Productivity and the post-crisis capital movements

In the medium and long-term, the countries and companies with higher productivity tend to be the winners. That is, disregarding market imperfections.  Therefore, observing recent productivity trends might provide us with clues as to the future. In particular, the difference in productivity gains between the U.S. and Europe, where Europe is lagging in productivity.  Even starker is the difference between the developed and less developed world, where the latter is showing strong signs of already having returned full force from the crisis.  

All this adds to the acute question of what we can learn from economic history. When is a country at the apex of its productivity curve? Given that we don't observe any disruptive movements away from a lower productivity growth in the  developed world, relative to the less developed world, there should be an acentuated production movement  from the developed to the less developed world.

What does this imply for capital movements? Return on capital should be better where productivity is higher. So, the BRIC countries should continue to receive foreign investments. Especially countries like Brazil should benefit, where we observe a democratic society, a stable legal system, a solid financial sector and a relatively well-functioning currency. China is a difficult choice: impossible to ignore but, lacking the institutional guarantees, one could lose everything tomorrow. India is moving towards a better business-climate. However, it might not have time to capitalize on this before other countries have surpassed its current cost-advantage. Then it would be restricted to its own domestic market, with a tendency to favor trade hinders and import duties. Russian is the energy provider for Europe. However, alternative routes and sources are trying to avoid the country. As there is no perestroika on the horizon, it is hard to imagine increased foreign investment.

In short, Brazil and China seem to have a good bet on the future, where Brazil will be hugely helped but foreign direct investment and China will try to run its own race. However, the two will have very intertwined destinies and the outcome will affect the rest of the world.

Upstream integration and the end of long-term raw material contracts

Shorter contracts and their implications for the steel industry

In order to capitalize on improving economic conditions, and subsequent price increases, the main raw material producers for the steel industry are rethinking the yearly contracts. They evidenced that even during such a dire crisis as the last one (2008-2009), the raw material prices do not fall too much. And the rebound is much quicker if the price isn't adjusted through long-term contracts (≥ 1 year). In fact, the aim is to mimick the spot prices. Therefore, BHP is moving towards quarterly contracts for coking coal and Vale for iron ore. Given a stable economic outlook, the trend is set to continue and include other suppliers.

What does this trend imply for the steel industry? Coking coal and iron ore are the biggest cost items in producing steel. A bigger variation in these prices could have profound implications for the way that the steel industry operates.

Given that the integrated steel plant is capital intensive, a constant high-level production level is important for two reasons, where the first reason converges towards the second. Firstly, productivity depends on constant production level. Varying the production volumes normally tend to decrease productivity and equipment life-time. Secondly, not using the highest possible production level, the fixed assets will quickly erase any EBITDA.  This analysis also holds true for mini-mills, though the impact is slightly lower given that the reduction area is really where constant production is essential.

With these considerations, it becomes obvious that the steel industry needs to try neutralizing price variations in raw materials. Formerly, this has been achieved through long-term contracts.  With a clear industry-wide tendency to approach spot prices even for contracts, the steel industry is forced more than ever towards upstream integration.

The upstream integration could take two forms: joint-venture/shareholder participation or full ownership.  In the first case, the bargaining power for more constant prices is strengthened through a formal, long-term relationship.  In the second case, the price is an internal decision, where the price could be anything in the range between the production cost to the market price (being a strategic decision where the company wants to generate the profits.).

In South America, Vale is quickly increasing their steel production business.  Thus, the other market participants in the area should be forced towards similar upstream integration, or they would become underperformers, and eventually, take-over targets. Given the logistics costs of iron ore, one could deduce that the price premium for well-located (read: close to existing steel plants) mines should be considerably higher than the general market valuation.

What will Q1 financial results for the steel industry look like?

On February 10th, both Mittal and SSAB presented their 2009 results and, more importantly, profit warnings for Q1 2010 results.

Why already now warn about the first quarter results?  I believe that there might be a couple of reasons, but the first and principle reason is that the crisis is not over (so prices are still low even as volume is coming back) and when it's over, the steel industry will still be bleeding. Once and for all the market structure has been changed -- in favor of the Chinese industry.  Trade intervention (read: the Americas and Europe) might very well delay this teuctonic change to appear before the naked eye, but it has already happened.

This might imply that the steel industry is an interesting investment in the short term, perhaps even the medium term. But in the long-term, the cyclical profits might not return. If that is the case, one has to analyse the systemic differences between the steel companies to see who is really fit for fight and in which markets.

In the short run, a difficult Q1 might help the investor to pick some great opportunities -- to hold in the medium term!

Market imperfections -- do they still exist?

One is painfully reminded of our hubris when reading Martin Rees concluding word in Seeing Further: The Story of Science and the Royal Society:

"Any creatures witnessing the sun’s demise 6 billion years hence, here on Earth or beyond, won’t be human—they’ll be as different from us as we are from bacteria."

With this in mind, we might be more inclined to understand that any equilibrium is, at best, a very short-term equilibrium. Market imperfections might not be as much imperfections as the very constant change of the underlying conditions resulting in the possibility of a new short-term equilibrium.

In Imperfect Information and Aggregate Supply, Mankiw and Reis conclude that even such a “solid” relationship as the Phillips curve is not so solid in the short-run, as there seem to be information problems. So far, so good. What isn’t addressed, and probably ought to have been addressed, is the question if there is such a thing as a long-term equilibrium that, in this context, can be expressed through the Phillips curve.  What if there tends to be constant structural changes that might allow us to believe that the economy tends to the old equilibrium, but which in reality, has been supplanted by a different, new equilibrium.  This fact is made subtle clear by the fact that the tools available today still are those of the rational expectations theory, which is from a temporal point of view backwards looking, that is, not able to foresee new facts, apart from skewing the past a little and then believe that will be the future. Here we can remember the quote from Rees and wonder if his statement – though speaking about a vast time span – shouldn’t have philosophic implications for our economic prediction approach. At least, we might become less inclined to look for an ideal world and realize that the ideal is the enemy of the good.

Brazilian economy is back on track? At least inflation is!

Living in Brazil, it is refreshing to read accounts from abroad, dealing with our everyday situation from a slightly different perspective.  This week's article in The Economist is showing the dangers to the economy -- and we should all remember that election years have a certain track-record of being economic roller coasters.

http://www.economist.com/world/americas/displayStory.cfm?story_id=15501901&source=features_box_main