China’s Supply-Side Reform Myth
In late 2017 many commodities investors foresaw a killer trade, expecting announced Chinese steel capacity cut reforms to smother output and jumpstart prices. Our data dispelled the notion that capacity, much less output, was actually falling. When official figures soon made clear that steel output was instead on track for a record high, our clients cashed in.
Situation
When in 2017 Beijing announced it would prioritize crackdowns on both pollution and industrial overcapacity, it was taken as gospel that the steel industry was in for an extended hibernation. This false belief drove up prices, under the mistaken notion that Beijing was finally committed to dealing with historic levels of oversupply.
Wall Street Forecast
“Chinese supply-side reforms should keep coal, steel and aluminum prices higher for longer. Though China is backtracking on coal cuts, production increases won’t go far.”
Sell-side research shop
“An aggressive reduction in excess capacity in several industrial sectors has been one of the key factors behind the revival in producers’ pricing power. Reflecting this, headline PPI inflation has risen to a six-year high of around 7%. We believe that policymakers will ensure that supply discipline is maintained.”
Global investment bank
Outside of naively taking Beijing at face value, market analysts failed to grasp two critical pieces of the puzzle—obvious from our private data.
First, to the extent that anti-pollution efforts are implemented in China, they often result in replacement of old capacity with newer, more efficient capacity, allowing firms to further crank up output without forcing the hand of environmental regulators.
Second, after years of operating deep in the red, steel firms were finally making money—and lots of it. Government proclamations aside, it would have made no sense for them to shut operations and fire workers just as the going got good.
CBB Forecast
Based on signals from our proprietary supply-side tracking, in December 2017 we warned clients that far from cracking down on oversupply, steel firms in our survey told us they were hiking overall capacity while investing, borrowing, and hiring more. The sector was gearing up, not backing down.
By spring 2018 our forecast was a clear winner, as data showed steel capacity, output, and sales rising faster alongside higher capex, borrowing, and hiring.
Result
Few of our calls encountered initial pushback than this one. But analysts who bought into Beijing’s claims of capacity cuts were in for a rude surprise when in April—a full five months later—reports of surging steel output during the winter season were released by the government. By late 2018 the worsening supply glut had sent. The Street consensus had not just gotten this one wrong, it had gotten it exactly backwards.
