London, 22 September 2011: Reuters

Divergence and disconnect are the names of the game in the industrial commodities sphere right now. Positive micro dynamics in the likes of copper are being smothered by a blanket of macroeconomic gloom and doom. Mining equities seem to be pricing in a worst-case scenario, or certainly a worse-case scenario than most of the underlying metals.

And LME-traded base metals are punching out fresh 2011 price lows, while bulks such as iron ore are holding lofty station. Signals proliferate but which of them is "correct"? Much of the current divergence is down to the differing time-horizons and assumptions held by industrial and speculative players, as my colleague John Kemp pointed out in a column last week.

Hedge funds, for example, view the combination of slowing manufacturing growth and accelerating financing problems as a sell-signal for cyclical industrial metals. Industrial players, by contrast, are still responding to micro signals, such as copper's fragile supply and heightened buying interest from China.

Fundamentalists will cite the still-robust ferrous sector, largely cocooned from the attentions of hedge funds, as a sign that selling of exchange-traded metals such as copper is overdone.

But the latest global steel production figures should cause pause for thought, since they too are now starting to show signs of divergence, in this case between China and the rest of the world.

CHINA DRIVER

Global steel production dipped sharply in August to 124.59 million tonnes from 127.51 million tonnes in July, according to the latest figures from the World Steel Association. Well, no surprise there. August is traditionally the weakest month of the year for steel production in the Northern Hemisphere and this year is no different.

The global rate of production growth is a more telling indicator and it was still running at an elevated 9.8 percent last month relative to August 2010. The driver remains China, where year-on-year growth slowed slightly in July but was still high at 13.8 percent. Seasonal summer weakness has been highly muted in China this year thanks to continued strong demand for long products from the construction sector.

That has meant smaller mills continuing to churn out construction products even while larger ones, particularly those selling flat products, took the usual maintenance downtime over July and August. Production looks set to re-accelerate as they return.

The more recent figures from the China Iron and Steel Association (CISA), showed Chinese production bouncing back above the 700-million annualised rate in the first 10 days of September.

That marked a 3.1-percent rise from the closing days of August but the production jump was higher at 4.7 percent for medium- and large-sized mills, according to CISA. Slower manufacturing growth in China combined with credit tightening in the country makes for an uncertain outlook going forward.

But right now, Chinese steel production is still booming. Since China is the biggest buyer at the margin of seaborne iron ore, that is what is keeping iron ore prices at their current elevated levels.

EARLY WARNING

Things, however, look a bit different in the rest of the world, where steel production growth slowed to 6.5 percent in August, less than half that in China. Most regions are still seeing positive year-on-year growth rates with the exception of Africa and Oceania. Political turmoil in North Africa has fed through to reduced steel production since the start of the second quarter.

Australian production, meanwhile, has nosedived over the last couple of months as producers such as Bluescope experience margin compression due to Australian dollar strength and shut capacity. North American steel production remains robust. U.S. production growth actually accelerated from 8.9 percent in July to 13.8 percent in August, matching that in China.

The warning flag, though, has gone up in Europe. Production growth in the core 27-nation euro zone bloc braked sharply from 8.8 percent to 4.3 percent between July and August. Everything is currently pointing to a further slowing of that growth rate.

ArcelorMittal , Europe's largest steelmaker, announced at the start of September it would shut down a blast furnace at its plant in Eisenhuettenstadt in Germany as a way of "optimizing production flows and aligning production capacities to seasonal demand".

Other steelmakers are on watching brief with a view to following suit. To some extent European producers may be paying the price for over-production in the first half of the year. But it is surely no coincidence that steel production is weakening, and fast, in the region that is the prime source of those macroeconomic woes causing turmoil in the risk asset universe.

FUTURE(S) UNCERTAINTY

There is still plenty of momentum in the global steel sector, first and foremost in China. But the nascent slowdown in Europe is a sign that macroeconomic uncertainty is starting to infect the "real economy" supply chain.

More evidence will come with the September steel figures, which "should" show a seasonal bounce-back from the summer doldrums in Europe. But if, as seems increasingly likely, that post-summer recovery fails to materialise, steel sector dynamics will start to echo in micro the macro doom-and-gloom that is permeating the futures markets.

Futures markets, of course, are there to facilitate the expression of future prices, which is why hedge fund selling predicated on a medium-term time horizon has been a dominant theme.

Although the world of ferrous metals is gradually opening up to shorter-dated pricing, a full-blown futures market is still missing, with the arguable exception of the Shanghai rebar contract. That makes the sector a lagging indicator and iron ore pricing, predicated as it is on Chinese marginal demand, an especially lagging indicator.

That's not good news for metals fundamentalists who argue that it is iron ore not copper that is transmitting the "correct" signal about the health of the global economy.

It may be for now. But for how long?

Ends --

By Andy Home, Reuters market analyst – for Commodities Now.

The views expressed here are his own.