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), United States Steel Corp. (X), ArcelorMittal (MT), AK Steel Holding Corp. (AKS) and Nucor Corp. (NUE).

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.