Macquarie thinks this is the chart to watch for the global steel outlook

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On the back of a resurgent property sector, Chinese steel production staged a dramatic recovery last month, rising by close to 100 million tonnes on an annualised basis according to analysis from Macquarie Capital, the third largest gain on record.

Despite continued weakness in Chinese steel demand, the rapid acceleration in steel output has certainly caught the attention of markets, bolstering sentiment towards the outlook for not only Chinese construction activity but also demand for iron ore.

Like many across the markets, Macquarie have been pondering what to make of the recent rebound in Chinese steel production.

Though the bank suggests demand may absorb this surge in production over the short term, it doubts this will continue past mid-year.

The bank believes that gauges on sentiment and new orders, along with inventory levels, should be watched closely to determine possible turning points in demand.

“Both the sentiment and new orders indicators from our steel surveys over the coming months will be very important,” says the bank.

“Steel trader inventory is a good indicator. At present, it is drawing rapidly, as you would expect at this time of year as we move into a better demand environment. If this starts flat lining, or even rising, this is a red flag for trouble.

“Should this happen, the implication is traders are no longer able to shift material as quickly, and they will reduce purchases from the mills, which in turn will have to cut both prices and production. A sequential gain in steel inventory was a good indicator of problems in each of the last four years – most notably in 2012.”

The chart below, supplied by Macquarie, shows the changes in Chinese steel inventory levels each year starting from 2012. Although inventories remain low by recent standards, should levels flat line or move higher later in the year, history suggests that it may act as a lead indicator to renewed weakness in steel prices.

While Macquarie believes that the Chinese economy has short term momentum, it believes that the government may have given “too much of a boost” to the nation’s struggling heavy industry, suggesting that “many of the structural problems they are trying to solve could become unmanageable”.

“We would expect a shift towards a tightening bias over the coming couple of months, and while property sales will remain strong (as this is the chosen asset class to drive 2016 growth) we would expect developer sentiment in this area to become more wary, leading to a normalisation in construction activity levels,” says the bank.

As a result, Macquarie doesn’t expect the strength in steel prices will last.

“There is a good chance that even with macro data continuing to surprise on the upside the strength in ferrous prices may not last,” it says.

“This would be similar to the late 2012 and 3Q13 cyclical upturns we saw. Such mini-cycles have seen steel and iron ore break away from the underlying downtrend (thus outperforming expectations) for short periods, before correcting quickly.”

Given the relationship between the two, should Chinese steel prices come under renewed pressure, it’s highly likely that iron ore prices will follow suit.

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