A VIEW FROM THE TOP END

Markets:

Another few weeks have passed and markets continue to trade sideways as growth companies see their valuations ground down by rising bond yields, and value tilted companies benefit from the current broadening of the market. Since our last writing 10yr bond rates have risen 6% in the US as inflation expectations push the bond sell off further (remember yields move inversely to prices). The Nasdaq and S&P 500 finished the period up as the USD appreciated against the AUD, returning 0.63% and 1.84% respectively. The local share market was down 0.47% over the past two weeks. Utilities (+4.99%), healthcare (4.49%) and consumer discretionary (3.09%) sectors led the ASX, while energy (-1.67%), industrials (-1.36%) and materials (-0.89% includes mining) were the laggards.

Iron and Steel Forever Together:

Australia is the world’s most important producer of iron ore, but despite being one of the premier mining nations on the globe, where that iron goes, and what it becomes is a bit of a mystery. If we are going to talk about iron ore, we are talking about the steel market, as 98% of the iron dug out of the earth is turned into steel. For nearly 4,000yrs humans have been crafting steel, it is 1000 times stronger than elemental iron, similar in weight and incredibly versatile. It is no wonder that as humans we use 20x as much steel as second place aluminium.

As mentioned, steel is an enormous market, with world consumption topping 1,889 million tonnes this year and demand is growing at 2.6% per year. The linkage to iron is 1.5kg of iron ore to 1kg of steel, and Australia produces nearly 900 million tonnes of ore a year, exporting it abroad and pocketing over $100bn annually from the transaction. In a country that has an annual GDP of ~$1.4 trillion, iron ore export is very important to our quality of life.

Now where does that iron go? Unsurprisingly, the answer is China, as they import nearly $93bn a year, 75% of the total export supply, to feed the world’s largest steel industry. The steel that the Chinese produce from that iron ore ends up 30% in the construction industry (residential and non-residential), 30% in infrastructure, 30% in machinery / transport and the final 10% ends up in appliances. With the pandemic on the run in 2021 and stimulus checks in the pockets of millions, there are significant tailwinds behind all of steel’s markets.

Since we know the market now, what about the detail, how is steel made and are their substitutes in the process? To answer there are two main methods of making steel.

• Blast Furnace (70% of world steel production): Iron ore is dug out of the ground, processed, and shipped from our shores at 55-65% iron content. Finished steel is 98% Fe (Fe is iron’s periodic table symbol) and under 2% Carbon (C is carbon’s periodic table symbol). To upgrade the raw iron ore, the material, plus some limestone to catch impurities, is fed into a blast furnace fired with metallurgical coal that has been reduced to coke (pure carbon with no impurities). The coke has three functions. First it chemically reacts with the iron ore to remove oxygen and leave pure iron, second it acts as fuel for the furnace to generate heat and finally it acts as a source of carbon for the finished product. Out of the first phase of the blast furnace you get a brittle version of steel that is 95% iron and 5% carbon, its name is pig iron. For the second phase the hot pig iron is fed into another furnace to burn off the excess carbon with pure oxygen blown over the hot metal at supersonic speeds. This removes any remaining impurities and burns off excess carbon with carbon monoxide as the emission. At the end you are left with 98% iron and less than 2% carbon…Perfectly formed steel!
  


• Electric Arc Furnace (“EAF” - 30% of world steel production): The EAF method relies on scrap steel as a feedstock or “sponge iron”. An electric arc furnace is a one step process that uses three graphite rods charged with electricity until the electricity “arcs” and generates heat, melting the scrap or sponge iron. During the heating phase coke and limestone are added to the process to reduce impurities and get the proper carbon / iron mix. EAF’s emit less greenhouse gases, but rely on scrap steel for feed stock, unable to take less processed grades of iron ore or iron pellets. Unfortunately, EAF is also known to make a lower grade of steel than the blast furnace process.


