CommentaryMarket Analysis

Last week was quite the week in Europe.

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U.S. readers may only be picking up the roller coaster in Italian politics via the fluctuations in their pension fund share portfolio values, but it is probably no exaggeration to say European democracy has been tested this week … and the process is far from over.

Italians kicked the process off with March parliamentary elections that ushered in months of wrangling between the two biggest winning parties, the anti-establishment Five Star Movement (or M5S) and the far-right League, formerly known as the Northern League. Both are considered to be the most extremely populist parties Europeans have voted for in decades. When they finally formed a working coalition with an aim to form a government, markets got nervous that many of their campaign promises may actually be put into practice.

Sound familiar?

Well, those fears crystallized when Five Star Movement head Luigi Di Maio announced the appointment of Euroskeptic economist Paolo Savona for finance minister, before the Italian president overruled them (at the behest of Brussels, many believe).

Even if President Sergio Mattarella acted in isolation, his willingness to go against the politically elected representative with the avowed aim of protecting the Euro and the European ideal, is a remarkable case of prioritizing European stability over national democracy. His actions were no doubt attended by sighs of relief in Brussels, Paris and Berlin, where the rise of populist parties in Europe and elsewhere have been met with disdain and derision.

Savona is well known for his anti-Euro views and his proposed appointment spooked markets, which promptly took fright. Investors dumped Italian debt and spreads between Italian and benchmark German rates spiked.

Source: Reuters, Adam Samson/Financial Times


Meanwhile, bank shares across Europe were dumped as investors feared Italy could crash out the Euro and banks would be left nursing massive liabilities, despite the fact most debt is held by the European Central Bank (ECB) after months of bond buying under quantitative easing (QE).

The bank share price collapse is what led downfalls in share prices across the world. Yet, after a few days of uncertainty, markets are recovering after M5S indicated it may be willing to reconsider the appointment of Savona. The League is not sounding quite so conciliatory, but the two parties are back in discussion to try to find a solution.

The irony is if Italy is forced back to the polls, the two parties will probably increase their share of the vote. There has been widespread support across Italy for their actions since the March election, but if they increase their share of the vote it will provide an even clearer mandate for an anti-austerity, reflationary, debt-fueled agenda.

Early comments from European politicians — such as Günther Oettinger, Germany’s E.U. commissioner — that upheaval in the markets would exert healthy, pro-European discipline on Italian voters were met with derision across the country, as it was seen as Brussels telling the Italians how to vote. Oettinger’s comments on German television — “My concern and expectation is that the coming weeks will show that developments in Italy’s markets, bonds and economy will become so far-reaching that it might become a signal to voters after all to not vote for populists on the right and left” — were promptly slapped down by more media-sensitive officials, like European Council President Donald Tusk, forcing Oettinger to issue an apology.

Italian President Sergio Mattarella tried to appoint Carlo Cottarelli, a former International Monetary Fund (IMF) official, to form an interim government, but that simply encouraged M5S and the League to get back to the negotiating table to find a solution of their own.

This story has a long way to run.

Italy has lagged behind the rest of Europe’s major economies for the last decade with minimal growth. Voters blame the E.U. — and, in particular Germany — for the trend. Germany is running a persistent current account surplus of 6%, well above E.U. rules, yet is not being held to account.

Italy feels if Germany can break the rules to the detriment of fellow E.U. states, then why cant they? Why should the economy be hobbled by debt limits and austerity when fellow E.U. members flout the rules?

You can see their point.

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In such an atmosphere, the rise of populist parties is understandable, even if their solutions make little economic sense.

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Well, he went and did it, didn’t he?

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Against advice from consumers and pleading from politicians in Europe and the Americas, President Trump went ahead with the imposition of 25% import tariffs on steel and 10% on aluminum from the E.U., Canada and Mexico.

Stock markets dropped on the news and politicians blustered while the biggest loser, U.S. consumers, resigned themselves to paying higher prices for the foreseeable future.

According to the Financial Times, those three economies accounted for 44% of all U.S. steel imports in the first quarter of 2018. U.S. consumers are already paying more for their raw materials than the rest of the world following tariffs announced on other countries earlier in the year, the Financial Times reports.

Source: Financial Times

About the only people not complaining are producers (at least here in Europe).

Speaking to sales offices of European producers, there is firm belief little will change except U.S. consumers will end up paying 25% and 10% more for steel and aluminum, respectively. The U.S. does not produce anywhere near enough finished steel or aluminum to meet its massive domestic demand, and you do not bring new rolling or extrusion mills online in months — it takes years.

