(The author is a Reuters columnist. The opinions expressed are his own)
--Clyde Russell is a Reuters market analyst. The views expressed are his own.--
By Clyde Russell
LAUNCESTON, Australia, Nov 5 (Reuters) - Iron ore and steel prices were buoyed by the strength of China's manufacturing indexes, but there is a risk the market is focusing on the wrong indicator.
The official Purchasing Managers Index (PMI) hit an 18-month high of 51.4 in October, while the HSBC measure reached a seven-month peak of 50.9.
Both PMIs indicate improving conditions in China's vast manufacturing sector and this was enough to spur gains in iron ore and steel prices.
But at the same time that the manufacturing indexes were looking up, the PMI for China's steel industry was heading the other way.
The steel PMI dropped for a second month, falling to 47.5 in October from 49.2 in September, according to the China Federation of Logistics and Purchasing, which compiles the index.
The decline to well below the 50-level that separates expansion from contraction on a monthly basis was driven by falls in overall production, finished product inventories and new orders, according to a Morgan Stanley research report e-mailed on Nov. 5.
The decline in the steel PMI fits with some other evidence that not everything is rosy in the sector, with average steel output falling 1 percent to 2.107 million tonnes in the second 10 days of October.
The drop was the second consecutive decline, following a 1.1 percent fall in output in the first 10 days of October, according to data from the China Iron & Steel Association.
The volume produced was also the lowest since the 10 days ended July 31.
There are also indications that steel inventories are rising, with association figures showing stocks at 13.2 million tonnes, up 3.1 percent since the end of August.
It's likely that this inventory build-up has continued in recent weeks, meaning that the mismatch between steel output and consumption may be increasing.
It also doesn't appear that exports are taking up some of the slack, with steel product exports dropping 4.4 percent in September to 4.92 million tonnes from a year earlier, according to customs data.
Year-to-date exports are still up 14.6 percent, but this strength seems to have built on exceptionally robust shipments in July and August, which recorded gains of 19.1 percent and 44.9 percent respectively.
So, what should the market believe? The emerging strength in the manufacturing PMIs or the weakness in the steel PMI?
As is often the case, the contrasting PMIs aren't necessarily at odds with each other.
It's certainly possible to have improving conditions in manufacturing and weakening fundamentals in steel at the same time.
In theory, an improving industrial sector PMI should act as a spur to the steel industry by boosting demand for metal products, but it still may be the case that in China spare steel capacity is larger than any potential increase in consumption.
What the steel PMI shows is that there is still likely over-production happening in the sector, which means the recent rebound in benchmark Shanghai Futures Exchange rebar may not be sustained.
The contract is up 2.5 percent since hitting a four-month low of 3,585 yuan ($588) a tonne on Oct. 28, closing at 3,673 yuan on Nov. 4.
Iron ore prices have outperformed steel, with spot Asian iron ore .IO62-CNI=SI up 3.5 percent since Oct. 28 and the new Dalian Commodity Exchange's most active contract gaining 3.7 percent over the same period.
If there is a contrast in the steel sector, it's between the ongoing robust demand for iron ore and the weak profitability of steel producers.
China's iron ore imports are up 9 percent in the nine months to September over the same period in 2012, with the third quarter recording the first-, second- and fourth-highest monthly totals.
October imports are likely to be strong as well, given the 3.2 percent on-month rise in September shipments from Australia's Port Hedland, the main export port for iron ore.
However, at some point the overcapacity in China's steel sector will have to be addressed.
While the recent gains in the manufacturing PMIs provide the possibility of rising demand in coming months, the problem of structural overcapacity remains.
(Editing by Joseph Radford)