• Future: Blast furnaces are an enormous emitter of greenhouse gases, both through the energy they deem from coal (coke) and the reduction process of the iron ore into steel that emits CO2 and carbon monoxide. All is not lost though, as there are ways to replace coking coal and clean up the steel making process. The most promising method is replacing coke with hydrogen. When hydrogen is used in the process the emissions are water. Unfortunately limiting hydrogen’s adoption is that to produce hydrogen you need to get it naturally as part of natural gas extraction, or you need to run a costly electrolysis procedure to create hydrogen from water. Renewables give hope to the hydrogen-based process of making steel, but legacy equipment will also need to be retrofitted.
  
  Another path to greener steel could be scrap replacement and electric arc furnaces. The lower emission steel making process using EAFs is limited by the availability of scrap steel. Supply is so short, in times of scarcity countries limit the export of scrap metal to support local steel industry. The world is hungry for the material, and one replacement is direct reduction iron (sponge iron). Direct reduction iron itself is unstable and prone to spontaneous combustion, but can be stabilised by pressing it into briquettes, known as HBI (Hot Briquetted Iron). The process involves natural gas to convert iron ore to HBI, so factories are found where there is abundance of natural gas production. The current lead exporting region is the Middle East as it dovetails with their existing fossil fuel industry. HBI, like scrap steel commands premium pricing, so there is an economic case to build more processing facilities as electric arc furnaces become more prevalent with tighter environmental standards.

Now that we know all about the different steel making processes, lets look at the two dominant forms of naturally deposited iron. The world’s most popular iron ore is hematite, also known as direct shipping ore. It can be mined and sent straight to the blast furnace and is non-magnetic. It is the most popular type of iron ore found in Australia and is a big reason why the Aussie miners in the Pilbara find themselves as the lowest cost producers in the world.

The second most popular type of iron ore is magnetite, which by molecular weight is higher in iron content and magnetic. Unfortunately, despite magnetite’s higher iron content, it is generally deposited in lower concentrations than hematite, so it needs to be processed to meet steel foundry specifications. Brazil’s miner Vale runs the world’s largest magnetite mines in Brazil and coincidently is also the planet’s largest producer of pelletized iron ore. To make pellets the magnetic properties of the magnetite are used in a physical rolling process to create high concentration pelletized ore that fetches premium pricing, offsetting some of the cost of the naturally occurring lower iron concentrations that plague magnetite deposits.

Now it is harder to stay on top, than it is to reach the top. As the world’s number one exporter of iron ore, the threat of being unseated is real, however, Australia does have some natural advantages that will see it unlikely to be dethroned in the next decade. As the lowest cost producer, and the advantage of hematite over magnetite to keep future processing costs low, Australia is poised to remain a strong competitor in iron ore export. New production from a mega project in Papa New Guinea sees mines backed by China, but they are not scheduled to come online until 2028, and their production will only displace 10% of the Aussie production into China. With the demand for steel already growing, numerous infrastructure packages, and low interest rates to drive construction, the future is bright this decade for iron ore mining.

Updating our checklist:

• Valuation: The ASX200 P/Efwd is 19.17x and the S&P P/Efwd is 22.91x. We do expect these figures to revert to the mean over the next few years, but we do not expect it to come from a price fall in the market necessarily. Expansion expectations are high for global economies this year and next. That growth in GDP will translate through high operating leverage to company’s bottom lines and grow earnings quickly this year. During the pandemic, companies cut expenses and increased productivity to achieve that operating leverage. Now is the time to reap the benefits of that belt tightening as profits should expand and bring the P/Efwd back to 10yr averages.


• Global PMIs: This week we got very strong Chinese PMI surveys, suggesting that the preceding surveys from Jan/Feb were lower due to COVID outbreak control measures rather than a severe tightening in Chinese credit and manufacturing. The rebound seen in March suggests that the service and manufacturing sectors continue to run at near full capacity. That dynamic should be good for global growth and commodity demand.
  


• Downgrades on guidance: After the Easter holiday, we will start to hear Q1 figures and receive quarterly guidance out of the US for Q2 which will lead the Aussie sectors. Until then, COVID lockdowns, rising yields / inflation expectations, and policy changes (e.g.: taxes) will dominate the conversation. We do expect Q2 and H2 to be good for markets as reopening will be more of a story, and leaner companies that cut during the pandemic will be able to take advantage of their newfound operating leverage with expanded profit margins. One early reporter, Micron (a semiconductor producer), came out this week with better-than-expected earnings and upgraded their Q2 outlook, adding evidence to our hypothesis.


