All Steel Must Pass Through Fire

Includes: AA, AKS, SLX, X
by: Wall Street Strategies

By Jennifer Coombs

The finest steel has to go through the hottest fire.

-Richard M. Nixon

Call it word association syndrome, but whenever I hear the word "steel" my mind immediately drifts to the "Pittsburgh Steelers." I know, call me weird, but the Steel City is a fantastic illustration of what the ebb-and-flow of industrial metals can do to an economy. Many might not know that Pittsburgh's NFL team officially was called the "Steelers" (previously "Pirates") prior to the start of the 1940 season. However, their iconic logo wasn't introduced until 1962. The "Steelmark" logo was originally designed by U.S. Steel (NYSE:X) as a representation of the broader steel industry. The three asteroids (yellow, red and blue) originally represented the mission statement of the industry: "steel lightens your work, brightens your leisure, and widens your world." Later on, the colors came to represent the ingredients used in the steel-making process: yellow for coal, red for iron ore, and blue for scrap metal. Steel has been the major industrial metal responsible for driving economies for decades - and not just Pittsburgh. It's no wonder that "steel" is synonymous with "strength" and "resilience." The largest and strongest economies in the world are also the largest producers of steel: China, U.S., Russia, India, South Korea and Japan. (Makes sense for a sports team name now, doesn't it?)

Ultimately, though, I'm not here to talk about football. The supply, demand and pricing of steel and other industrial metals, such as aluminum, can serve as great barometers for the overall health of an economy. In recent days, there has been a slew of new data released on industrial metals that has helped us connect some important dots on global economic health and the outlook appears quite positive.

The Global Steel Outlook

Last week, the World Steel Association (WSA) provided its short-range outlook for the use of steel going into this year and next. According to the WSA, global steel use is expected to increase by 3.1 percent to 1,527 million tons (Mt) in 2014, after growth in 2013 increased by 3.6 percent. However, growth should pick up in 2015 by about 3.3 percent to 1,576 Mt. The report notes that the surge in growth for 2013 came from stronger than expected industrial recovery in developed nations - in particular, the United States. Additionally, steel demand had bottomed out in the European Union in 2013, and going forward the WSA expects steel prices to grow positively in the EU in 2014. Below is the WSA's table of actual and forecasted steel usage by geographic region.

Despite this pick-up in strength by the developed world, emerging markets continue to struggle, namely with financial market volatility and structural issues. China is the primary culprit behind the lower than expected steel growth numbers in 2014 compared to last year. In 2015, economists expect global usage of steel to improve, but China will not be one of those improving nations. After growing by about 6.1 percent in 2013, thanks to government support programs, the use of steel in China is expected to slow to 3.0 percent growth in 2014 (or 721.2 Mt). The Chinese government continues to boost efforts to rebalance the economy and continues to limit certain construction projects and investment activities. In 2015, steel demand growth in China is expected to decelerate even more to 2.7 percent. As we've seen from the monthly economic data out of China, the services sector is quickly and drastically surpassing the industrial/manufacturing sector as the primary driver of jobs and GDP. If this trend continues, industrial activity should dwindle in China, which would be great for helping pollution issues, but industrial growth would remain flat - more indicative of a developed nation. Below is a chart comparing the spread between China's manufacturing PMI (industrial) and non-manufacturing PMI (services) over the last five years. A reading above 50 indicates expansion while a reading below 50 indicates contraction. As of now, the non-manufacturing PMI shows a reading of 54.5 while the manufacturing PMI remains hovering just above contractionary levels at 50.3.

Elsewhere in the world, numbers indicate a pick-up in economic growth. Analysts at the WSA expect steel demand to increase by 3.3 percent in India in 2014, up from 1.8 percent growth in 2013. The construction and manufacturing sectors remain strong in India despite inflation and structural problems. Remarkably, in spite of government election uncertainties, steel demand in India is still expected to grow by 4.5 percent in 2015. In all of Central and South America, steel use is expected to grow by about 3.4 percent in 2014, which is significantly down from the 4.3 percent growth experienced in 2013. However, expectations for 2015 are expected to slow down to about 2.7 percent due to a contraction in Argentina, a slowdown in Chile, and high inflation and interest rates in Brazil. Russian steel demand is anticipated to accelerate to 4.4 percent in 2015, but demand should contract in Ukraine as it will be struggling to meet financial obligations to the International Monetary Fund (IMF).

Lastly, here in the United States, after a decrease of -0.6 percent in steel use in 2013, this year and next are expected to bring back a higher level of growth and recovery according to data from the WSA. Steel use will grow by 4.0 percent to 99.4 Mt in 2014 and by 3.7 percent in 2015. The impact of the Federal Reserve's tapering on the US economy has been contained so far, but future actions still remain a risk, albeit modest for now.

Overall, it should be noted that steel growth in developed economies is expected to be above 2.0 percent in 2014 and 2015, but despite their recent weakness it is likely that developing and emerging markets will surpass developed economies in steel use looking beyond 2015.

