China’s ‘zero-COVID’ strategy is starting to bite. Last month, China’s Purchasing Manager Index (PMI) for the manufacturing industry was 47.4%, down 2.1 percentage points from the previous month. The Non-Manufacturing Business Activity Index (41.9%) fell even more, down 6.5 percentage points month-on-month, highlighting the drop in consumer demand.

In late April, China’s President Xi Jinping vowed to increase infrastructure spending to simulate the economy, but this commitment seems more than challenging while mass lockdowns continue. Overall, China’s 5.5% GDP target for 2022 looks increasingly unrealistic as we move towards the second half of the year.

Although Q2 traditionally marks the peak of the Chinese construction season, steel production remains subdued. Steel output rose in the first ten days of May compared to April, as some maintenance exercises were completed, but is still 3% lower on a year-on-year basis. Mills are adopting a prudent stance and adjusting their output to current demand. Prices have been soft, and relatively high raw material costs put pressure on margins. China’s National Development and Reform Commission (NDRC) has reportedly called for a cut in crude steel production in 2022, encouraging mills to focus on quality rather than quantity. Given the COVID-related restrictions, lower output should be easier to achieve this year than last.

Outside of China, the ongoing conflict in Ukraine, sanctions related to it, and aggressive tightening monetary policies by Central Banks have the potential to trigger a global economic slowdown which would add further downside risks to global demand and steel production.

Despite weak demand, the price of iron ore has been supported by constrained supply from the large miners. The latest quarterly production from BHP was flat, impacted by labour constraints in the Pilbara, while Rio Tinto and Vale production was constrained by operational issues and bad weather. Production should increase in the second half of the year, primarily at Rio and Vale, but downside risks remain on their latest production guidance.

The biggest impact of the Ukrainian conflict on iron ore has been on pellet prices, although the pellet premium to 65% Fe fines also declined in April, as Chinese mills shifted their purchase to lower grade ore and domestic concentrate, due to lower margins and deteriorating forex. The pellet premium is about 15% below Vale’s quarterly negotiated BF pellet premium.

The short-to-medium term outlook for iron ore will largely depend on if and when China’s COVID restrictions are lifted. As noted above, iron ore supply may increase in H2, but only moderately. A strong rebound in steel production in China would bring the iron ore price back to US$150-160/dmt. However, a more subdued recovery would likely keep prices ranging between US$110-140/dmt with downside, should the global macro environment worsen.

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