Steel Rallies on Trump Memo, but Our Outlook Is Still Negative

Share prices for operators across the U.S. steel supply chain rose after President Donald Trump dusted off the Trade Expansion Act of 1962 as a vehicle for potentially tougher barriers against steel imports. Trump’s official memorandum empowers Commerce Secretary Wilbur Ross to investigate “the effects on national security of steel imports.” More specifically, the investigation will analyze U.S. capacity relative to the country’s needs for national defense requirements, the effect of imports on the welfare of the industry, unemployment effects resulting from imports, and the likelihood that global overcapacity can be reduced.

Given the wide-ranging list of criteria regarding the conditions that represent a threat to national security, it is difficult to surmise how the Commerce Department’s findings will be manifested in the form of policy. Furthermore, considerable uncertainty exists as to how any such policy might be translated quantitatively in the form of tariffs. One possibility would involve a blanket tariff against all imports. However, we are skeptical that any such tariff would be sizable enough to materially alter our long-term industry outlook.

If a significant blanket tariff were to be enforced, it could bolster steel prices and, in turn, increase production costs for industries that consume large amounts of steel, such as nonresidential construction and automotive manufacturing, among others. In that case, we’d probably see considerable pushback from affected trade groups. Steel purchasers would probably argue that the cure is worse than the cold when considering the broader economic implications. In this scenario, steelmakers would be able to capture economic rent from those further downstream the supply chain, and we’d reassess our industry outlook accordingly. However, under our base case, our long-term outlook is unchanged, as we don’t view a significant change to the status quo as likely.

Trump’s memo inherently expresses the view that, even after a barrage of steel trade cases, the Commerce Department has been ineffective in leveling the playing field for U.S. steelmakers. However, the fact remains that purchasers will always have the choice to buy from U.S. steel mills or from producers abroad. Trade protectionism simply factors into the spread that will be sustained between U.S. steel prices and world export prices.

U.S. mills would certainly prefer that purchasers behave in a more “patriotic” manner (as CEO Mark Millett put it during Steel Dynamics’ April 20 earnings call) by eschewing imports. However, it is unrealistic to expect steel buyers to sacrifice margin in the name of buying American unless more-stringent legislation compels them to do so.

Share prices for U.S. steel supply chain operators had fallen in the weeks before Trump’s directive, but we continue to see considerable downside ahead under our base case. The spread between U.S. prices for hot-rolled coil and world export prices has expanded rapidly as U.S. prices have remained elevated amid a decline in world export prices. Although a wider spread is partly justified by more stringent import tariffs, this phenomenon has historically led to rising import volume.

Bulls contend that this time is different, as higher imports will be stymied by the bevy of steel trade cases that have been levied in recent years. We’re skeptical on this front. Even though trade cases targeting key exporters across a variety of high-volume product types have led to increased duties, imports still account for roughly a fourth of total steel consumption in the United States. Although this is down from consistent 30%-plus levels in recent years, the impact has been more modest than many market participants would have predicted.

Additionally, trade cases can sometimes lead to counterproductive results. First, weak duties (typically 10% or lower as a general rule) resulting from trade cases often have little impact on import volume. At times, they can even inspire sharply higher import volume by essentially giving the green light to high-volume exporters. Additionally, when highly punitive duties are levied against a targeted country, it isn’t uncommon for other countries to capture some or all of the forgone tonnage. We saw this dynamic play out at the end of 2015 when cold-rolled coil from China was eliminated from the U.S. market but volume from Vietnam and Turkey (which had previously been minimal) entered the market en masse and captured nearly all of the tonnage forgone by China. This whack-a-mole phenomenon would be rendered irrelevant if the investigation stemming from the April 20 memorandum leads to a blanket tariff against steel imports from all countries.

Although global steel prices far exceeded our expectations in 2016, we contend that higher prices were driven in large part by elevated Chinese fixed-asset investment stemming from stimulus measures. Bulls have been quick to argue that higher Chinese steel consumption and higher steel prices represent a sustainable improvement to market fundamentals. Additionally, bulls contend that China’s promises to address rampant, persistent overcapacity will take hold sooner rather than later. We don’t buy into either argument. Instead, we view the rally as a stimulus-driven head fake along the path of a more substantial downtrend.

Rhetoric from the Trump administration has captured considerable news flow and mind share regarding the attractiveness of investing in U.S. steel supply chain operators. However, for long-term investors, the primary focus should always remain on market fundamentals. With Chinese steel prices and the benefits of Chinese stimulus measures again on the wane, we expect steel, iron ore, metallurgical coal, and ferrous scrap prices to decline from current levels by the end of the year. Accordingly, we think 2017 will represent a cyclical peak for U.S. steel industry profits as the benefits of trade protectionism are overshadowed by a resumption of the hangover from China’s commodity supercycle.

Trump’s memo follows a March 31 executive order to enhance the collection and enforcement of antidumping and countervailing duties and violations of trade and customs laws, as well as an April 18 executive order reiterating the faithful execution of U.S. “buy American” and “hire American” policies. Depending on how they are implemented, both of these executive orders could benefit the U.S. steel industry. Ultimately, however, we firmly believe that the fortunes of U.S. steelmakers will remain closely tied to global fundamentals, with protectionist trade policies providing only fringe benefits. The Trump administration has long argued that regulation spawns inefficiency. Steel purchasers would undoubtedly hope that heavy-handed regulation of steel imports avoids doing the same.