The Power of Aluminum

Many find it hard to believe, but at one point in history aluminum was considered the light, miracle metal and was more valuable than gold. Obviously that's not the case today: I don't think you'd wrap your leftover pizza in gold foil before storing it in the fridge. Nevertheless, the usage of aluminum is also a great indicator for economic health - why else would investors care so much about Alcoa Inc. (NYSE:AA)? Alcoa has a reputation for being the first bellwether stock to release performance results every earnings season, despite the fact that the company was removed from the Dow Jones Industrial Average back in September 2013 after trading in the index for 44 years.

Alcoa released first quarter earnings results on April 9, and given The Street's reaction, the figures were quite optimistic. The company not only beat on earnings per share expectations but also noted that 2014 global aluminum demand should increase by 7 percent in 2014 - which is still on-par with the growth rate of 2013, but growth at these levels is still remarkably high. This means that for the first time in almost 10 years, global aluminum demand will exceed the level of production. The surplus had been driven by China in recent years, where increased output that saddled the industry led to lower prices. Amazingly, Alcoa now anticipates a global supply deficit of aluminum at 730,000 metric tons when back in January it had anticipated a surplus of 106,000 tons.

Additionally, management's outlook for 2014 remains fantastically optimistic: below is a table from Alcoa's FYQ1-2014 earnings presentation with the geographic growth expectations in all sectors. It's still rather impressive how the overall level of production growth is still expected to remain strong in China for 2014. Aerospace is usually a good gauge for economic growth since aircraft purchases tend to occur more frequently when the economy is strong: from the chart below you can see that global growth is expected to come in 8-9 percent higher this year. The company currently possesses an eight year production backlog for large commercial aircraft with a 7.5 percent end market compounded annual growth rate (OTCPK:CAGR) between 2013 and 2016.

Of Alcoa's $13.1 billion revenues in 2013, $4.0 billion came from aerospace, $3.1 billion from packaging, $1.8 billion from industrial products, $1.5 billion from commercial building and construction and 1.3 billion for commercial transportation. The company has some pretty impressive CAGRs for its four major growth segments. In the auto space, Alcoa expects auto sheet aluminum in North America to grow above a 50 percent CAGR between 2013 and 2016, and it is expected that North American aluminum auto sheet demand will be over 1 million metric tons by the year 2025.

Alcoa's earnings report should have a ripple-through effect to the overall industrial fundamentals going forward - there remains substantial demand for industrial metals although the only proponent that really changes is what the material is used to build (i.e. more soda cans is OK, but more airliners is awesome). We believe that the signs point to a fundamentally healthy 2014 in spite of the roller coaster ride the equity indexes have been taking in recent days.

In Conclusion

When the markets get rough, it's important to realize that everything is getting tossed around. A dip in the market does not mean cars will stop being sold, that bridges will stop needing vital repairs, and that brewers will stop filling aluminum cans with beer and soda. The global fundamentals of industrial metals are staying afloat in some markets and are soaring in others. Overall, growth fundamentals remain strong around the world and it would certainly be in every investor's best interest to have exposure to this space. With more earnings results being released in the coming weeks, we hope that investors will consider the corporate outlook for the rest of 2014 rather than focusing on difficult business during the first quarter due to weather. The steel industry has certainly gone through fire in recent years - but it should come out the other side strong.

We believe the following two stocks will help with proper positioning in the industrial metals market going into the rest of the year:

Noteworthy Stocks in the Space


This small-cap steel producer out of West Chester, Ohio, announced early last week that it plans to increase its current spot market price for hot roll carbon steel to a minimum of $700 per ton - a move which is starting to really resonate among other steel companies as they re-price metals to match demand and inflation. To us this suggests that supply and demand are meeting a more reasonable balance. Additionally, the company announced on Tuesday that it will increase prices for all of its stainless steel products. For the following products, the increase will be achieved through a discount reduction of two percentage points: commodity sheet and strip; pipe and tube sheet and strip; specialty sheet and strip. For all other stainless steel products, including automotive exhaust sheet and strip, prices will be raised by $40 per ton. AKS also lowered guidance back in March for the first quarter, but it was primarily due to weather and repairs that aren't expected to carry over going forward. The stock broke out above its 50-day moving average mid-March, which tells us that the stock is heading back toward a long-term bullish trend.

U.S. Steel (X)

U.S. Steel (X) was founded in 1901, and was the largest business enterprise ever started at the time at a capitalization of $1.4 billion and was put together by a team headed by Elbert H. Gary with help from the likes of Andrew Carnegie, J.P. Morgan and Charles Schwab. Since U.S. Steel is among the largest domestic steel companies, any changes in steel fundamentals affects the company first. Recently, we've seen the stock get a boost from China's government offering a mini stimulus package in order to boost industrial production in order to meet their lofty annual growth rate of 7.6 percent. We note that U.S. Steel's long-term chart is very similar to that of AKS - both have broken above their 50-day moving average and are making long-term moves to the upside.

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