Iron Ore Tells Us A Story About The Chinese Economy

Iron ore is the key ingredient in the production of steel. Steel is a basic building block for infrastructure. In the heady days when the Chinese economy was booming, the price of iron ore soared. In February 2011, the price reached a high of $187.18 per ton.

Brazil and Australia are both major producers of iron ore. Back in 2011, the economies and currencies of these nations reflected the strong level of iron ore prices and other commodity prices.

That year marked the highs for many raw material markets. Since then, commodities have entered a secular bear market that has resulted in a series of lower highs and lower lows for raw material prices and iron ore is no exception. In early 2016, the price of iron ore was around $39 per ton, a decrease of 79% from the 2011 highs. The lower price of this important commodity is one of the factors causing a decrease in revenues and the value of currencies for major producing countries like Brazil and Australia. Along with the price of iron ore, both the Brazilian real and the Australian dollar have decreased in value dramatically since 2011.

The prospects for the price of iron ore continue to be negative for 2016. On Tuesday, December 22, the National Bank of Australia commented on the current state of the iron ore market and said, "Risk remains titled to the downside amidst stubborn oversupply and weak demand conditions".

The bank went on to say the price of the commodity could fall to the $30 per ton level in 2016. In early 2016, Citigroup said that the bear case for the price was $28 per ton. The main reason for the bearish outlook for the key ingredient in steel is the state of the Chinese economy.

China is still a growing nation.

However, the fantastic levels of growth seen in the nation over past years may become a distant memory for two key reasons. First, the Chinese economy is shifting from a heavy manufacturing economy to a consumer-oriented one. Second, the sheer size of the Chinese economy makes growth rates seen in the past harder to achieve. Think of it in these terms, it is easier to make a 7% return on a smaller amount of capital than a large one. The Chinese economy has grown to levels where maintaining double-digit levels of growth had become virtually impossible.

The official growth target for the Chinese government was 7% in 2015. As it became clear during the year that the lofty target would be difficult to attain, the government took steps to stimulate the economy. The Chinese cut interest rates by six times throughout 2015. They devalued their currency, the yuan, in a shocking move that rocked markets at the end of August. When the Chinese stock market plunged in the summer of 2015, the government stepped in with new rules and regulations that inhibited selling and encouraged or almost required buying to stabilize domestic equity prices. Despite these moves, China continued to experience a lower than desired rate of growth in 2015.

As China has become the demand side of the equation in many commodity markets, this resulted in growing inventories of raw materials and slumping prices. In early 2016, the Chinese stock market once again plunged.

The decent of the price of iron ore is a direct reflection of the economic slowdown in China. As the economy of the Asian nation shifts from manufacturing to a consumer based economy, the trend of lower demand for commodities like iron ore is likely to continue. Iron ore will eventually find a bottom; however, that bottom is likely to come from the supply rather than the demand side of the fundamental equation. Iron ore is approaching a price level where production will become uneconomic. At that level, output will grind to a halt and inventories will start to decrease. At that point, classic economic theory tells us that the besieged commodity will begin to rise from the ashes once again.

Meanwhile, as 2016 is the fifth year of a secular bear market in commodity prices, iron ore continues to be a market that is suffering from oversupply and decreasing demand from its biggest consumer, China. The price action in iron ore tells us that China continues to face a myriad of economic issues in early 2016.