The steel industry is poised to benefit from solid demand in the U.S and emerging markets like India. However, steel stocks have to struggle with equity market volatility and a host of other broader factors. Below, we discuss some of the key reasons and what investors in the steel sector can look forward to in the coming months and years.

Valuation Questions

Steel stocks have been one of the strongest performers in the market lately. The Zacks Steel Industry stock prices were up +156.4% in the past year, with industry’s stock price performance an impressive +21.2% since November 8th. This compares to +20.2% gain for the S&P 500 index in the past 12 months and +5.8% gain since the election. Based on most conventional valuation metrics, the industry is no longer cheap. This will likely make further gains difficult going forward.

A Rise in Cheap Imports in the U.S.

A slump in the domestic property market, which accounts for a significant part of China’s steel consumption, severe credit crunch and weak infrastructure investment are hurting steel demand in China.

China’s steel exports crossed the benchmark of 100 Mt for the first time last year in the wake of shrinking domestic demand and a flagging economy. Notably, China is the world’s top steel producer, contributing around half of the total global output.

The country has built up a massive excess capacity, posing a threat to the global steel industry. The worsening gap between supply and demand, along with barely any sign of a recovery, worsens the scenario further. The Purchasing Managers’ Index (PMI) for the Chinese steel industry has stayed below the mark of 50 for the past two years, indicating a noticeable disparity between supply and demand. These cheap imports hurt the margins of American steel players like Steel Dynamics Inc. (STLD - Free Report) , United States Steel Corp. (X - Free Report) , ArcelorMittal (MT - Free Report) , AK Steel Holding Corp. (AKS - Free Report) and Nucor Corp. (NUE - Free Report) .

Slowdown in China

As discussed above, demand in China has slowed down due to the country's tepid property market and weaker infrastructure investment. China’s economy grew at an annual rate of 6.7% in the third quarter of 2016, flat with the prior two quarters, marking its slowest in seven years. For 2016, the government anticipates the growth rate to remain in the same range.

While rebalancing progresses, the Chinese economy continues to slow down. Lower construction activities are leading to a slowdown in the manufacturing sectors, especially metal products. A recovery in the construction sector is not expected any time soon either.

Geopolitical Tensions

Performance of some key emerging and developing economies has deteriorated due to internal structural issues, lower commodity prices associated with China’s economic slowdown, and escalating political instability. Russia and Brazil are experiencing severe contraction in steel demand. Geopolitical tensions and political instability in the Middle East, Africa continues to have a negative effect. Political uncertainty in the Brazilian economy has resulted in a sharp decline in steel demand.

Excess Capacity: Perennial Problem

The biggest obstacle to persistent growth and profitability in the steel industry is excess capacity. The industry is under relentless pressure caused by years of excess steel-making capacity, further aggravated by weak demand and uneven economic growth. To solve this problem, steelmaking capacity needs to be reduced for the industry’s profit margin to reach a sustainable level, and to raise the capacity utilization rate from below 80% levels. The industry remains highly fragmented compared to other global businesses and the restructuring and consolidation needed to eliminate overcapacity is progressing at a slow pace.

Impact of Low Oil Prices

The energy sector, which was once buoyant due to shale discoveries and rising production of crude oil, accounts for 10% of steel consumption in the U.S. Steel is necessary to make rigs and transport oil. Steel demand from the energy sector is being impacted as exploration companies have reduced their capital expenditure budgets in the wake of tumbling oil prices.

Steel products used by the energy industry are also known as oil country tubular goods (or OCTG). U.S. Steel being the biggest supplier of these goods in North America is bearing most of the impact.

Lower oil prices would urge energy companies to preserve capital to shore up their balance sheets instead of spending money on new exploration. Thus, leading suppliers to the energy sector, such as United States Steel and Tenaris S.A (TS - Free Report) , could continue to be under pressure throughout the year.

Low Crude Steel Capacity Utilization

The crude steel capacity utilization ratio remained stubbornly below 80% in both 2014 and 2015. The average capacity utilization in the 2016 was around 69%. Excess steel capacity has been a perennial problem for the steel industry as steel prices generally move in tandem with capacity utilization rates. To remain competitive and rationalize operations, some major steel companies have resorted to idling their steel plants.

Increasing Use of Aluminum in Auto Industry

Currently, steel is the major raw material for the auto industry, the second largest steel consumer. However, major automakers like Ford Motor Co. (F - Free Report) , General Motors Company (GM - Free Report) and others are becoming increasingly aluminum-intensive, given the metal's recyclability and light-weight properties. The global push to improve fuel efficiency in vehicles is expected to more than double the demand for aluminum in the auto industry by 2025. Hence, in order to remain competitive, the steel companies will have to come up with better and lighter varieties of steel.

How to Play the Industry

The short-term prospects are a bit clouded considering the headwinds plaguing the steel industry globally as discussed above. So, it would be prudent to stay away from steel stocks that carry an unfavorable Zacks Rank now. Particularly, we suggest staying away from stocks such as Haynes International, Inc. (HAYN - Free Report) , which carries a Zacks Rank #5 (Strong Sell) and Carpenter Technology Corporation (CRS - Free Report) which carries a Zacks Rank #4 (Sell). Haynes International, Carpenter Technology delivered an average negative earnings surprise of 140.08% and 32.58% respectively in the last 4 quarters.

However, investors, who can look beyond the near-term clouds to the industry’s bright long-term prospects, may consider buying some steel stocks based on a favorable Zacks Rank. We highly recommend AK Steel, which sports a Zacks Rank #1 (Strong Buy). AK Steel delivered an average positive earnings surprise of 170.80%. You can see the complete list of today’s Zacks #1 Rank stocks here.

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