The Greenwich Economic Forum—the yearly gathering of financial market influencers from across the globe—just wrapped (in borderless cyberspace, due to covid) with a look at the rising heft of China as a global market influencer. And this influence is increasingly being reflected in a single tradable metal: iron ore.
Speaking to investors at the virtual event this week, Jian Hong Chen, Managing Director, Chief Strategist and Head of FICC Research at China International Capital Corporation Limited, characterized iron ore as Asia’s “first global commodity.”
Proxies and more proxies
China is the primary destination market for global iron ore. China’s dependency on iron ore foreign trade exceeds 60% and contributes about 70% to the global seaboard market for that metal. Because 60 percent of the metal’s total cost is used in producing pig iron and crude steel (1.6 tons of iron ore are used to produce 1 ton of pig iron), iron prices are highly correlated with prices of finished goods, such as steel rebar, and China’s steel consumption—reflected in shipping indices such as the Baltic Dry Index (BDI) and Baltic Exchange Capesize Index (BCI) is a usable index for pricing.
Bilal Hafeez, CEO of macroeconomic research firm Macro Hive, told the forum that tracking China’s economic growth remains challenging, as the country’s official GDP data releases appear “artificially smooth.” Alternative datasets tend to show more realistic volatility, he said, and can be used as a truer proxy for Chinese economic activity: these measure could include the C-CAT (Chinese Cyclical Activity Tracker) Index, which is used by the U.S. Federal Reserve and other financial players, based on imports, PMI, railway traffic data and electricity consumption data; and finally, Chinese import data as reflected in exporting country numbers.
Hafeez noted that iron ore, as China’s third-largest import (behind integrated circuits and crude oil), is a fairly reliable tracker of overall Chinese economic activity, with a correlation of 54-59 percent (between iron ore prices and estimated growth figures) viewed as a coincident indicator. The correlation rises to 60-65 percent correlation when viewed as a leading indicator, suggesting that iron prices reflect forward-looking expectations about Chinese economic growth.
The spread between iron ore with different grades can also serve as a leading indicator in analyzing supply and demand. Jian Hong Chen told the Forum that profit margins of Chinese steelmakers have been high since 2016, when China’s government pushed vigorous reforms, which had the effect of curbing supply. More high-grade ore was imported and prices rose in tandem.
Ways to trade
Jian Hong Chen pointed to a number of different trade strategies that investors have used in this market. Some take long (bullish) positions iron ore and short steel rebar if they expect steel mill profits to decline. Likewise, investors could long steel rebar and short iron ore if they expect steel mills profits to increase. He said steel mills profits bottomed in mid-2016 before peaking in 2018. Currently, profits are near the low of 2016.
As an intercommodity arbitrage play, some investors are taking long positions in steel and short non-ferrous metals futures, for a purer China economy play, due to the ferrous metals price being more closely related to China’s economy. As China’s economy has outpaced its global peers over the past several years, non-ferrous metals have been a closer indicator of global risk appetite.
Bilal Hafeez suggested another inter-commodity arbitrage is to short the Singapore iron ore futures contract and buy WTI or Brent futures oil contract until they converge, in the anticipation that iron ore price momentum is slowing, and is overvalued relative to oil. He said current iron ore price momentum reflected in the Micro Hive Growth Tracker suggests weaker forward-looking growth in China— something Jian Hong Chen attributed to lower anticipated growth in real estate and infrastructure building.
Finally, he said, Jian Hong Chen said that a simulated RMB (renminbi) hedging strategy could be achieved by trading iron ore contracts on different exchanges, the Dalian Commodity Exchange (DCE) and Singapore Exchange (SGX). Buying long DCE iron ore contracts and shorting SGX iron ore contracts, investors are able to create a “synthetic” RMB position, by actually trading onshore/offshore iron ore ratio. This strategy has been particularly attractive to financial institutions of late, he said.