So, imports will continue to flow and consumers will just pay more. Admittedly, there will be a short-term blip; U.S. consumers have been buying ahead of the curve. One aluminum mill interviewed by MetalMiner confirmed its normal 3,000 tons of monthly sheet sales has been running at 8,000 tons recently in an effort by consumers to stock up ahead of a possible tariff. That stock will carry over into the summer, but if tariffs are still in place Q3 deliveries will resume as before, just at higher delivered prices.

Meanwhile, Mexico has already hit back with retaliatory tariffs against U.S. products. The Financial Times reports a Mexican minister saying, “Given the tariffs imposed by the US, Mexico will put in place equivalent measures on a range of products including flat steel . . . legs and shoulders of pork, sausages and other food preparations, apples, grapes, blueberries, and various cheeses, among others.” Sen. Patrick Toomey (R-Pa.) pointed out that the tariff on Mexico is particularly bizarre, as the U.S. runs a trade surplus on steel with Mexico.

Although European politicians have howled with fury at the imposition of the tariffs, it has to be said there appears to have been scant progress on talks over the last month aimed at avoiding a crisis.

The U.S., trying to negotiate on a range of bilateral trade terms, has argued that U.S. tariffs on European cars are much lower than E.U. tariffs on American cars – a seemingly unfair situation that as an observer is hard to see how it could be justified.

Never let it be said, though, that logic gets in the way of European Commission President Jean-Claude Junker. After calling the move “protectionism, pure and simple,” he reiterated retaliatory measures listed in a 10-page document published in March, which included Kentucky bourbon and Harley-Davidson motorcycles.

In reality, the E.U. has more to lose than the U.S. in a full-blown trade war. Although Germany’s exports of steel products are in a low single-digit percentage of German steel industry output, the country is a major exporter of automobiles and machine goods. Of all the countries in the E.U., Trump probably has his eyes set on Germany’s massive trade deficit with the rest of the world as much as he does the E.U. as a whole.

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Still, where this goes from here is anyone’s guess. If either side blinks first and shows willingness to negotiate rather than ratchet up the stakes, then there is a chance a trade war can be avoided.

A trade war is not what either side wants, but it is a risk Trump has shown he is willing to take.

What a difference a few days in politics makes.

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Just last week many analysts, including this publication, were optimistically speculating that President Trump’s aggressive application of tariffs to force a major realignment of U.S.-China trade terms was actually paying off. Although the tone and nature of the president’s position shocked politicians and business leaders around the world, raising the specter of a trade war, the howls of protest from Chinese politicians were also matched by indications that inward investment could be relaxed and import tariffs on U.S. products could be reduced in an effort to reach some kind of settlement.

The New York Times, however, reports that as the president’s position on North Korea falls apart, so, too, is progress with China — and the two may not be unrelated.

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Steelmakers’ fortunes are up, and for that we should all rejoice; an industry fighting bankruptcy or suffering long-running losses is not an industry that invests in its products or services.

But questions remain about how long the current run of good fortune will continue for Western steelmakers.

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Source: Financial Times

Posting Profits

On the plus side ArcelorMittal has just posted its best quarter since 2011 with EBITDA quarterly core profits rising 17% year on year to $2.5 billion for the January-March period.

Analysts quoted in the Financial Times put the recovery down to rounds of cost-cutting and efficiency instigated after the downturn of 2015-16. Rising global GDP and, hence, demand has built on these improvements to raise prices for steelmakers and, in particular, the delta between raw material costs and finished steel prices, lifting profitability to the highest in a decade.

Source: Financial Times

ThyssenKrupp of Germany posted a tripling of half-year earnings on the back of better sales prices and reduced losses, having offloaded its South American slab mill to Siderúrgica do Atlântico (CSA) and its Calvert, Alabama carbon and stainless mills to ArcelorMittal/Nippon Steel and Outokumpo, respectively.

Some would argue it got out at the bottom of the market and would have lost less if it had held on for a better price when the market turned, but both plants were making losses and ThyssenKrupp was under pressure from shareholders to turn the group around.

ThyssenKrupp is not alone — many steel mills have demerged, shuttered, divested or otherwise re-structured in order to focus on their more profitable opportunities in recent years and are reaping the benefits.

Eyes on Chinese Exports

However, the extent to which this happy state of affairs can continue lies, at least in part, in China.