• Infection rates to slow globally: Brisbane was in lockdown this week, with Easter holidays on the cusp of cancellation, so we were HYPER focused on Australia’s COVID story and current vaccination rates. Australia is ticking up and is roughly a month behind where Canada is as far as vaccination rate, but we are still far from the clip we need to achieve herd immunity by the end of the year. By our count Australia fell 3.4million vaccinations short of the January promise of 4million vaccinated and 1million vaccinations short of the updated March target. It is likely that, like other countries, Australia’s vaccination rate will ramp up significantly during the year, so all is not lost for those that have hopes of a holiday overseas at Christmas time. We do expect an announcement this month (April) of a travel bubble, without quarantine, to be agreed with New Zealand.
  
  You can follow Australia’s vaccination journey with our live vaccine tracker at the link below:
  
  TFM Vaccine Tracker




• Monetary and Fiscal stimulus announcements globally: Abroad, President Joe Biden is set to release his much-anticipated infrastructure plan this week. Speculation is that the plan will include up to $2.3trillion in spending over the next 8yrs and would dwarf the 2015 infrastructure plan that rang in at $305bn spread across 5yrs. The 4x larger Biden plan is set to be paid for with corporate tax hikes that will see a minimum tax implemented and corporate rates bumped from 21% to 28%. The US is not alone in targeting corporate taxes as the UK is set to increase taxes on businesses from 19% to 25% by 2023. Higher taxes will have an impact on company earnings for those exposed to these two markets. Overall earnings reductions for Aussie companies are expected to be 3-4%, with standouts like Appen, James Hardie Industries and Janus Henderson twice as exposed.
  
  
  JobKeeper expired this week, as did the latest HomeBuilder subsidy scheme. The JobKeeper impact will not be known until the April labour force figures are reported in May. Early estimates are that 150,000 people could be impacted by the cancellation of the program. Most of the impact is focused within the hospitality and tourism industry. Both have recently seen support from the Federal government in a target stimulus effort that sees the Feds picking up 50% of select airfares and tourism activities in affected regions. As for HomeBuilder, the program drove a 36% surge in housing approvals and alterations the past 12months. After the halt of the program applications are tipped to fall back.

With inflation at the forefront of the conversation, we have seen a lot of comparisons to the 1970s and early 1980s where inflation spiked to double digits. We note that at the time Keynesian ideas dominated suggesting that governments spend their way out of recession. While this idea does have merits, in the 1970s, several other destabilizing manoeuvres by Central Bankers occurred which led to the hard economic times experienced during the decade. The move from the gold standard for the USD which led to the devaluing of the currency, expansion of the money supply in an economy with low unemployment and high inflation, and large budget deficits eventually eroded confidence in Central Bankers during the ‘70s. Once trust was lost, it was incredibly difficult to regain. It took the ideas of Milton Friedman, and his revelation that inflation was always a monetary policy issue for the market to regain faith in the Central Banking institution. Friedman suggested that the money supply should stop expanding and that would reel in inflation. The chairman of the Federal Reserve listened, rates went up, the money supply contracted, and inflation was halted.

Some of the boxes from that time are being checked now, but the key difference is that we have inflation expectations that are below 2% in the medium term, compared to 3-6% inflation from 1966-1972. We want inflation during the recovery and when Central Banks see inflation above their target for a period of 3yrs they will take away the punch bowl and make lending more difficult. Looking at the misery index below, which is the addition of unemployment rate and the inflation rate, we see that we are a long way off the misery of the 1970s and early 1980s, so there is room for loose monetary policy before inflation gets out of hand.

Despite inflation fears, the COVID recovery is still on and we do continue to see the current market as a great opportunity to invest any excess capital. If you are in a position to invest, there is no better time than now to book an appointment and speak with one of our advisors about your financial goals. Until next time, have a happy Easter break and we will be in touch in two weeks.

Regards,