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“Steel is a global cyclical and over there the pricing power has emerged because the largest exporter decided to decarbonise and this is a structural change. China is not going to come back to exporting 120 million tons of steel that it used to do and there is just not enough capacity to meet up for that lost supply. The steel industry’s changes are more structural in nature and should keep on playing itself out,” says Pinakin Parekh, ED-Metals & Mining, Oil & Gas, Cement, JP Morgan.

Is the golden period for steel over? I had started saying steel is the new gold; but now I am realising that gold is gold and steel is steel?
Right now, we are seeing a mini downcycle. What we need to understand is that globally steel prices come off starting April-May into September. There is a seasonal destocking; industrial activity slows down, prices come off and then prices start moving higher post October into Feb-March. There is nothing different this time we are seeing at least in terms of price trends globally and regionally.

Now obviously, the export tax is leading to very negative sentiment for investors but the question here is are we at the end of the global demand cycle? What we would highlight is that for metals, China accounts for 50% of the demand. The Chinese demand has been running negative since October of last year. At some point of time, once the lockdowns fade away, there is going to be policy support and that will drive demand higher from here.

China is more than 50% of every metal and so to that extent, at JP Morgan our house view is still that metal prices should move higher. Stocks obviously are pricing in a very severe earnings contraction which looks very unlikely at this point of time. I think overall strong cash flows, depressed stock prices and still higher commodity prices support our positive view on metals as a sector.

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You said stocks are pricing in earnings contraction, which is unlikely to happen. So why do you think stocks are pricing that in?
A couple of things. If you take a step back and look at ownership, this is a sector which had very decent foreign ownership and high retail ownership over the last 18 to 24 months. News flows started turning lower and obviously at this point of time, there is a very high degree of investors’ scepticism as to what policy makers would do in order to fight inflation.
If you look at it across the board, when one looks at commodities, Indian stocks have underperformed massively compared to global peers and so it is not as much a worry on the global commodity price cycle as it is a worry on what policy makers over here do and how does it impact earnings and in the backdrop of ownership, which was relatively high.

I do not think we need to worry as much about the commodity prices outside of India as to what happens within India and over here, in steel, for example the policy action has been laid out and one can price it in and move forward

The balance sheets have got healthy, the margins look promising but the regulatory action which has been taken on steel exports, can pose a threat to capex plans. Many believe that capex plans may get cancelled or delayed since exports would be out of the equation?
It would be interesting to see how companies do the pullback on capital expenditure plans. There are two parts to it. One is existing projects: if they are already 50-70-80% through, they are not going to put it on the backburner. One would want to bring them forwards as quickly as possible.

The second is new expansions and new projects. I think everybody would want to wait and see how long does the policy action stay in place. At some point of time, if steel prices cool off in India and globally, does export duty reduce or come off? I would be very surprised if companies were to go forward with newer projects if the export duty remains in place.

Do you think there is an argument to lower the multiples for both the ferrous and non-ferrous companies? Some believe that multiples could be lower by 10% to 15%?
That argument would have been valid if the stocks were trading at normalised valuation multiples. One year forward consensus earnings forecast across the board are meaningfully lower than what the companies are earning today. On those consensus earnings estimates, the stocks are trading between two to three times EV/EBITDA. I do not think there is an argument for multiples to reduce further from where we are at this point of time.

What happens in a recession scenario? Ultimately steel demand is a function of underlying growth in the economy. What happens to steel stocks if the underlying demand reverses?
The historical play book is about demand falls, prices fall, earnings fall that is how every recession has historically played out in the past. The only difference this time is that the price cycle we are seeing at this point of time across commodities is not demand driven, it is supply driven and the supply story started a few years back because of China, because of global under investment.

So to that extent, if there is recession and if demand falls, there are two questions we would need to ask: One, is it a global recession in the sense that does Chinese demand fall even further from here or is it a western world recession and Chinese demand holds up? Then the impact would be far lower.

The second is supply. There was no additional supply even when prices were very high. If prices were to pull back, will global supply even reduce further from here? So the point we are trying to make is that even in the next recession, it looks unlikely that margins would revert back to what we saw in the previous down cycles simply because there has been years and years of under investment.

The other moving part is the Russian steel is not there in the world. I have been told that Russians have the most efficient steel capacity. If there is any change on the war front and if the Russian steel comes back, could that have an impact on the underlying supply demand trend?
Again, we would not like to comment on individual countries and on the conflict but what we would highlight is that when talking to investors, the feedback that we have received is de-escalation will not necessarily translate into normalisation.

There has been a meaningful reduction in steel supply from the key exporting countries. The five big exporting countries globally are China, Russia, Ukraine, Japan and Korea. India is a very small one and we have seen either a reduction or an export duty in some of the countries. The seaborne steel market supply has only been reducing over the last few years and that does not look like meaningfully changing anytime soon.

Where does cement fit in? We can argue both ways for cement; pressure on raw material but demand remains intact?
We have not been very positive on cement as a sector and we still like metals and the view being that both the sectors are facing cost inflation. Cement is facing very severe cost inflation and our view is that thermal coal prices are unlikely to come off anytime soon simply because of what is happening with gas in Europe which essentially pushes up thermal coal prices.

Companies have had limited ability to pass on the higher coal costs and that ability has further got trimmed given the policymakers focus on inflation. In this backdrop, the consensus estimates for cement are substantially higher than what the companies are making today versus let us say metal companies.

On those high consensus estimates, the stocks are trading at cycle high valuation multiples. It is just that risk reward does not stack up well for cement unless one makes the assumption that coal prices are going to collapse from here, commodity prices are going to collapse from here which is not our base case.

Consolidation is happening in the cement sector. There is one large M&A deal, maybe more are coming. Could there be further consolidation in the cement sector leading to more pricing power?
Again, we would not like to comment on individual companies. At this point of time, the way we are looking at it is that the next six to 12 months are challenging for the sector given where costs are and demand has not really been very strong and that has limited the industry’s pricing power and we maintain that view that FY23 would be the same.

Steel is a global cyclical and over there the pricing power has emerged because the largest exporter decided to decarbonise and this is a structural change. China is just not going to come back to exporting 120 million tons of steel that it used to do and there is just not enough capacity to meet up for that lost supply. So the steel industry’s changes are more structural in nature which should keep on playing itself out.


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