As the Financial Times points out, a combination of industrial reform in China and positive profit margins has lifted steelmakers’ focus on the domestic market and reduced exports. From a peak of 110 million tons in 2015, China’s steel exports have shrunk by one-third to 73.3 million tons in 2017. The Financial Times credits this restriction of supply as helping restore a sense of balance to the steel market, which is reflected in regional price rises in Europe and North America.

There remains dispute about the depth and speed of the steel market restructuring program in China, but even if it is not as radical as the authorities claim it has contributed to sentiment and supported prices. The questions the Financial Times poses is thus: how long will this new balance last and, with prices falling in China, will exports rise later this year?

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Making Moves

An indication of European concern is a new registration program started just this month that requires importers to register all incoming shipments by origin, value and tariff code.

At present, there is no requirement for a license or any cases of approval not being given, but many see it as a first step to Brussels more closely monitoring steel (and aluminum) imports from China, Russia, etc., with a view to introducing quotas or tariffs if volumes rise.

For once, Brussels can be said to be ahead of the game.

You would think that U.S. Treasury Secretary Steven Mnuchin’s announcement last week of a “framework” deal that would see Beijing increase its purchase of U.S. goods and services and commit to reducing the U.S.’s $337 billion annual trade deficit with China would have been met with universal acclaim.

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Certainly, the stock markets surged on the news on what appeared to be vindication of the Trump administration’s hard-line approach to realign the stars of the US-China trade relationship.

Yet, as the Financial Times points out, the news has been met by howls of protest in some quarters of the U.S.

The Financial Times reports U.S.-China hawks fear that the Trump administration may be giving up the leverage it created by threatening tariffs on up to $150 billion in Chinese imports earlier this year and sacrificing a broader push for change in China.

Even accepting the idea that you cannot please all of the people all of the time, what chance does Mnuchin’s team have of negotiating either an increase in U.S. exports or a reduction in Chinese imports — or a mixture of both — to bridge this $337 billion gap?

None, is the immediate answer.

To be fair, the U.S. has set a $200 billion deficit reduction as its target, but even that is going to be extremely challenging. This is particularly true if the U.S. rightly sticks to its guns on respect for intellectual property rights and associated design theft in China, as this will limit U.S. firms from selling or sharing technologically sensitive products with China. For example, China is desperate to lift the seven-year ban on Chinese telecommunications company ZTE sourcing US parts, a ban which it says jeopardizes the future of the company and its 70,000 employees.

Mnuchin is said to be following a strategy of setting targets industry by industry, an easy first win being to ramp up exports of energy by some $50-60 billion. Bloomberg ran a report that identified considerable opportunities in ethanol, liquefied natural gas (LNG) and crude oil exports. China is already the U.S.’s second-largest buyer of crude oil, but demand is growing across all energy types and China could certainly switch supplies to the U.S.

Source: U.S. Energy Information Administration via Bloomberg

The U.S. is also a major supplier to China of agricultural products, particularly soybeans and cotton. The U.S. is not without its rivals, particularly Brazil, but while China has diversified purchasing there is scope within a central-command economy to switch more to U.S. sources.

Is that what the U.S. really wants, though, to become a raw material and agricultural products exporter like Russia or Brazil?

Surely, the U.S. should be promoting higher value-add goods and services as its priority? That’s where the jobs and future lie, but they also run counter to China’s avowed aim of becoming a world leader in advanced technologies itself, per its Made in China 2025 policy.

Forbes explains the program aims to increase the domestic content of core materials to 40% by 2020 and 70% by 2025. At present, domestic content is relatively low for high-tech goods, with the foreign content comprising more than 50% in these products on average. In some categories, such high-level digital control systems and high-level hydraulic components, China is almost entirely dependent on foreign production. ZTE’s reliance on U.S. components falls exactly into this situation. The short and simple route to achieving the strategy’s objectives is to pinch foreign designs and technologies until you can develop your own.

This story has a long way to run, but China hawks should not be alone in worrying that in order to claim the headline “deal” of a possibly temporary reduction in the trade deficit, the administration does not sell the farm down the road.

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There is much that is wrong with the global trading system. As the two largest players, the balance between the U.S. and China is the most stark. However, it is equally a very complex situation and, as such, is not well suited to a quick-fix deal.

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It is a question we often see on the financial pages of newspapers or news sites, but rarely take time to seriously consider the consequences – why is the West apparently in a period of stagnant productivity growth?

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A recent article in The Telegraph explores the position for the U.K., but many of the trends observed — and, likely, reasons behind — Britain’s poor productivity growth are very similar to those in the U.S. and the rest of Europe.

