As we enter the Year of the Pig in the Chinese calendar, the performance of iron ore has been, well, piggish of late. Coal and iron ore are the two key ingredients in the production of steel in the Bessemer process. As popular as Alibaba, Tencent’s WeChat, iQiyi and countless other Chinese apps may be, steel production is still the best determinant of the health of the Chinese economy.
Chinese government estimates place 2018 steel output at 923 million tonnes, an 11% increase over 2017’s figure. October’s output of 82.552 million tonnes reflected an all-time record for the Chinese economy. So, all those out-of-context, sentiment-based data points that seem to be showing a slowdown in the Chinese economy–PMI data for example–really are giving a false positive for the all-important “China’s economy is slowing” narrative that so many market observers in the U.S. love to push.
Structural inflation can be a hindrance to economic growth, of course, and that’s where the recent spike in iron ore prices comes in. The catalyst for this move in iron ore prices, unfortunately, was the breach of the dam at Vale’s Córrego de Feijão mine in Brumadinho in Minas Gerais state in Brazil. This disaster has obviously taken an enormous human toll–at least 60 fatalities–but coming so soon after the 2015 dam collapse at the Samarco mine–a joint venture between Vale and BHP Billiton–this has brought the safety of the entire Brazilian mining industry into question. As Brazil is the second largest producer of iron ore, that obviously has brought supply issues to the fore.
So, benchmark iron prices (62% ferrous content; Qingdao exchange) have reached $88.16 per tonne today, after trading in fairly narrow range of $60/$80 per tonne for the 18 months preceding the Brumadinho accident. Some analysts are predicting that supply disruptions could cause a move through $100/tonne, a level last seen in the first half of 2014. That is an iron ore price level that, in my opinion, would cause smaller Chinese mills to significantly lower prediction.
The number one beneficiary of higher iron prices, by far, is Australia. In 2017 Australia produced 880 million tonnes of iron ore, double that of Brazil, and nearly three times as much as China’s domestic iron ore production.
There are a number of Australian ETFs available for U.S. investors, but by far the biggest is iShares’ MSCI Australia ETF, EWA. EWA has rebounded smartly, +9.45% year-to-date, after a miserable 2017, but still sits more than 10% below its level of February 6, 2014. This five-year underperformance has largely been caused by the devaluation of the Aussie dollar, which sits at $0.71 to the U.S. dollar today, versus $0.90 five years ago. With the Fed sounding as dovish as possible of late and 10-year U.S. Treasury rates unable to crack 2.7%, let alone 3%, I believe the U.S. dollar is currently overvalued, and thus non-U.S. investments will outperform in 2019.
Perversely, higher iron ore prices also help the Brazilian stock market, even as the human toll rises there. The iShares MSCI Brazil ETF, EWZ, has been an absolute rocket ship this year, returning 17.8% year-to-date. The policies of Brazil’s recently elected President, Jair Bolsonaro, often referred to as the “Tropical Trump,” have excited market participants much as the election of the original Trump juiced the U.S markets in November 2016 and beyond.
So, EWA and EWZ are ways to play higher iron ore prices and also to hedge against further uncertainty in U.S.-China relations.