* Rising material cost may hurt mills' margins - Morgan Stanley (NYSE:MS)
* China's steel demand seen dropping for a third year - CISA
By Manolo Serapio Jr
MANILA, Sept 26 (Reuters) - Shanghai steel futures stretched gains to touch a two-week high on Monday following recent similar rises in raw material iron ore, although a shaky demand outlook capped the upside.
China's steel demand is likely to shrink for a third year in a row, even as an early-year rally in prices helped many Chinese mills return to profitability, Wang Liqun, vice chairman of the China Iron and Steel Association said last week.
China's crude steel consumption slipped 1.9 percent over January to July, said Wang. Stanley said the sharp increase in raw material prices and moderating demand growth should slow or partly reverse this year's gains in profitability among global steelmakers, "thus increasing cyclical earnings risks".
"While it is too early to quantify the impact of those trends on steel margins, we argue that slowing demand growth is likely to erode some pricing power of steel producers, all else equal," Morgan Stanley said in a report.
The most-traded rebar, a construction steel product, on the Shanghai Futures Exchange SRBcv1 , was up 0.8 percent at 2,316 yuan ($347) a tonne by 0308 GMT. It rose to as much as 2,353 yuan earlier, its strongest since Sept. 12.
A key risk to steelmakers' profit margins, Morgan Stanley says, is the surge in coking coal prices which has far outpaced the gains in steel prices.
Driven by a shortage in China and supply disruptions in Australia, spot Australian premium hard coking coal .PHCC-AUS=SI has soared 164 percent this year to $206.40 a tonne on Friday. Shanghai rebar futures have risen 37 percent.
Chinese steel prices were more aligned with iron ore, with the spot iron ore price .IO62-CNI=SI up nearly 32 percent this year to trade at $56.50 a tonne on Friday, also a two-week high.
On the Dalian Commodity Exchange, the most-traded January iron ore DCIOcv1 slipped 0.4 percent to 409.50 yuan a tonne on Monday, after touching a two-week high last week. ($1 = 6.6704 Chinese yuan)