For the sake of good order, we should define productivity growth. Simply put, it is a measure of the efficiency of production, usually measured as the ratio of inputs to outputs, or output per unit of input. Clearly, for workers to be paid more without a firm going bankrupt, just as for a country to raise living standards without living beyond its means, productivity per unit of labour has to increase over time. And so it has broadly over time, but not in a straight linear fashion, and therein lies a clue to our current malaise, the authors of the article suggest.

The article draws substantially on comments made and work done by Ben Broadbent, the Bank of England’s deputy governor. Broadbent fears Britain is past its peak and destined for a sustained period of poor growth in living standards due to stagnant productivity growth. Measuring productivity growth is far from easy, not least because “work” changes. In the days when most outputs were delivered by the manufacturing industry, it was easier to measure inputs and outputs; in today’s digital world, many services, like the internet, are largely free at the point of use.

Yet even so, the trend is clear: over the past decade, productivity has grown by just 2.1%, according to the Office for National Statistics as quoted by the news source. That is compared to before the financial crisis, when it typically grew by more than 2% every year. As a result, for much of the 2008-2014 period, real wages were in negative territory, a situation that was variously blamed on the financial crash, low interest rates perpetuating companies that would otherwise go bust, and lack of finance to allow firms to invest.

But Broadbent believes it is more deep-seated than those reasons, saying the wave of benefits seen from digitization we accrued in the 1990s and early 2000s has now passed. In addition, he argues, our position now is more akin to the industrial world’s lull between the age of steam and the onset of electricity – the big gains arising from steam had all been made yet and the benefits of electrification had not been felt, such that firms did not have a technological advantage encouraging investment, growth and expansion or face the threat of being left behind.

So far, there is limited evidence of new technologies like the mobile internet, artificial intelligence and mass automation transforming productivity. Broadbent believes it is simply too soon, but that given time and further technological progress, we could see these technologies having a transformational impact.

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Let’s hope so. Combined with the impact on traditional manufacturing jobs that globalization has had in mature markets and the growing disparity in incomes during this century, populist politics could have a destabilizing effect on Western societies, which will only be encouraged by a prolonged period of flat, or worse, negative growth in standards of living.

Does your company strategy call for a European manufacturing base but you worry you have missed the boat in terms of accessing lower-cost opportunities created when eastern European countries like Poland and the Czech Republic came into the E.U.?

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Lower land and labour costs, aligned with ample financial support from the E.U. to the poorer parts of Europe created a fertile investment environment for new business growth in these eastern European states. With a good standard of education, generally good rule of law and a high work ethic, it is not surprising eastern Europe has gone through something of an industrial revolution over the last 20 years.

But for firms looking to set up in those markets now, they are the Johnny-come-latelies to a maturing investment environment.

But fear not — a new wave of entrants may be on the horizon.

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India has been champing at the bit ever since the United States imposed a 25% import tariff on steel and 10% on aluminum imports to protect its own industry.

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Last week, India told an informal meeting of heads of delegations at the World Trade Organization (WTO) that the U.S.’s move was an abuse of global trade provisions that could spiral into a trade war, the Economic Times reported.

India raised concerns and warned that this had a “clear risk of spiraling into a trade war” since it would prompt other countries to take retaliatory measures. The U.S. Department of Commerce in February had found that the quantities of steel and aluminum imports “threatened to impair national security.”

On March 8, the U.S. enacted the tariffs, invoking national security. (Since then, South Korea, Australia, Brazil and Argentina have won long-term exemptions, while the E.U., Canada and Mexico have temporary exemptions which are now set to expire June 1 after a 30-day extension was recently announced.) After the March announcement, several countries — China, India, the E.U., Russia and Thailand, among others — called upon the U.S. to enter into safeguard consultations.

India, specifically, said it would lodge a trade dispute against the United States at the WTO if Washington did not exempt it from the higher tariffs.

Following an outcry, U.S. President Donald Trump agreed to suspend their imposition until May 1 for Argentina, Australia, Brazil, South Korea, Canada, Mexico and the European Union — but India was not included on this list.

The U.S. had also rejected a request from India to enter into what are called safeguard consultations at the WTO.

India said it considered the U.S.’s measure to “be an emergency action/safeguard measure within the meaning of Article XIX of the General Agreement on Tariffs and Trade, 1994, (GATT 1994) and the Agreement on Safeguards.”

“As an affected member with significant export interest to the United States for the products at issue,” India said it wants “consultations with the United States pursuant to Article 12.3 and Article 8.1 of the Agreement on Safeguards and Article XIX:2 of the GATT 1994.”

