The Surprising Sell Case For Rio Tinto plc

Today I am looking at an eye-opening reason why shares in Rio Tinto (LSE: RIO) (NYSE: RIO.US) are set for fresh pressure, despite fresh data from China that suggests that a recovery in commodities demand could be just around the corner.

Beware of Chinese whispers

In my opinion, investors should not be fooled by a slew of recent data from commodities glutton China, the world’s largest exporter and widely regarded macroeconomic barometer, which at face value points to an uptick in the global economy.

Most recently, optimism over a resurgence in the fortunes of the Asian powerhouse was given an additional boost by HSBC purchasing managers’ index (PMI) numbers released over the weekend. This produced a reading of 51.2 for September, the highest reading for six months and above the expansionary/contractionary benchmark of 50.

Still, Chinese PMI numbers are notoriously choppy, and this month’s readout follows a string of oscillating releases throughout the course of the year. On top of this, many of Rio Tinto’s key markets continue to display signs of worsening oversupply, a phenomenon that is set to drive prices still lower even if flailing confidence in the global economic recovery fails to deliver a body blow to commodities prices.

Latest data from the World Steel Association showed that, for the 64 countries covered by the institution, total crude steel production rose 5.2% year-on-year in August to 130 million tonnes. Although production performance was mixed across the globe, output from China — by far the world’s largest metal producer — advanced 12.8% to 66.3 million tonnes.

However, the general consensus is that there is no fundamental case to back up this surge in steel output. Excess material continues to flood the market despite a clear lack of demand recovery, a scenario that is tipped to lead to a marked slowdown in steel mill churn in coming months and with it iron ore demand. The iron ore market alone is responsible for around 75% of Rio Tinto’s earnings.

Indeed, for the bloated iron ore sector, broker Investec notes that “the spread between six month and 24 month futures continues to indicate that spot prices are high relative to longer-term prices”, and that continued oversupply in the steel market is likely to drag iron ore prices lower. With chronic supply/demand balances in vogue across all of the company’s main markets, including copper, coal and aluminium, I reckon that investors should be on guard for sustained earnings pressure.

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> Royston does not own shares in Rio Tinto.