The recent approval of $157 billion of infrastructure spending by China has increased speculations of a possible turning point in the iron ore market, which is heavily dependent on China's recovery from the currently sluggish growth. We see a huge upside for long-term investors in iron ore equities and recommend Cliffs Natural Resources (NYSE:CLF) and VALE S.A. (NYSE:VALE) as pure plays on an iron ore recovery. A relatively safe but less promising move would be to invest in diversified metal giants, like BHP Billiton (NYSE:BHP) and Rio Tinto plc (NYSE:RIO).
China's Data and Recent Steps
On Friday, China approved infrastructure spending worth almost $157 billion in an attempt to bolster the currently depressed economic growth. Economists are now increasingly speculative about the possibility of a monetary stimulus in the world's second largest economy, which is currently undergoing its worst slowdown in three years.
According to the National Development and Reform Commission (NDRC), China's economic planning agency, twenty-five subway projects, thirteen road construction projects, five port projects and two waterway projects have received approvals. Consequently, iron ore prices increased by 2.3% to reach $89/metric ton.
China's YoY growth rate of 7.6% in the second quarter of 2012 is the lowest since the global financial crisis. In addition to the deepening of the economic downturn, China is also facing augmenting inflation pressure, posing problems for policy makers as they are faced with a strange dilemma: decrease interest rates (through monetary stimulus/quantitative easing) and risk a surge in inflation, or take no steps for a stimulus and risk a sharper meltdown.
China's August data, which was released yesterday, showed continued signs of economic weakness, especially in exports and imports. Specifically, Chinese imports dropped by 2.6% on a YoY basis, relative to a 4.7% increase in July, showing the sluggishness of the pace of economic activity in the country.
Iron ore imports have dropped by a whopping 20.9% from last year's levels in terms of value. However, they were up by 5.7% on the basis of tonnage. Plus, according to Mr. Lu of the Bank of America Merrill Lynch, this fall in imports is less scary than it appears because the prices of some commodities, like iron ore, also dipped during the same period.
Iron Ore - Market Dynamics
Iron ore markets have slid enormously, as prices dropped below $90/metric ton last week due to weak steelmaking demand, especially from China. In addition, the destocking trend is continuing its toll, which has adversely impacted the rate of recovery. According to a recent Credit Suisse report, "The Chinese have almost completely withdrawn from the [iron ore] spot market." However, it says that this trend of destocking is not sustainable, as it expects China to start rebuilding inventories within the upcoming 2 months, pushing prices in the range of $100-$120 per metric ton.
We also suspect a possible bottoming point in the near-term, although its timing is uncertain. Nonetheless, it's an ideal entry point for long-term investors who aim to target big returns, albeit a risk of a little loss remains there if iron ore prices keep their downward trajectory. CLF and VALE remain our top picks, in a decreasing order of preference, for investors who are targeting a bigger bounce in case of iron ore's rebound, as these companies have high iron ore exposure. A relatively risk-averse strategy would be to go for big mining giants, BHP and RIO, as their diversification makes them less reliant on an iron ore recovery. However, the disadvantage in going for these mega miners is the limited expected upside relative to CLF or VALE, if the rebound happens indeed. You can also read our previous articles on CLF, VALE, RIO and BHP by clicking on their respective tickers.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by Qineqt's Basic Materials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.