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The U.S. said that under Section 232 of the Trade Expansion Act of 1962, Trump determined that tariffs were necessary to adjust imports of steel and aluminum articles that threaten to impair the national security of the U.S.

India has over-promised and under-delivered on so many fronts over the decades.

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Home of the world’s largest and, despite its young age and huge diversity, still thriving democracy, it has promised growth to rival China. Apart from brief bursts of activity, it has generally failed to live up to its plaudits expectations.

One reason often cited, apart from chromic infrastructure and the legacy of a British love of bureaucracy, is endemic corruption.

Graft had become so deeply engrained in Indian business culture that many had written the country off from delivering sustainable long-term growth for its hundreds of millions of poor. The relatively very few rich got richer while the miserably small middle class grew so painfully slowly compared to China that many thought India would never haul itself out of its emerging-market status.

But critics had not factored in Narendra Modi. While not everyone would support his Hindu-biased populism, he has brought immense progress to India, overcoming entrenched interests with a politically astute skill and dynamism.

There is still a long way to go, but a recent Economist article describes how he has taken the fight to the ruling business elites in a blitzkrieg campaign to dismantle tycoons’ practices of personalizing gains and socializing losses.

Founding shareholders of Indian companies have long made use of a loophole of Indian corporate law that prevents banks from seizing companies in default on their loans, so owners of companies can run their organizations badly or, worse, suck out funds for personal gain with little fear of losing their money-making enterprise.

The system has actively perpetuated this system with a bunged up judicial system that takes months, if not years, to hear cases and state banks’ lending to firms on the basis of personal connections rather than sound business-lending principles. This cronyism was almost encouraged by officials not wanting banks to post losses, such that state banks are kept afloat by the government yet are carrying massive debts which will never be repaid.

Modi’s government new bankruptcy code came into force in May 2016. After almost two years of preparation, the first big cases have hit the headlines last month, The Economist reports. The fate of 12 troubled large concerns amounting to 2.2 trillion rupees ($33.4 billion) of non-performing debts is due to be settled within weeks. Another 28 cases worth a further 2 trillion rupees are set to be resolved by September. Between them, these firms account for about 40% of loans that banks themselves think are unlikely to be ever be repaid. In total some 1,500 companies are said to be insolvent, according to The Economist.

A new set of dedicated courts, backed by a cadre of insolvency professionals, is on hand to help banks seize assets and sell them to fresh owners, the article states. To focus the minds of both bankers and borrowers, if no deal can be cut within nine months the firm is shut down and its equipment sold for scrap.

As a result, those looking for cheap, distressed assets are already circling for pickings from the current 12 and 28. Such turmoil on this scale will create a short-term drop in investment as firms hold off to see what becomes available. In the longer term, the process of death and renewal will probably be highly dynamic for the economy.

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It will also focus the minds of today’s Indian tycoons on running their businesses better and courting political favor less. Indian business is shifting focus from “who you know” to “what you know,” which is definitely a good thing for the health of the country in the future.

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On March 26, ATI Metals filed an exemption to the Section 232 tariffs on behalf of its joint venture (JV) with Tsingshan Stainless called Allegheny & Tsingshan Stainless.

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In November 2017, the JV sought to produce and market 60” wide sheet in the North American market, a width ATI can no longer melt and cast due to the idling of its Midland, Pennsylvania, melt shop. Chinese company Tsingshan, the largest stainless steel producer in the world, has supplied the slab since Q4 2017 from its vertically integrated mining, refining and casting assets in Indonesia.

ATI has been converting slab using its state-of- the-art Hot Rolling and Processing Facility (HRPF) in Brackenridge, Pennsylvania, and the JV’s Direct Rolled Anneal and Pickle (DRAP) facility in Midland.

Although ATI has long supported anti-dumping and countervailing lawsuits in the United States to combat unfairly traded imports, the JV presents a unique situation.

Although the final hot and cold rolled stainless steel is produced in western Pennsylvania, the slab is currently subject to the 25% Section 232 tariff because it is of Indonesian origin. To claim an exemption from the tariff, ATI must prove that there are no viable alternatives available in the United States.

In last week’s earnings call, Outokumpu’s CEO Roeland Baan stated that they could supply slab from its Calvert, Alabama, facility, and, thus, ATI should not receive an exemption. Others have proposed that ATI could restart its 60” wide melt shop in Midland, Pennsylvania, idled three years ago.

Are these options feasible?

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