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This article first appeared in Corporate, The Edge Malaysia Weekly, on May 2 - 8, 2016.

STEEL stocks have enjoyed huge rallies in the last two months, with some counters rising as much as 98%. Not surprisingly, the sector has seen a rise in unusual market activity (UMA) queries in recent weeks.

YKGI Holdings Bhd received one on March 30, after its share price jumped 30% in a single day. On April 14,  Ann Joo Resources Bhd was queried when the price of its shares rose 6.03% in just 20 minutes after the opening bell. Its share price has surged 85.7% to close at RM1.17 last Friday, from 63 sen six weeks ago.

Last Friday, Bursa Malaysia issued Hiap Teck Venture Bhd an UMA query after its share price more than doubled since March. Year to date (YTD), Hiap Teck’s share price has risen 92.3% — outperforming the FBM KLCI, which has declined 1.05%.

Data on 18 selected steel stocks compiled by The Edge reveal that two-thirds of them have risen by at least 20% since the beginning of March.

Apart from Ann Joo and Hiap Teck, other top-performing steel stocks were Malaysia Steel Works (KL) Bhd (69.2%) and Melewar Industrial Group Bhd (59.5%).

YTD, the aggregate market capitalisation of these 18 steel stocks has gained 33% (see Chart 1), making steel the second best performing sector after airlines (59.4%). Even though both sectors experienced heavy selldown pressures last year, airlines returned to profitability in 4Q2015. The steel sector as a whole, however, was still loss-making in the last quarter of 2015.

If most steel companies are still in the red, why is there a strong rally in steel counters? In its response to Bursa’s UMA query, Ann Joo says the rebound in steel prices may have boosted investors’ confidence in the stock. It added that global and domestic steel prices have rebounded by more than 30% from their lows in December 2015.

 

Steel rally a global phenomenon

To put things in perspective, the recent recovery in steel prices and the renewed interest in steel stocks is a global phenomenon. The world’s major steel players started to see a bull run in mid-February (see Chart 2). Shares of European steelmaker ArcelorMittal, the world’s largest steel producer by production, have risen 61.6%, while US Steel, the lar­gest American steelmaker, has more than doubled since the beginning of the year.

On April 21, South Korean steelmaker Posco reported a stronger-than-expected profit for its first quarter ended March 31, stoking hope of an upturn in the global steel industry.

Despite a 17.5% year-on-year drop in revenue, Posco’s normalised net income increased 5.2%, reversing the earnings contraction in the previous three quarters.

Its shares are now up 41.7% YTD on strong foreign buying, beating the broader Kospi’s 2% gain. Citing its significant restructuring efforts over the past few years are now bearing fruit, analysts have turned bullish on the stock on the back of surging steel prices in China — the world’s largest producer and consumer of the industrial metal.

 

Mini cyclical upswing under way

China’s slowing economy and its transition from an infrastructure-led to a consumption-led economy have reduced its domestic demand for steel, unleashing cheap Chinese steel exports and roiling steelmakers around the world. Now, China’s hot-rolled coil, used in everything from fridges to freight containers, is a key reference price for the global steel market due to the country’s dominant position in the global steel business.

The price of Chinese hot-rolled coil has jumped 53% this year and reinforcement bar, used in construction, has climbed 47%.

In general, April’s steel price has recovered to the level of 2Q2015. Higher Chinese steel prices support the global pricing environment and boost the prospects of steel manufacturers across the globe.

As to what caused the unexpected upswing in Chinese steel prices, analysts believe three factors are at play — improvement in demand, supply constraints and, more importantly, a cyclical change in inventory.

First, 1Q2016 economic and industrial data indicated that growth of fixed-asset investment, industrial output, property new starts, automotive production and excavator sales volume were all faster than market consensus. China’s steel market sentiment appeared to bottom out, industry players say, as the steel Purchasing Managers’ Index for March was 49.7, its highest in 23 months.

Secondly, although supply is recovering in response to improved profitability, supply restraint has kept near-term markets tight. Many steel mills now have cash flow issues and may not be able to resume production rapidly due to the unavailability of funds as banks have become more stringent in lending to steel producers.

Thirdly, as steel traders have been exiting  the market since 2011 due to persistent price declines, steel inventories have been shrinking, and even hit a global financial crisis low in early 2016. The low inventories and supply constraints have triggered a massive restocking rally in March.

 

Make hay while the sun shines

Last Wednesday, the China Iron and Steel Association said in a statement that it is cautiously optimistic about the steel market and expects margins and profitability to improve this year. The group, representing the biggest producers in China, estimates that losses will narrow to RMB10 billion, from over RMB100 billion from 2015.

However, there are conflicting views over the strength of the steel price rally. Fitch Ratings says in an April 25 report that the eye-popping steel rally is not sustainable as mills are expected to bring back idled capacity, raising supply and bringing prices down again. The spike in spot prices is also exacerbated by increased speculation in the commodities futures markets by Chinese hedge funds and other punters.

Last week, China’s securities regulators moved to clamp down on the commodities frenzy. To cool activity, the Shanghai Futures Exchange increased transaction fees while the Dalian Commodity Exchange raised iron ore margin requirements and tightened rules on abnormal trading activities.

That said, consensus expectation among the analysts covering China’s steel sector is that steel prices are unlikely to fall back to the level of 4Q2015 and could remain firm until the restocking season ends. If the restructuring in China progresses and Chinese demand improves, the current upward trend could be sustainable.

While analysts believe this upward momentum in steel prices will continue in the near term, they are divided on how long the rally will last. JP Morgan, Deutsche Bank and Morgan Stanley believe it could be sustained in the second quarter, while Credit Suisse expects this recovery cycle to last at least until June and possibly until the end of the year.

 

The commodity run could be short-lived

If the upward momentum in steel prices does indeed sustain until mid-2016, are local steelmakers offering attractive risk-rewards given that the sector is now trading at dirt-cheap valuations? Based on the quarterly earnings and share price data, it seems that investors are speculating in companies that might be turning around this year.

As shown in Table 1, the best-performing counters are the ones that posted a quarter-on-quarter improvement in their 4Q2015 results. Nine of the top 10 performing steel stocks narrowed their losses or improved their earnings in the latest quarter compared with the previous quarter. They also tend to have an Altman Z-score of more than 1, which indicates stronger balance sheet strength.

Malaysia Steel Association (MSA) says in a recent statement that the local steel supply is tight at the moment, as Chinese exporters are cancelling numerous contracts as they can get higher prices domestically. In light of the sudden shortage of steel, MSA members are now looking to retool, rehire and restock their raw materials to increase production capacity.

Nonetheless, Public Investment Bank analyst Chong Hoe Leong says the bottoming out of steel prices is part of the commodity run, buoyed by a weak US dollar and the slower pace of interest rate hikes.

Chong believes the rally of local steel counters is largely sentimental as industry fundamentals are still weak.

While he expects earnings for the steel sector to improve to a slight profit in 1Q2016, the current optimism could reverse in the second half of the year when the US Federal Reserve is expected to raise interest rates.

Pacific Mutual Fund Bhd, a unit of OCBC Group, echoes this view. It reduced its exposure to the steel sector last month.

The fund sold 1.8 million shares or a 0.3% stake in Hiap Teck, decreasing its shareholding to 0.4%. It also exited its investment in Ann Joo, selling 1.7 million shares or a 0.3% stake in the company.

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