The New Old China:Steel,Bullish 2017Outlook,Stable demand meets substantial curtailment

We expect supply side reform to mean a cut in operating capacity

On Dec 9, China’s Politburo reiterated that supply side reform is among thetop priorities for economic development, and that this reform process willenter a “substantial stage” in 2017. We think recent policy moves in thesteel space indicate steel supply-side reform is intensifying, and thereforethat “substantial” development for steel will lead to the curtailing of moreoperating capacity next year, after mostly cutting idle capacity in 2016.

Potential for the market to slip into undersupply in 2017

We believe the favorable market conditions in 2016 tested the productionlimits for China’s steel industry. We calculate that with stable demand andno loosening of emission control efforts in 2017, further production controlor curtailment could lead to market shortage — as seen with coal in 2016 —further boosting profitability.

Manufacturing demand explains above-trend 4Q steel demand

Steel demand has historically shown high correlation with infrastructureand property FAI. However, 4Q16 steel demand is significantly above trendcompared with these traditional drivers. We think this can be attributed torestocking in industrial sectors, after five consecutive months of recoveryin the PPI (Producer Price Index) and manufacturing FAI. We expect thisrestocking to chiefly benefit flat steel producers.

Raw materials prices to stabilize

We expect coking coal tightness will start to ease after Chinese New Year,when transportation and labor supply improve, and mines are betterprepared to meet safety regulations. This will remove the incentive to usehigh grade iron ore (which requires less coking coal/coke in steel makingthan lower grade ore), easing the temporary structural shortage in iron ore.

Buy flat steel (Angang) for demand; long steel (Magang) for supplyWe raise our 2017-18E earnings for Baosteel, Magang and Angang by 20-141% largely on our revised steel price forecasts (+14-28% in 2017-18Epartly on higher raw material prices post our global team’s iron ore priceforecast change). With these, our 2018E P/B-ROE based TPs rise 12-32%.

We upgrade both Angang-A and Magang-A to Buy.