travel so well, so worldwide prices should not be hit the way steel prices will, hence it's more of a local problem.
  • Australia will be hit severely, given the prevalence of China and basic materials in its exports, and the importance of mining investment in its economy. This will be negative both for Australian stocks (NYSEARCA:EWA) and for the Australian Dollar (NYSEARCA:FXA).

Conclusion

Even though the basic materials sector has been hit hard these last few days, the thesis that dictates this market movement it not short term in nature. It will take a year or more to play itself out, so for now the whole space still seems mostly off-limits. For now, we're still seeing mostly negative developments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am short AUD/USD.